For many years, company profits were taxed twice in Australia. The first time was in the hands of the company when they were derived. The second was in the hands of the shareholders when and if they were paid out as dividends. There was no ‘imputation’ of tax already paid by the company on those profits when they were paid out to the shareholders. This meant there were very high effective rates of income tax on company profits.
The 1985 reform of the Australian taxation system identified this as a major inefficiency and, consequently, recommended a change to a partial imputation system of taxing company profits. This system started in 1987 and has now been extended to a full imputation system of taxing company profits. This system relies on a complex system of record-keeping to track income tax paid by companies and to allow their shareholders to claim a credit for that tax. This credit is called variously an ‘imputation credit’ or a ‘franking credit’ and, as the name suggests, provide the shareholder with a credit for tax already paid when they include those dividends in their assessable income computations.
The basic logistics of taxing franked dividends are as follows:
- The company pays tax on its taxable income at the company tax rate (currently 30%) and records this tax as a credit in a notional account called a ‘franking account;’
- When the company pays a dividend, it determines the extent to which the dividend is paid out of taxed profits, debits its franking account and advises its shareholders via a written dividend statement of the amount of the cash dividend and the attached franking credit;
- The shareholder includes both the cash dividend and the attached franking credit in their assessable income computation; and
- The shareholder claims a tax offset in their tax payable computation, equal to the value of the imputation credit; this tax offset, unlike most tax offsets, can generate a refund of tax.
This means that, ultimately, the amount of income tax paid on the company’s profits depends on the income tax profiles of its shareholders. If all of a company’s shareholders faced the 47% marginal tax rate, then all of its income would ultimately be taxed at that rate. If all of a company’s shareholders faced a nil tax rate, for example because they were super funds paying allocated pensions, then all of its income would be ultimately taxed at 0%.
This means that income derived through companies, like income derived through trusts, is ultimately taxed in the same way as it would have been had it been derived directly by the underlying owners i.e. the shareholders or unit holders, as the case may be.
This means that the level playing field identified as a major policy goal in the 1985 reform of the Australian taxation system has largely been achieved. This, and particularly the removal of the structural tax bias against companies through the imputation system, is recognised as a major factor fuelling Australia’s economic growth and, in particular, the strong growth in share market values since 1985.
Large investment trusts
Large investment trusts (also known as ‘managed funds’) invest in cash deposits (and similar facilities), properties and shares. This means that they derive interest, rent and dividends from holding investments, and capital gains when the value of those investments increases. ‘Net income’ is the phrase used to describe the equivalent of taxable income for trusts i.e. assessable income less allowable deductions. The trust’s beneficiaries or unit holders are said to be ‘presently entitled’ to a share of net income, usually in proportion to the number of units that they hold.
The character of the trust’s net income in the trustees’ hands determines its character in the hands of the unit holders. This is called the ‘flow through’ or the ‘attribution’ principle. This means that if the trust’s net income is made up of, say, 50% cash franked dividends, 30% rent, 10% interest and 10% capital gains, then a unit holder receiving a distribution of $1,000 technically derives $500 rent, $300 franked dividends, $100 interest and $100 capital gains.
Under special rules designed for trusts, the benefit of any franking credits, the benefit of any tax deferred amounts connected to depreciation and building allowances, and the benefit of any capital gains discounts flow through or are attributed to the unit holders. This way the trust’s net income is ultimately taxed in the same way as it would have been had it been derived directly by the unit holders. In practice, the details of the income distribution are made very clear to unit holders in the distribution advice statements provided by trusts to their unit holders.
This can all seem quite overwhelming, but the take home message is this: if you invest in shares in an Australian company, either directly or through a managed fund, then the ultimate tax paid on your share of that company’s profits will be determined by your marginal tax rate.