Corporate tax cut plan needs to factor in franking credits

A blind spot in our corporate tax cut debate means that long-term investors are being left to foot the bill.

A huge chunk of the cost of the large corporate tax reduction will be borne by long-term investors because it substantially reduces the value of their franking credits. (AAP Image/Mick Tsikas)

Guess who is going to cop it on the chin if we reduce the corporate tax rate for large listed companies? No prize for answering correctly. Yes, it is ordinary Australians who are saving for retirement or in retirement — the same group that copped it the neck with the arrival of lower interest rates.

A huge chunk of the cost of the large corporate tax reduction will be borne by long-term investors because it substantially reduces the value of their franking credits. People who don’t know much about Australian taxation have a habit of comparing the raw Australian corporate tax rate to the raw rate in America and other overseas countries.

It is simply an incorrect comparison and the people involved usually should know better. None of those countries have franking credits. Our four biggest listed companies are the banks and they usually pay between 70 and 80 per cent of their profits out in dividends and it can go a lot higher.

The corporate tax they have paid on those dividends in effect becomes a reduction in personal tax or a tax on superannuation funds. And, if there are more deductions than tax payable, then a credit is generated. In other words, if the corporate tax rate is reduced then the franking credit will also fall. Now, of course, all other things being equal, the profits will go up and the companies will pay higher dividends. In a lot of companies it is highly unlikely that this will happen.

Overseas investors in our stockmarket are not eligible for franking credits but there is an underground trade in franking credits that sees a portion of overseas franking investor credits, that can’t be used, ending up with Australians. But in essence, the people who benefit from the proposed large cuts in corporate tax are overseas investors in the stock market (subject to the manipulation described above) and overseas groups who own Australian businesses.

That second group often seeks to leverage their operations as much as possible so that their profits are reduced by the cost of interest. The interest normally goes to a low tax haven.

There are constant battles between large overseas corporations and the tax office about the level of gearing overseas companies use to reduce their tax liabilities. In addition all sorts of tax games are played to switch profits off shore to lower tax jurisdictions.

The combination of franking credits on Australians and profit manipulation by overseas companies means that reductions in the Australian tax rate will not be nearly as costly to the Australian Treasury as the theoretical estimator might calculate. Treasury hated franking credits when Paul Keating introduced them and over the years they have cast aspersions at franking credits but its strong support among the Australian investment community meant that no Australian politician would touch it.

But now Coalition politicians and the big corporations in the Business Council are really beginning to push for lower tax rates in the full knowledge that the costs will be borne by local Australian investors.

As I mentioned yesterday, (Company tax cuts aren’t enough, January 31) there is no particular point in making a small tax reduction over ten years when the US is planning to move its tax rate to 15 per cent almost immediately. It is a debate hardly worth having because the tax reduction is useless.

If we believe a substantial US tax reduction presents a problem to the nation, then we will need to start looking at matching the US. In that debate, we need to introduce the impact on franking credits.

My own view is that it might make a lot more sense to have a discount tax rate for a new business that might be owned overseas or locally. But if owned locally it gets no franking credits. In other words, the owners of the new business declare they do not want franking credits but would rather receive a lower tax rate. I am not in stone with that proposal but at least it begins the process of a sensible debate — something we have yet to have.