Franking policy may increase corporate tax avoidance

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The heated debate continues regarding Labor’s proposed removal of refundable franking credits. The primary focus is the impact of the change on retirees, SMSF trustees in pension phase and low-income earners. Attention has also been given to the policy’s potential impact on asset allocation, investment in Australian companies and even the value of shares of some Australian companies.

However, one potential consequence that has flown under the radar but would indirectly impact all Australians, is the possibility for a rise in corporate tax avoidance.

The extent of corporate tax avoidance in Australia

Accusations of tax avoidance have thrust many publicly-listed companies into the spotlight in recent years. In 2014, the Tax Justice Network and United Voice accused Australian listed companies of tax avoidance on an industrial scale claiming that the federal government is short-changed by $8.4 billion annually in corporate tax revenue. A more recent study in 2018 by the National Bureau of Economic Research in the US found that in 2015, multinationals shifted roughly $15.5 billion (US$12 billion) in profits out of Australia and into tax havens. This equates to approximately $4.7 billion in lost company tax revenue to the Australian Budget.

While exact numbers are elusive, it is clear the public perception in Australia is that many companies, and large multinationals in particular, do not pay their ‘fair share’ of tax. And there is no other time when public perception matters most than election time.

Regulatory response from the Australian government

Australian governments have implemented several initiatives in recent years designed to combat corporate tax avoidance including the diverted profits tax, multinational anti-avoidance law, and the adoption of many of the OECD’s base erosion and profit-shifting reforms e.g. country-by-country reporting. In 2018, the Australian Taxation Office (ATO) claimed its Tax Avoidance Taskforce had netted $5.6 billion in additional tax in the first two years including extra tax raised through the aforementioned initiatives.

However, despite these targeted initiatives, Australia’s current dividend imputation (including full franking credit refundability) also plays an important role in curtailing corporate tax avoidance.

Role of dividend imputation system in mitigating corporate tax avoidance

The introduction of full franking credit refundability from 1 July 2000 enhances shareholder’s after-tax returns and provides stronger incentives for firms to pay company tax (minimise tax avoidance) to generate valuable franking credits for distribution to shareholders.

Clearly, the change was especially attractive to resident taxpayers whose marginal tax rate is less than the statutory company tax rate of 30%, such as Australian superannuation funds in pension where earnings are tax-free, or accumulation phase, where earnings taxed at 15%. Superannuation funds are major investors in Australian listed companies and seek to maximise after-tax returns for members.

Indeed, in 2013 two UNSW academics, Gordon Mackenzie and Margaret McKerchar, interviewed Chief Investment Officers of 22 Australian superannuation funds and found that 71% claim to actively-manage franking credits as part of their overall investment strategy.

Academic research confirms impact of franking

Academic research shows that the dividend imputation and corporate tax avoidance in Australia are inextricably linked. In 2013, researchers at ANU investigated large publicly-listed Australian firms in the 1999-2003 period and found that firms distributing franked dividends adopt a more conservative tax strategy compared to firms that do not pay franked dividends. More recently, in 2018, researchers at UTS found that in the 2004-2015 period, firms paying partly-franked or fully-franked dividends are less likely to engage in tax avoidance compared to firms that pay unfranked dividends or firms that pay no dividends at all.

Recent research conducted at UNSW takes a different approach. We analysed the impact that the introduction of full franking credit refundability from 1 July 2000 had on the level of corporate tax avoidance in the years following the change, 2001 to 2004. Consistent with the results of the prior studies, we find that following the introduction of the new rule, Australian dividend-paying firms significantly reduce tax avoidance relative to foreign firms listed in Australia and Australian non dividend-paying firms. The findings are even more pronounced for firms paying fully-franked dividends.

The results of all three studies are consistent with the notion that firms undertake less tax avoidance in the post 1 July 2000 period given the presence of stronger incentives for them to pay corporate tax.

Unintended consequence?

Interestingly, there was no mention of the possible impact Labor’s policy may have on corporate tax avoidance in the recent Report on the inquiry into the implications of removing refundable credits by the House of Representatives Standing Committee on Economics delivered in April 2019. At a time when corporate tax avoidance is especially on-the-nose with the public, this policy change has the potential to exacerbate the problem.

It is surprising that the incumbent Government has made little attempt to communicate this to the electorate and explain that this policy may undermine some of the good work it has done in recent years to safeguard revenue and preserve tax system integrity.

Possible policy compromise?

This forgotten element of the system adds to the debate and highlights one of the broader benefits of the current rules that are not related to individual investor financial circumstances. However, it does provide new weight to arguments for a modification to Labor’s policy such as including a cap on franking credit refunds so that the policy intent is better achieved and to minimise the impact on low-income earners. Perhaps such a compromise would result in the best of both worlds.

 

Dr Rodney Brown is a Lecturer in Taxation and Business Law at the University of NSW Business School, including the Master of Tax and Financial Planning course. He completed his PhD at the London School of Economics after working as a financial planner in Sydney. This article is general information based on a current understanding of tax law and Labor’s proposal, and it does not consider the circumstances of any individual.

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5 Responses to Franking policy may increase corporate tax avoidance

  1. Greg May 16, 2019 at 11:48 AM #

    Thank you for such a thoughtful article. In the imputation debate it has been forgotten that companies are queuing up to pay tax so that they can frank dividends. This is one of the great successes of the imputation system. Without imputation companies will look to minimise tax wherever possible. What also does not get mentioned is that the ATO considers that the tax not collected from the small business segment is much greater than large corporations.

  2. Jim May 16, 2019 at 11:28 AM #

    OK with your article in general Rodney, but why introduce another taxation variable, in a cap value for refundable credits?
    Wouldn’t it be simpler to just use the $1.6 million balance, which is already tracked in personal and taxation dept administration? That is, if a SMSF account is under the $1.6m at year end, then that account stays entitled to refund of all earned credits!

    • Graeme May 17, 2019 at 4:45 PM #

      And for those receiving excess franking credits outside of super? Would they have to fill in a whole new form every year detailing assets so as to get the same benefit? Not so simple after all.

  3. GM May 15, 2019 at 3:48 PM #

    I can confirm that as Tax Manager at a major company, we actually brought an otherwise Aus. tax free transaction back on-shore specifically to pay tax for our Shareholders who ‘loved ‘ imputation credits.

    • Tom May 15, 2019 at 11:47 PM #

      Well as a tax manager at a major company, the shareholders of Australia applaude you. Keep up your diligent hard work.

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