Deborah Wixted examines advanced imputation rules and explains why excess franking credits are not always refundable.
Financial advisers may have to provide investment advice to tax entities other than individuals, such as companies or trusts.
While most of us have a good understanding of how the imputation system works for individual investors, some may not realise that different rules apply when franked dividends are paid to other tax entities.
Under some circumstances, these other tax entities may not be eligible for a refund of excess franking credits, which may reduce the effective usage of shares paying franked dividends as part of a wealth creation strategy.
Generally, under the current imputation system, when a resident individual receives a franked distribution directly or indirectly through a managed fund, the distribution plus the declared franking credit would be included in their assessable income and subject to tax at marginal tax rates.
The individual is then entitled to a franking credit tax offset to reduce their overall tax liability.
Where the amount of franking credits exceeds a person’s tax liability, they are entitled to a refund of these tax credits, potentially enhancing the total after-tax return of an investment portfolio.
It is important to bear in mind that eligibility for the franking tax offset (and therefore the refund as well) is subject to various anti-avoidance rules such as the holding period rule and share tainting rules. For the purposes of this article, assume no anti-avoidance rules are triggered.
If there is no trust income for tax purposes, excess franking credits may not be refunded
Generally, the net income of a trust for tax purposes is the total assessable income of the trust calculated as if the trustee were a resident taxpayer, less any allowable deductions.
The tax offset and the refund of any excess franking credits are only available where a share of this net income is included in the assessable income of a beneficiary or the trustee.
Therefore, if the trust has no net income or has made a loss for tax purposes, there will be no share of the trust’s net income assessed to the beneficiary or trustee and no entitlement to either the franking credit tax offset or a refund of excess franking credits.
Case study
ABC trust is a discretionary family trust that is negatively geared into a portfolio of direct Australian shares valued at $500,000 with an outstanding margin loan of $400,000. If the trust receives fully franked dividends of $20,000 for the current financial year,
it would include $28,571 in its assessable income, being the dividend amount of $20,000 plus the franking credit amount of $8,571. The trust will be able to claim the interest expense of $32,000 (8 per cent per annum of $400,000) as a deduction.
The trust will therefore have a tax loss, it will not be eligible for the tax offset of $8,571 and the franking credit will not be refundable to either the trust or its beneficiaries.
Should the same scenario apply to an individual resident taxpayer instead, the individual would be entitled to a full franking credit refund of $8,571.
Only certain trusts are eligible for refund of excess franking credits
Assuming a trust has positive net income for the income year, in the event that the trustee, rather than the beneficiary, is taxed on the trust income, the trustee may not be eligible for a refund of the excess franking credit.
Net income of a trust may be taxed in the hands of the trustee in some circumstances depending upon the nature and terms of the trust.
An example would be a discretionary trust making no distribution of income to its beneficiaries in a financial year. In this case, the trustee would not only be subject to tax of 45 per cent on the net income, it would not be eligible for a refund of the franking credit.
On the other hand, trustees of certain trusts are generally still eligible for a refund of franking credits, including:
- deceased estates;
- special trusts for the benefit of the beneficiary by way of damages for loss of parental support or for mental or physical injury;
- trusts established with property transferred in certain family breakdown situations;
- complying superannuation funds.
Franked dividends paid to companies
Companies have their own unique rules regarding the treatment of excess franking credits.
When a company receives a franked dividend, the franking credits attached to that dividend are credited to the company’s franking account, which can then be used by the company to frank its own dividends.
Generally, a company (with the exception of certain non-profit companies) with a loss or nil income is not eligible for a refund of excess franking credits. Instead, the excess franking credits of the company may be converted into tax losses, which can be carried forward to offset tax in future income years.
The company may not be able to take advantage of these tax losses until the company generates positive income. If the company expects to run at a loss for a substantial period, it may take some time to recoup the benefit of the losses.
Summary
When constructing investment portfolios for clients, advisers should remember that different tax structures and investor circumstances may impact the effective use of franking credits.
The taxation treatment of excess franking credits paid to non-individual investors can be complicated and it is always prudent to seek professional tax advice.
Deborah Wixted is head of technical services at Colonial First State.
