By Jesse Hamilton

The Senate is considering a proposal from Treasury to make changes to the franking system.

The franking system is a clever solution to the challenge of double taxation, introduced in 1985 by then-treasurer Paul Keating and designed so that dividends are fairly taxed at the marginal rate of individual shareholders.

Countries that do not have a similar or equivalent franking system tend to have a lower fixed tax rate on dividend income, something Australian politicians fail to mention when franking is debated.

Treasury’s current plans for change appear to solve a simple problem – a few large companies in the past raised capital from shareholders through fully underwritten capital raisings and promptly paid out all the money raised as a franked dividend, triggering a raised eyebrow at Treasury and the Australian Tax Office.

Some companies did this as a cash flow management tool to distribute franked dividends to shareholders while maintaining their working capital for general operations and expansion.

But it was the blatant nature of it being an underwritten raising that matched the dividend dollar for dollar (Tabcorp, Harvey Norman, Vita Group) that the ATO did not like. It believed shareholders then received a large benefit (the franked dividend) in a deliberate and artificial way.

The proposed change itself seems simple enough. Companies will not be able to pay out fully franked distributions that, in Treasury’s view, are directly or indirectly funded by a capital raising.

But as with much in policy, the second- and third-order effects of this plan have not been fully thought through, given the broad nature of the drafting in the proposed legislation.

Changes tucked away

It’s perhaps not surprising there’s not more attention on these damaging changes – they are tucked away in Schedule 5 of the innocuously named Treasury Laws Amendment (2023 Measures No. 1) Bill 2023.

But in our view, and the opinion of taxation experts and leading lawyers, this fiddle with the franking system will have wide and unintended consequences on small businesses and their shareholders, and even risk dramatically reducing company tax revenue itself, damaging the federal budget.

Some in parliament recognise this risk and are mobilising to protect Australian taxpayers and small businesses.

The Senate Economic Legislation Committee has been carefully investigating Schedule 5. It has uncovered some disturbing facts and identified three key unintended consequences.

First, under Treasury’s plans, companies will be prevented from funding franked dividends by raising equity, but they are free to fund those dividends by taking on debt.

This will put smaller companies at a distinct disadvantage.

Family-owned Australian businesses will struggle to get their bank to approve a new loan. Their large multinational competitors have debt funding on tap, ready to deploy.

The heightened reliance on equity funding, often raised from family and friends, puts small companies in an invidious position as they seek to compete with the big end of town.

Second, newer companies are also disadvantaged.

Treasury’s proposed test to determine whether companies can pay out fully franked distributions examines the “established practice” of a company’s dividend payments to ensure compliance.

But the engine of growth in the modern world has been fast-growing start-ups that repeatedly raise equity funding until the point they are self-funding and can start paying dividends from profits generated.

These companies cannot pass an “established practice” test, and their dividends will be unfranked as a result, denying their shareholders the benefit of the franking credits.

Revenue at risk

Third, the proposal seems to capture a simple dividend reinvestment plan, a popular mechanism that allows small shareholders to reinvest dividend payments into additional shares of a company’s stock, rather than receiving the dividends in cash.

Reinvesting dividends is a form of capital raising and, unless carefully planned to comply with Treasury’s provisions, the dividends reinvested could lead to the entire dividend paid being unfranked and shareholders losing their associated franking credits.

But the unintended consequences go even further than that and put at risk an important revenue stream for Australian taxpayers, who benefit from $36 billion in taxation paid each year by companies that is not distributed to shareholders as franked dividends.

Most of that tax is paid by Australia’s largest companies. Under the franking system, this tax is essentially an interest-free loan that shareholders provide to the government, which it is now looking at ways to default on.

One of the dividend imputation system’s great successes has been encouraging these large companies to arrange their affairs to pay more tax in Australia.

Treasury’s proposed changes undercut this success.

If big corporates reduce their tax bill by just 0.14 per cent, the entirety of the meagre $10 million in associated savings promised by Treasury will disappear in the new regime’s first year of operation.

A 2.5 per cent to 5 per cent reduction or deferral in corporate tax payments not paid out in franked dividends would deliver a $900 million to $2 billion cash flow problem for the federal budget.

These are not theoretical concerns. Reducing tax bills is a trivial affair for big corporate taxpayers – as the Senate committee discovered, simply funding capital raisings with debt instead of equity directly and legally reduces tax bills.

We empathise with Treasury’s difficult balancing act, but we propose it heeds the advice of the expert witnesses who spoke at the recent public Senate inquiry into this matter. There’s a unanimous voice in questioning the value of Schedule 5 and the risk implementing it would have.

It looks as if Treasury might be realising the changes aren’t good: Assistant Treasurer Stephen Jones told The Australian Financial Review’s John Kehoe on 4 May the government was committed to the reforms, but was open to amendments that “keep the faith with the original objectives”.

“If they are having unintended consequences, we’ll look at that”.

Good call, Jones, because the effectiveness of the taxation system is crucial for continued economic growth and the continued prosperity of Australians.

Small, family-owned and fast-growing businesses are the lifeblood of the Australian economy, and it’s critical that we avoid the potentially devastating second- and third-order consequences of what on the surface appears to be such a simple change.

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