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The Impact of Changing Franking Credits

The Impact of Changing Franking Credits

The widely welcomed cut to the small business tax rate has come with a sting in its tail.

The changes will put pressure on business owners to pay out retained earnings sooner than they might have otherwise planned, to give shareholders the benefit of existing franking credits before they lose some of their value.

The tax rate for 2016-17 has been reduced to 27.5 per cent and the franking rate has been cut along with it. As a result, the value of tax credits held in companies’ franking accounts has fallen too.

Take a business that paid tax at 30 per cent in previous years, but retained the earnings inside the company to use for working capital and investment. For 2016-17, the maximum franking credit it can attach to dividends is 27.5 per cent.

This means it is holding “excess” credits in its franking account and, since they cannot be distributed to shareholders, these excess credits will be wasted. The situation will worsen over the coming 10 years as the tax rate and franking rate both fall to 25 per cent by 2026-27.

The number of companies affected by the changes will also grow dramatically. A “small” business is defined by its turnover, and this threshold rises over the same period from $10 million to $50 million. After much heated debate in federal parliament, the changes became law on 19 May 2017.

The sting is that their effect is retrospective to the start of 2016-17.

This creates a very practical problem for small businesses that paid a dividend for the first half of that year.

Let’s say the company paid a dividend at the end of the December half, attaching a franking credit of 30 per cent. This rate applied in all years up to 2015-16 and was still technically legal when you made the distribution.

But in the eyes of the ATO, that dividend is now “over-franked”, because the maximum franking credit that your shareholders can claim is 27.5 per cent. The ATO is advising companies to write to their shareholders telling them the revised amount of franking credits they are entitled to claim.

Companies are also required to adjust down the value of their franking accounts in line with the declining franking rate.

As the tax and franking rates fall over the coming decade, the value of these franking accounts will slide even further.

The franking credits will also be less valuable in the hands of shareholders, because they will not have the same power to reduce tax on income from other sources.

This creates a dilemma for business owners. Should you pay out retained earnings as dividends faster than you might have planned? If you do, where will you get the capital to fund your daily business operations, and future growth of your business?

If the plan is to finish up in business soon, it might be worth liquidating the company and distributing its funds to shareholders.

If your business is still in its prime, but you do want to return some funds to shareholders, you will need to search for ways to tighten up cash flow and work your capital harder.

This does not have to mean going to the bank for expensive finance, pledging property as collateral and locking yourself in to expensive long-term loans.

Scottish Pacific offers a range of flexible alternatives, from invoice finance for day-to-day transactions to trade finance for importers who purchase both in domestic and international markets.

These financing methods accelerate payment of your receivables and lift from you the burden of chasing debtors, leaving you free to concentrate on the more creative side of building your business.

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