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Case study: business impacted by franking credit proposal

Arthur Smith's case study highlights how after years of applying a policy of funding his medium sized business through the use and re-use of equity as capital, under the new proposed Labor legislation this method would be penalized, creating an environment where business owners like himself would have to use debt funding, something he is inherently uncomfortable with. Mr Smith suggests that the proposed rule changes remove any incentive to plough profits back into his company to provide working capital.

Additionally, Mr Smith notes that he pays his way without the use of any pension, via fully franked dividends, using the refund of extra tax, adding that the proposed changes by the Labor Government will take away the refund, impacting his ability to save for retirement and further noting that “we see it as attempt to “steal” from us in order to fund a whole range of policies that we don’t necessarily agree with”.

Read the full case study below or click here to view the case study in PDF


CASE STUDY
Arthur Smith

"We operate a kitchen manufacturing business and deal directly with householders.
We decided 20 years ago that we wanted to provide for our own retirement and not depend on the pension. Alternatively, we could have “blown” everything we earned and lived very well, with the aim of ultimately living on the pension.

In a business like ours, stock levels are in the vicinity of $150,000, and debtors average about $200,000 (approximately 3 week’s sales). This can be funded a few ways.

With regards to stock, stock is purchased on credit so that 30-day “End of Month” accounts provide approximately 45 days credit on average. Stretching credit terms can provide a short-term extension, but this does not assist the relationships with suppliers and can damage pricing arrangements.

With regards to debtors. We are reluctant to provide incentives for early payment because this affects our margins. We have never been involved in interest free terms schemes. The onus is on us to complete our jobs with a high degree of customer satisfaction, and then chase payment. This requires a consistent effort on our part and for the most part we don’t have “long term” debtors.

One way of funding this is to use a third party (bank) credit facility. The cost of this is interest which is tax deductable. We like many people have an aversion to third party debt and the risks associated with it. Debt can be “addictive” and some business owners find it too attractive to fund a lifestyle based on debt and not profit, with a business failure being the consequence. It should be noted that if the business debt is ultimately repaid the source of this repayment is the “tax paid” funds that the business accumulates out of profits. Ultimately the working capital of a “debt free” business will be funded out of “tax paid” profits. The cost of those funds will be whatever the company tax rate is.

Our business started small and grew. In the initial stages our incomes were very low, and we paid company tax on our profits and ploughed them back into the business. It was also important at this stage to meet the liquidity and asset requirements of the “Building Authority”, and the ploughed back profits provided the funds to meet those criteria.

At present we have about $450,000 equity in the business, $150,000 of which is our shareholding. Ploughed back profits have contributed approximately $300,000 to the business’s working capital. This provides us with security, both for ourselves and our long term and loyal employees.

Over the last 20 years we contributed enough to our self-managed superannuation fund and the fund was able to purchase the premises that the business operates out of. From the rent received and a bit of interest the fund (which is in pension phase) earns about $70,000 ($35,000 each) annually which is tax exempt. We must draw approximately $60,000 of this as income, given the value of the fund assets.

“We receive dividends of approximately $30,000 each from the company, and these are fully franked. To date the gross value of these dividends has been our taxable income and we have received a refund from the ATO for the excess tax we have paid. We would be very concerned should the Labor Government change the rules, and simply take this refund away from us. This is how we planned for our retirement, and we see it as an attempt to “steal” from us in order to fund a whole range of policies that we don’t necessarily agree with.”

Clearly we would have been much better off withdrawing profits as income while working and earning a taxable income, and funding the working capital of the business through a bank. The proposed changes mean that we are being punished for funding our business through equity instead of debt. To fund debt (after tax) might have cost us 3 to 4%. Equity has cost us the company tax rate of 30%, and this excess cost has been compounding in terms of the earnings that those funds could have provided if they were invested elsewhere. The dollars that we ploughed back into the business in the past were more valuable than “today’s” dollars, and it cost us a lot through company tax to keep them there. Had we borrowed, the dollars that we owed the bank now would be less valuable than the dollars that we originally borrowed.

Changing the rules takes away any incentive we might have had to plough back profits to provide working capital, and then withdraw those profits in retirement.
At least any funds accumulated from past ploughed back profits should not be affected by the proposed legislation and credits against current tax liabilities or refunds should continue until those funds are exhausted.

If the proposed legislation was passed there would be far less incentive to plough back or retain profits, particularly in private companies, and far greater incentive to borrow in order to build working capital.

The unintended effect could be that in the future small startup companies will be induced to fund their working capital through debt, and many more might fail because it all becomes a bit too easy using other peoples’ money."