The benefits of franking credits in an SMSF
The benefit of franking credits in an SMSF cannot be underestimated, especially when the fund is in pension phase, writes Graeme Colley.
The introduction of the dividend imputation system in 1987 was seen as a boon to all investors, but more so to superannuation funds when they began to be taxed on their normal income in 1988.
The Treasurer at the time, Paul Keating, said that if a superannuation fund structured its investments strategically then it was possible to pay no additional tax due to the impact of franking credits.
The benefit of franking credits in a self-managed super fund (SMSF) cannot be underestimated, especially when the fund is in pension phase.
I'm sure you have clients on your front doorstep or who email you on the first day of every financial year with a reminder to prepare the fund accounts as soon as possible and lodge the fund's tax return for them to gain the maximum benefit of any franking credit refund due.
SMSFs with substantial equity portfolios containing franking credits can benefit quite substantially from any refund by assisting to pay the fund's expenses, including any lump sum or income streams due.
The common misconception about franking credits is that some advisers and accountants promote the credit as something like a gift from the Government which reduces the amount of tax payable by the fund.
While this may be the outcome it couldn't be further from the truth, as it is really a timing issue in relation to the tax payable.
In effect, the company pays tax on taxable income which in most cases may be used to offset any tax payable by a shareholder on franked dividends they receive.
What a franking credit does for the superannuation fund is alter the timing of the payment of tax which occurs in part at the time the company pays income tax, which may end up as the franking credit to the fund and at the time the dividend is taxed as part of the fund income.
In the income tax return of the superannuation fund, the grossed up amount of the dividend - the net dividend received plus any available franking credits - is taxed at the relevant tax rate and then a credit allowed for any franking credits on the dividend.
If the superannuation fund is a beneficiary of a trust that has received franked dividends, then the franking credit can accompany trust distributions.
Where the amount of franking credits exceeds the amount of income tax payable by the fund, the excess is refunded or may be offset against other outstanding tax that is due.
Not all companies pay franked dividends and some may not pay fully franked dividends.
As a general rule franking credits are only available on Australian-based companies, and then only on their Australian-based activities.
The question fund trustees should consider is whether they should invest in companies which pay franked dividends in preference to those that don't.
Evidence exists that in those countries which have a franking credit systems, dividend payouts are higher compared to those where a franking credit system is not available.
However, whether franking credits are available is only one consideration when trustees make an investment on behalf of the fund.
In the case of an SMSF, as with all superannuation funds, the tax rate on the fund's ordinary taxable income is 15 per cent and the maximum franking credit available for offset against the tax payable is equal to 30 per cent of the gross dividend - the same as the company tax rate.
The outcome of this is that the fund's net tax bill may be reduced significantly where its investments include a substantial proportion of franked dividends.
Any non-arm's length income earned by the fund will be taxed at the maximum rate of 45 per cent, irrespective of whether the assets that produce the income are in accumulation or pension phase.
Let's consider a simple example where the SMSF has only two shareholdings which pay fully franked dividends: Coca-Cola Amatil (CCA) and Commonwealth Bank of Australia (CBA).
If we assume that the fund holds shares in both companies each holding with a value of $100,000; and if we assume CCA has fully franked dividends with a current gross dividend of 5.85 per cent and CBA has a current gross dividend of 7.67 per cent, the amount of tax payable by the fund would be calculated as follows:
The effect of the excess franking credit permits the fund to offset any tax payable on other taxable income earned by the fund; for example, taxable contributions, income from unfranked dividends, interest, net income from rent, taxable capital gains and so on.
Eligibility to claim franking credits against the tax payable by the superannuation fund does have some limitations.
The entitlement to use the franking credit may not be available where the company paying the dividend is involved in a dividend streaming or stripping arrangement, or where there is a franking credit trading scheme in place.
Also, to be eligible for the franking credit offset shares must satisfy the holding period rule which requires the superannuation fund to retain the shares 'at risk' for at least 45 days, excluding the days of acquisition and sale, and for some preference shares for at least 90 days.
An exemption to this rule applies to small shareholdings where the total franking credit entitlement is less than $5000.
This is equivalent to a fully franked dividend of about $11,666 based on the 30 per cent tax rate currently payable by companies.
The benefit of franking credits, if the fund is wholly in accumulation phase, is clear, as any excess franking credits are offset against other taxable income earned by the fund and any amount remaining after that is refunded.
Of course, where the fund is wholly in pension phase the ordinary income is tax exempt and the full benefit of the available credit increases the income of the fund available for distribution to members.
Where the fund is in accumulation and pension phase at the same time the fund is taxable on the taxable income relating directly to the income earned in the accumulation phase, or a proportion of its total income as calculated by an actuary.
The calculation of the taxable amount depends on whether the assets of the fund are determined on a segregated or unsegregated basis.
While the income of the fund in pension phase is exempt the full value of any franking credits available to the fund can be used to offset income tax payable by the fund.
This means, in effect, that franking credits from shares held in pension phase are available to be offset against any taxable income earned in accumulation phase.
This creates an equity issue as a member in accumulation phase has the benefit of the franking credits earned by the investments that are also in pension phase.
In some cases a member's account in pension phase may wish to claw back the franking credit used to pay the tax in the fund.
The main reason to add back the benefit gained from the franking credits is because any income earned will continue to be tax free and the balances in the accumulation and pension accounts will be retained on an equitable basis.
Let's have a look at the impact of imputation credits on a member's account where part of the total benefit is in pension phase and the remainder is in accumulation phase (if we assume the fund earns income from dividends and interest only, and the proportion of the income attributable to the accumulation phase is equal to 40 per cent of the total income, and 60 per cent of the income relates to pension phase).
In the above example, the amount of the franking credit attributable to pension phase is $2430, part of which has been used to pay the tax payable by the fund on income earned in the accumulation phase.
The amount of the excess franking credit after the payment of income tax by the fund is $2,039.
This means that the member's pension account should be credited with the amount of the franking credit refund plus the difference between the amount of the refund and the amount attributable to the franking credit attributed to pension phase of $391.
The source of this amount and whether it can be transferred to the pension account would depend on the provisions of the fund's trust deed.
This may come from the accumulation account(s) and be credited to the pension accounts as an adjustment due to the tax payable.
Other sources could include fund reserves; however, it should be ensured that equity is retained between the accumulation and pension accounts.
The use of franking credits in a superannuation fund does provide a number of advantages to members.
While the greatest advantage is gained in pension phase by carefully planning the fund's investments, it may be possible for the fund to pay no more tax on its income with the economical use of the franking credits.
Where the fund is in accumulation and pension phase concurrently, it should be ensured that the use of franking credits ensures an equitable balance in the allocation of credits due to the income earned on investments in accumulation phase being taxable and having access to all the franking credits gained by the fund, including those relating to pension assets.
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