By Graeme Colley
One of Labor’s signature tax reform proposals is to cease franking credit refunds from 1 July 2019, which will impact most individuals and smaller superannuation funds from the 2019/20 financial year.
At this stage, we don’t know the detail of the proposal, as it depends on the outcome of the May election and the passage of legislation. Based on what we understand, individual taxpayers including SMSFs will not be able to receive a refund of any franking credits which are in excess of any tax payable. There are some exceptions:
Every recipient of an Australian government pension or allowance with individual shareholdings will continue to get cash refunds. This includes anyone receiving the Age Pension, Disability Support Pension, Carer Payment, Parenting Payment, Newstart and Sickness Allowance.
Self-managed superannuation funds with at least one recipient of an Australian government pension or allowance as at 28 March 2018 are exempt from the changes.
Charities and not-for-profit institutions, such as universities, are also exempt from the changes.
Superannuation funds that are wholly or substantially in retirement phase and have income that’s tax exempt under the current tax law will be affected. There will be no refund of franking credits in excess of the fund’s tax payable. For these funds it will mean, in effect, that the fund will pay tax at a notional rate equal to the excess franking credits divided by the fund’s taxable income.
To illustrate the point, if your SMSF is wholly in retirement phase and receives a fully franked dividend, the notional rate of tax could be as high as 30%. If the SMSF has a diversified portfolio the notional rate of tax could be lower if it has interest bearing investments, rent and other income that don’t come with franking credits attached.
Let’s assume that:
If Labor’s policy to deny the fund a refund of franking credits was to become a reality the fund would end up paying a notional rate of tax of about 23.48% calculated as follows:
|Income including franking credits||$18,296|
|Notional tax due to no franking credit refund||$4,296|
|Notional tax rate = $4,296/$18,296||23.48%|
|Net income received by SMSF||$14,000|
There are a number of strategies you could use to reduce or mitigate the loss of franking credit refunds which are outlined below. The strategy that is best for you and your SMSF depends on the goals and objectives of your SMSF as well as the circumstances of fund members. In some situations, from a pure investment return point of view, you may be better to retain shares or other investments that have franked dividends compared to an investment that has a lower rate of franking or no franking at all. Retaining the share with the franking credit attached may prove to be a more appropriate investment for your SMSF.
Prior to making any decisions, your SMSF should obtain advice from a tax specialist or financial adviser to determine the best course of action.
Here, the idea is to shift investments – particularly those with franking credits attached – into accumulation phase, which isn’t impacted by Labor’s proposal. Income on investments in accumulation phase is taxable and it may be possible to fully absorb any franking credits against the taxable income of the SMSF.
Transferring investments from retirement to accumulation phase requires a full or partial commutation of a pension to allow the relevant investment to be recognised as part of the accumulation assets of the fund. To this end, the pension in question must be one that can be commuted back to accumulation. Old legacy pensions, like market linked pensions, lifetime and life expectancy complying pensions, have commutation restrictions and consequently aren’t eligible for this strategy.
Rose is 64 and a member of an SMSF which is wholly in retirement phase. The balance of her pension account is $1.6 million which provides a minimum pension of $64,000 (4% of the pension account balance). Rose has been drawing a pension of $100,000 each year to support her lifestyle.
For the 2018/19 financial year Rose will draw down the minimum pension of $64,000 and commute $36,000 from her pension to be taken as a lump sum. The reason she is drawing down her living expenses from the fund in this way has to do with advantages under her transfer balance cap (TBC).
Because the fund is wholly in retirement phase and totally tax-exempt, all of the franking credits from the fund’s investments will be refunded to Rose’s SMSF for the 2018/19 financial year. Things will change in future if the proposal to stop franking credit becomes law as the fund will receive no refund of any excess credits.
As a strategy, Rose could transfer part or all of her pension to accumulation phase. If that occurs, income earned on investments in accumulation phase are taxable and any franking credits received on fund investments could be offset against tax payable. Whether this strategy would provide any advantage is a moot point as the fund was tax free in retirement phase prior to transferring to accumulation phase.
One advantage if Rose moves her retirement phase pensions back to accumulation phase is that there is no requirement to take a minimum pension each year. She could still withdraw lump sums from super when required for living expenses. Any lump sum would be tax free (as she is at least age 60) and there is no requirement to take a minimum amount, which is required if she takes a pension.
Here, the idea is to make concessional contributions to super and offset the franking credits against any tax paid on those contributions.
Contributions made by a member or their employer are taxed in the fund at 15%. Subject to meeting the work test if you are 65 or older, it may be worthwhile to increase concessional contributions to the maximum cap, which is currently $25,000, to use any franking credits if the fund has no tax to pay.
Changing investments to those that have a lower franked amount or are not franked at all needs to be considered carefully before taking any action. The reason is that any action needs to be considered from an investment point of view. This consideration should include a comparison of the franked investments versus other investments from a yield, capital gains and investment risk (including currency risk if you are considering overseas investments). If the proposed investment does provide a better overall rate of return within acceptable risk parameters, selling one or more investments held by the fund and purchasing the proposed investment may be justified.
If the fund was to purchase investments that have a lower or no franking credit, the trustee needs to balance the decision against the rates of return, capital gains and risk profile of the alternative investment.
If you are over 65, or have satisfied a full condition of release, having investments transferred from your SMSF to your name may allow you to use the franking credits attached to the investment. However, you will need to ensure you can use the credits effectively and not lose them if an excess results. Before the decision is taken, the long-term tax impact of the decision should be considered as the long-term after-tax investment return in your name may be less than what would have been achieved if the investment was owned by your fund.
The tax rate in a fund is 15% in accumulation phase or 0% in the pension phase, irrespective of the income received. In comparison, as an individual you pay tax only where your taxable income is greater than your tax-free threshold of $18,200 or greater where SAPTO and other tax offsets may apply to your taxable income. The minimum personal tax rate is 19% plus 2% Medicare which would enable franking credits to be used, in effect, for that part of your taxable income which exceeds the tax-free threshold for income earned on investments held personally.
However, in comparison, the fund tax rate is capped at 15% (or 0% if in the pension phase), but your individual tax rate can be up to 45% plus Medicare levy, depending on your taxable income. Capital that is moved from your SMSF into your name could be subject to higher tax rates on income, including capital gains and may not be fully offset by franking credits.
Depending on the situation the fund could be liable for CGT on the transfer of any investment to you and there may be other costs associated with the transfer of the investment into your name.
Here, the idea is to boost fund contributions by adding additional members, and to offset franking credits against any tax paid on those contributions.
If the new members are in accumulation phase and their superannuation benefits in other funds are rolled over, or concessional contributions are made to the fund, it may be possible to use any franking credits and reduce or eliminate the loss of any excess franking credits. This in turn helps grow those new members’ retirement benefits and ‘contributions tax’ can be reduced or even eliminated. But be careful, with a greater number of individuals involved with the running of the fund, without proper planning, it may lead to some unintended outcomes and consequences for existing members.
While most funds like to maximise the tax deductions available, there are one or two deductions which are optional to the fund. This applies to insurance premiums, but the type of insurance and the amount of the deduction for the premium depends on a number of issues.
Whether a deduction for insurance premiums is claimed by the fund is up to the trustee. If the fund does not claim a tax deduction for the premium the taxable income of the fund may be greater than if a deduction was claimed. This may allow the fund to use some of the excess franking credits against any tax payable by the fund.
On the death of a member, taxation of any amount received by a beneficiary that includes the proceeds of an insurance policy can be complex but depends on:
As a general rule a lump sum paid to a ‘tax dependant’ is tax exempt, however, if the lump sum is received by a ‘non-dependant’ for tax purposes, such as adult children of the deceased, tax is payable on the taxable proportion of the amount received.
There may be some strategies that provide advantages or a more tax effective way of using franking credits. However, we really need to wait to see the final form of any legislation as passed by the parliament before trying to work out the most effective strategy. Any change in the fund’s investments, or moving member’s benefits from retirement to accumulation phase, or even withdrawing them from the fund altogether need to be carefully considered. Importantly, it’s the risk-adjusted after-tax return of the whole transaction and not just whether there is a more efficient use of franking credits that really matters.