Franking Credit Refunds

Top of mind for many SMSF trustees – particularly retirees - is the upcoming Federal Election and the Australian Labor Party (ALP) policy on refunds of excess franking credits. 

Despite a parliamentary inquiry recommending against the policy and strong backlash from various sectors, the ALP remain committed to the measure. This means it has a reasonable chance of becoming a reality (in some form) if Labor wins the Federal election.

So what should SMSF trustees be doing now?

Whilst we don’t advocate making radical changes based on a proposal by a party that isn’t even in power, it’s always a sensible idea to plan. The place to start is to get a feel for how your SMSF is likely to be impacted.

Overview of the policy

In general terms, Australia’s imputation system currently allows companies to pass on the benefit of tax paid at the corporate level to its shareholders by attaching a “franking credit” on dividends paid. In the shareholders’ hands, the franking credit could be used as an offset to reduce their tax liability with any excess franking credits being refunded to the shareholder.

What the ALP policy proposes is that individuals and super funds will no longer receive a refund of any excess franking credits. 

In other words, if you don’t use your franking credits to offset tax on taxable income, they are effectively lost. This change is proposed to start from 1 July 2019.

Is anyone exempt?

As a result of strong backlash to the proposal when it was first announced more than a year ago, the ALP proposal was amended (the “Pensioner Guarantee”) to allow the following classes of shareholders to continue to receive refunds of any excess franking credits:

• Age Pensioners and Centrelink allowance recipients, and
• SMSFs with at least one member who was in receipt of an Age Pension or Centrelink allowance before 29 March 2018.

Impact on SMSFs (who don’t qualify for the Pensioner Guarantee)

Probably the largest group to be affected, and certainly the most vocal, are SMSFs. Why? SMSFs with retired members and paying pensions generate tax exempt income. Their franking credit refunds often form a crucial part of funding pension liabilities and covering expenses.

However, pension paying SMSFs aren’t the only ones that will be affected. Funds with only accumulation members will also need to be aware. If the members are not contributing much or at all, and the only taxable income of the fund is investment income and realised capital gains, there’s a good chance that the fund is not going to generate enough taxable income to allow for all of their franking credits to be used up.

The size and membership of an SMSF will be a strong factor in determining the extent to which this policy will affect it, as will the amount of taxable contributions being made and the asset allocation of the investments.

Let’s look first at an SMSF with retirement phase pension accounts totaling $1M, no accumulation balances, and no further contributions are planned. This SMSF pays no tax on investment income as it is all “exempt current pension” income. The fund currently receives a full refund of its franking credits every year. Under the ALP policy, the fund would cease to receive these refunds.

I’ve seen many SMSFs that have decided in their investment strategies to focus heavily on high dividend yielding Australian companies in defensive sectors in order to generate enough income to cover their pension liabilities and the fees, the long term strategy being that the dividend yield will cover pension payments until the members hit their late 70s. This defers the need to sell down assets to cover liabilities each year and their shares are left to grow with the market.

These funds may have weathered some volatile share price performance in the past 18 months, but this has been made tolerable through the strong dividend yield. The refund of the franking credits is key to the success of this investment strategy long term, and the loss of those will force these SMSF trustees to re-think their strategies ongoing.

Take for example, a $1M SMSF all in retirement phase pensions with 80% in Australian defensive shares – this fund might stand to lose around $15-$17K in “income” each year or nearly 2% in yield. These trustees are likely to be reconsidering their investment strategy, as under the ALP policy, the one they have is not going to serve them as well as it has in the past.

Even if the asset allocation were closer to a traditional ‘balanced” investor risk profile, with say 30% in Australian shares, there’s still around $6-8K pa in “income” the SMSF is no longer receiving and may bring forward the requirement to start selling assets down.

What are the Alternatives?

Change Investment Profile

The conventional wisdom is obviously that investment decisions should not be based on tax outcomes. This is probably true but there is no denying that historically (and quite reasonably), the expectation of franking credit refunds has contributed significantly to the total future return expectations for high yielding Australian shares.

Trustees affected by the ALP proposals may look to adjust asset allocations away from a franked dividend focus to other investment classes such as property (direct or through real estate investment trusts), global shares, fixed income and unfranked dividend yielding Australian shares.

Make Concessional Contributions

Another option for some SMSF members is to make concessional contributions where the members are eligible (restrictions apply - members between 65 and 74 year of age must generally pass a work test in the year of contributing and members age 75 or over generally can’t make concessional contributions.) Concessional contributions are tax deductible to the member and included in the fund’s taxable income, which can result in there being enough taxable income to use up the franking credits.

Add New Members

Alternatively, where the members/trustees have adult children, it might be appropriate for those children to join the SMSF and direct their employer, salary sacrifice and personal deductible contributions to it, thereby generating enough taxable income at fund level to use the franking credits. There’s pros and cons to this strategy though, so consider it wisely. Lyn Formica wrote about it here.

In summary, and at risk of stating the obvious, the more taxable income a fund has, the more franking credits can be used up rather than lost.

Consider Alternative Funds

There has been much discussion as to whether smaller, single member SMSFs in retirement pension phase that invest only in shares, cash and managed funds (ie not direct property) may even consider rolling over all or part their remaining fund balance to a retail “wrap” type pension account or an industry fund. These large super funds generally have both accumulation and pension members, so generally have enough taxable income to use the franking credits. Certainly this will be the right course for some funds. Others will find that the other benefits of the SMSF such as control, estate planning flexibility, ability to change course quickly in response to legislative change or a change in circumstances and many others outweigh the tax savings.

Move Balances to Accumulation Phase

Much larger SMSFs with retirement phase pensions will see less of an impact on them due to the $1.6M transfer balance cap rules introduced from 1 July 2017. As members can only transfer $1.6M into a retirement phase pension, very large SMSFs these days are likely to also have accumulation accounts. These accounts of course are taxed on their investment income, and so the larger the fund, and the higher proportion of the fund that is in accumulation phase, the more franking credits that can be used up.

Some SMSF pensioners whose minimum pension is more than their needs may even consider rolling some of their pension balance to accumulation phase (where permitted). The fund’s tax position will remain the same (eg no refund of franking credits but no tax payable either) but the minimum annual amount to be withdrawn from the fund will have been reduced.

Note, these are just some of the alternatives to be considered. The appropriate option for you will depend on your specific circumstances.

Summary

The proposal to abolish franking credit refunds has taken up a lot of space in financial media since it was first announced a year ago, and Mr Shorten has not budged on it. Like anything, it’s good to plan and be prepared, but important not to take drastic action until we see the results of the upcoming election. It’s not unheard of for a political party to lose an “unlosable” election, and this policy is very divisive. In addition, even if it wins the election, the ALP may need to make further concessions to their policy to win the support of the minor parties.