If elected, one of Labor’s signature tax reform proposals is to cease franking credit refunds from 1 July 2019. This will impact many 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 upcoming Federal election and the legislation passing through the parliament. 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 to Labor’s proposal:
- 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 is 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 dividend of $10,000 plus a franking credit of $4,286 the notional rate of tax could be as high as 30 per cent. 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 does not come with franking credits attached. For example, a fund that is wholly in retirement phase and has a fully franked dividend of $10,000 plus a franking credit of $4,296 and interest income of $4,000, would be tax exempt but have a notional rate of tax equal to 23.42 per cent.
Ways to minimise the impact
To minimise the impact, there are a number of strategies you could use, but it depends on the goals and objectives of your SMSF as well as the circumstances of fund members. In some situations, from a pure investment 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 the appropriate investment for your SMSF.
Prior to making any decisions, your SMSF should obtain advice from a tax specialist or financial adviser as to the best course of action.
Strategy one - Transfer investments from retirement to accumulation phase
Income on investments in accumulation phase are 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 pensions 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 her with a minimum pension of $64,000 (four per cent of the pension account balance). However, 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. However, this will change if the proposal to remove franking credit refunds comes into play from 1 July 2019 as the fund will receive no refund of any excess credit.
If the law changes to remove franking credit refunds Rose could commute her pension in full or in part, if she wished and transfer investments to accumulation phase. Depending on whether Rose’s fund uses the segregated or proportional method to calculate its taxable and tax-exempt income, all the franking credits received by her fund will be applied against any tax payable on the income attributed to accumulation phase. This means that if the investments were structured appropriately, Rose’s fund would continue to pay no tax because of the application of the franking credits against the tax payable by the fund. However, in years where the fund’s franking credits are insufficient to cover the tax payable, the fund may end up paying tax. This could occur if the investments in accumulation phase have taxable capital gains, lower dividends than expected or taxable contributions.
Whether the strategy for Rose’s fund would provide any advantage is a moot point as the fund was tax-free in the first place, due to it being wholly in retirement phase. Converting all or part of the Rose’s pension account back to accumulation phase may provide the opportunity to use the franking credits available. However, this may only reduce the fund’s tax payable to nil, the same result as if the fund had remained in retirement phase.
One benefit of moving all retirement phase pensions back to accumulation is that there is no longer the requirement to make the relevant minimum pension drawdown each year. If Rose was to commute all of her pension back to accumulation, she could still withdraw benefits as a series of lump sums when required. Any lump sum would be tax free (as she is at least age 60) and there would be no requirement to make a minimum pension amount – four per cent for Rose, increasing to five per cent when she turns 65. If there was a year where Rose required a smaller drawdown from her fund, say $30,000, she would not be forced to take a larger amount in order to comply with the minimum pension rules.
Another issue is the impact of Rose’s transfer balance account if the pension was commuted and transferred to an accumulation account. The transfer of the commuted amount to an accumulation account reduces Rose’s transfer balance account balance by the amount transferred to accumulation phase. If the amount in accumulation phase was to grow while in accumulation phase and needed to be returned to pension phase, the amount returned would be limited to the gap between Rose’s account balance and her TBC. As there is no limit to the growth of the value of assets supporting pensions in the fund for these purposes it may have worked out better to have left her pension in retirement phase.
The amount of franking credits is determined by the company tax rate. If this rate changes the fund may be exposing itself to unnecessary legislative risk and face a potential reduction in the available franking credit.
While there may be some reservations to transfer assets to retirement phase merely to use the franking credits available there may be some benefits for a fund that is partly in accumulation phase and retirement phase. This could occur for a member who has maximised their pension account for TBC purposes and has an amount in accumulation phase or where the SMSF has members who have pension and accumulation accounts.
Strategy two – Make concessional contributions to the SMSF
Concessional contributions made by a member or their employer are taxed at 15 per cent. 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.
Strategy three – Make investments that have lower or no franking
Changing investments to those that have a lower franked amount or are not franked at all needs to be considered seriously from an investment point of view before taking any action. This should take into account a comparison of the franked investments and other investments from both a yield and capital gains point of view. If the proposed investment does provide a better overall rate of return, sale of an investment held by the fund and purchase of another 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 and capital gains on the alternative investment.
Strategy four – Withdraw an amount from super and invest it in your own name
Having investments transferred into your name from your SMSF may allow you to use the franking credit attached to the investment. However, you will need to ensure you can use the credit effectively and not lose it if an excess results. Before the decision is taken, the long-term tax impact should be considered because the after-tax investment return in your name needs to be greater than if it was owned by the fund due to personal tax rates. Depending on the situation the fund could be liable for capital gains tax (CGT) on the transfer of any investment to you and there may be a cost associated with the transfer of the investment into your name.
The tax rate in a fund is 15 per cent in accumulation phase irrespective of the income received. In comparison you pay tax only where your taxable income is greater than the tax-free threshold of $18,200 or greater where the senior Australians and pensioners tax offset (SAPTO) and other tax offsets may apply to your taxable income. The minimum personal tax rate is 19 per cent plus two per cent Medicare which would enable franking credits to be used, in effect, for that part of your taxable income down to the tax-free threshold for income earned on investments held personally.
However, in comparison, the fund tax rate is capped at 15 per cent, but your individual tax rate can be up to 45 per cent plus Medicare, 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.
Strategy five – Add new members to the fund
Adding new members to the fund may need to be considered seriously as they may come with their own issues. However, 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.
Strategy six – Rethink deductions for some expenses
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 is claimed by the fund is up to the trustee. If no deduction for the premium is claimed the taxable income of the fund may be greater than if a deduction is claimed. This will allow the fund to use some of the excess franking credits if the fund has a taxable income. In addition, if the fund has not claimed a deduction for insurance premiums any benefits that may be paid to the fund due to the death or disability of a member will not be an untaxed benefit if paid to an adult child. The position will not change if the insurance forms part of a benefit that is paid to a dependant such as the member’s surviving spouse.
As discussed above there may be some strategies which will 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 a fund’s investments or moving member’s benefits from retirement to accumulation phase or withdrawing them from the fund altogether need to take into account the net after tax return of the whole transaction and not just whether there is a more efficient use of franking credits.
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