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Self Managed Super Fund (SMSF) Article
Self-managed super and franking credits
By Tony Negline.
This article may be out of date.
13th May 2009
Any superannuation investor with money invested in Australian companies needs to understand what imputation credits (aka franking credits) are.
The imputation credits system allows companies to pass onto shareholders a credit for the income tax paid on distributed profits. In most cases imputation credits are given to shareholders as part of dividend payments but sometimes they are used to make an off-market share buyback arrangement appear more attractive.
A common misconception is that imputation credits reduce a super fund’s income tax liability.
This mistaken belief arises for two reasons. Firstly companies that can pass on imputation credits historically pass on a greater share of their profits to shareholders. Secondly imputation credits will reduce the income tax that a taxpayer would pay out of their own pocket and some people reach the false conclusion that they are paying less tax.
In effect imputation credits alter the timing of income tax payments but don’t reduce the overall level of taxation.
Imputation credits have been a feature of the Australian taxation system since 1987 and super funds have been allowed to use them when working out their tax liabilities since July 1988.
The best way to understand how imputation credits work is to look at an example. Suppose a company has sales during a year of $1,000 and that it costs it $900 to make those sales. It’s profit for the year will therefore be $100. In Australia, companies pay 30% tax on profit made; in our example the company owes $30 tax, so its net profit after tax is therefore $70. The company must record that it has imputation credits of the amount of tax paid – that is, $30.
If the company’s directors decide to distribute some profit to the shareholders then those shareholders must include the dividend paid plus the franking credit in their taxable income. In our example assume that all of the net profit earned by our company will be paid out as a dividend.
Suppose that a super fund owns half the shares issued in our company which means the super fund will receive half the dividends.
Finally assume that an employer has contributed $100 to the super fund and also that the fund has no administration expenses.
The super fund will therefore have income for tax purposes of $150. This is worked out by adding the dividend ($35), the imputation credit ($15) and the employer contribution ($100).
Super funds pay a fifteen percent tax rate if the fund assets are not supporting a pension. Our fund therefore owes $22.50 tax. Fifteen dollars of this tax owing has already been paid – it was paid by the company. To work out how much tax the super fund has to pay the Tax Office we need to reduce this payment by the tax already paid by the company. The net tax payable is therefore $7.50 ($22.50 - $15).
This definitely looks like the fund’s tax rate has been reduced.
As a super fund’s tax rate is 15% and a company’s tax rate is 30%, it is possible for a super fund to invest in such a way that the franking credits exceed the actual amount of income tax. If the franking credits are bigger than the actual tax payable then the ATO will pay a refund.
However when you look behind the numbers you will quickly realise that franking credits merely change the amount of tax paid on a dividend to the shareholder’s actual tax rate.
Remember franking credits represent tax already paid. In effect that money is being loaned to the government at 0% per cent interest. Any super fund with lots of franking credits should try to get their income tax return in as quickly as possible to get that money back so it can be invested properly.
The need to obtain a timely refund of franking credits from the ATO will be important if the income from shares is being used to pay a pension. For example in the year to March 2009 the total dividend paid from the ASX 200 All Ordinaries index without taking into account any franking credits was 4 per cent. If we assume that 70% of these dividends have imputation credits attached then the return increases to 5 per cent.
The minimum income payments from account based pensions are 4 per cent for those under 65 and 5% for those aged at least 65 but under 75.
Not all companies can pay franking credits. In general they are only payable on profits earned on Australian based activities for Australian based companies. Therefore should a super fund invest in companies that can pay franking credits ahead of other companies?
This is a very good question. Research in a number of countries has shown that when a franking credits system operates the amount of profits companies pay out as dividends is higher than if the franking credits is not available. However while the level of income paid from an investment is very important, it is only one element that must be considered when a trustee is working out where to invest.
Recently it has been suggested that the government might do away with franking credits. It has been reported that if this occurred the government could reduce the company tax rate from 30 per cent to 20 per cent. If super funds then had to pay tax on that dividend income then those dividends would be taxed at 35 per cent (20 + 15). By any measure this would be a lousy outcome.
One last point – not all super fund investors can control how many franking credits they can earn. Only super fund investors, who are able to invest directly into Australian companies, can knowingly invest in companies that have a reasonable expectation of paying franked dividends.Super investors who invest in Australian companies via managed funds probably have no control over the level of franking credits they may earn because it is the fund manager who decides these issues.
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