Franking credits and offsetting personal tax

Summary: Can franking credits be used to offset personal tax? And the rules on capital gains tax when a home is used for business.

Key take-out: Many small business owners operating from their home do not claim deductions because of potential capital gains tax complications.

Question:  My wife and I are both in our 70s and we have a SMSF, but I separately receive a superannuation pension of around $58,000 a year from my time as an academic. As this superannuation pension comes from untaxed superannuation I pay tax each year, is there any way that I will be able to use the franking credits for the SMSF to offset some of this personal taxation of the pension, or will they be treated as entirely separate entities?

Answer: When it comes to claiming a tax credit for franking credits included in dividends received the ownership of the investment is what dictates who receives the benefit. Clearly when shares are owned by individuals, or a couple, the individuals must declare the dividends they receive as income, plus include the value of and claim a tax credit for the franking credit included with the dividend.

When shares are owned by a trust, such as a family discretionary trust, the dividend income is distributed to individuals, which results in them having to declare the inflated value of the dividend that includes the franking credit, plus they claim a tax credit equal to the franking credit.

When shares are owned by an entity that is taxed in its own right, such as a company or superannuation fund, the franking credit can only be used to reduce the tax payable by the entity.

This means in your situation the franking credits received by your self-managed super fund can only be used to decrease income tax payable on super contributions and income earned on accumulation accounts by your SMSF, and cannot be transferred as a credit to you to reduce income tax payable on your taxable superannuation pension.

Question: For the past 20 years I have been operating a small business from home with a turnover of approximately $40,000 per year, which my husband and I purchased in 1996. I have been claiming home office expenses, such as gas and electricity related to the business usage and phone and internet charges, as well as a small proportion of the property costs including rates and interest on a mortgage. My husband and I are thinking of retiring in the next few years but do not have any plans to sell our home, although this may be an option if we want to downsize.

Can you tell me what the CGT implications would be for myself and my husband when selling the home? In order to apply the 15-year rule exemption, how closely does the sale of the home need to be linked to retirement, does it still apply if the home is sold some years after retirement? Also, if we decide to leave the home to our children when we die, will they have to pay CGT?

Answer: I am surprised that your accountant has allowed you to claim a proportion of the property costs as well as the occupancy costs. Under income tax law property costs can only be claimed for a place of business, which when a business is operated from someone’s home requires a number of criteria to be met.

These include the portion of the home used for the business must be separate from the residence and not have a mixed-use of both private and business purpose, and it should also have its own separate entrance.

I know of many small business owners that have decided not to claim a portion of their property costs, even though they would meet the definition of a place of business, due to them being concerned about the impact of Capital Gains Tax when and if they sell the property.

The tax impact of a portion of someone’s home being subject to CGT is virtually non-existent if the homeowner can pass all of the relevant small business CGT exemption conditions. The first of these is the turnover test that requires business income turnover to be less than $2 million a year. Having an annual turnover of only $40,000 a year means that you pass this test.

When a business has a turnover of more than $2 million a year the owners can still qualify for the small business CGT concessions if the total value of their assets, which are counted under this test, is less than $6 million.

The next test requires that the asset being sold must have been actively used in the running of the business. This means if a person, partnership, or other entity that operated a business, in addition to having an asset that was connected with the running of the business also had an investment property, the small business CGT exemption can only apply to the active asset.

Once this test is passed an owner of the business can claim the CGT exemptions or concessions available. These include the 15-year exemption, the 50 per cent active asset discount, the retirement exemption, and/or the rollover concession.

The 15-year exemption can only be claimed when the business has been operated for 15 years, and the asset sold must have been actively used in the running of the business for at least half of its ownership period. If the 15-year exemption is claimed no other concessions are available.

If the active asset discount is claimed, after taking into account the 50 per cent general discount that applies to all individuals who make a capital gain, effectively only one quarter of the capital gain made will either be taxable or can have the remaining CGT concessions applied.

In your case, as a result of having claimed a percentage of the occupancy costs of your home used for running your business, you would need to apply that percentage to any gain made on the sale of the house to assess what portion of the gain would be assessable and eligible for the small business CGT concessions.

If you did not sell the house and your children inherited it, theoretically the business percentage portion of the profit made on the sale of the house after your death would be assessable without the benefit of the small business CGT concessions.

Given the complexities of the CGT business concessions you should seek professional advice before taking any action.

If you have a question for Max Newnham please email it directly to max@taxbiz.com.au