Make the most of franking credits

PORTFOLIO POINT: Dividends are on the rise again, which is handy, because the market has done squat for 12 months. What’s the value in a franking credit for a SMSF?

For several decades, the word “Frank” only ever conjured up Michael Crawford playing the hapless and accident-prone Frank Spencer in the 1970s British comedy Some Mothers Do ’Ave ’Em for me. It took years of Crawford playing serious characters, such as the lead in Phantom of the Opera, for me to believe he could be anyone else.

“Franking”, as a result, was highly unlikely to be anything particularly clever. I certainly wouldn’t have actively sought out “franking”.

So it was a good thing then Treasurer Paul Keating left it until the late 1980s to use of the phrase “franking credits” when he ended the double-taxation of company dividends. Because franking credits are actually very clever, and can deliver enormous benefits to SMSFs.

Franking, also known as dividend imputation, is an acknowledgement by the tax office that company profits have already been taxed once. To then make shareholders pay tax again on the dividends would be to tax the same profit twice. Franking is a credit for tax already paid.

And now dividends are on the rise again, generally across the board. For some, given that the All Ordinaries and the ASX 200 have done virtually nothing in the past 12 months, dividends might be the only real return SMSF trustees have received in that time from a diversified portfolio.

So, where’s the advantage in franked dividends for SMSFs? There are several. But they largely stem from the fact that (fully) franked dividends are generally at the company tax rate of 30%, while compliant super funds are taxed at 15%, 10% or 0%.

And, thanks to changes made about 10 years ago, you can get back the difference between the 30% paid by the company that issued the dividend and the lower tax rate paid by your SMSF on its own income.

So, let’s look at a few companies and the value of the tax credits. For a start, let’s assume equal investments of $10,000 in some of investors' favourite companies, including the banks.

In the table above, an SMSF in accumulation mode (green) that has a $10,000 investment in ANZ would receive a dividend of approximately $471. However, come tax time, the accumulation fund would have a tax credit for having paid $201.

Because its tax rate is only 15%, compared to the 30% company tax rate that was paid on the distributed dividend, the SMSF would be entitled to a tax return of approximately $101.

That is, they have received a dividend of $471, but they will receive a further $101 for the difference between the 30% company tax rate and the 15% they are due to pay on income.

It’s even better for SMSFs in pension phase, presented above in red. Because super funds in pension phase don’t pay income or capital gains tax, the investor is entitled to get back the whole of the tax franking credit back. In the case of the ANZ, $201 would be returned to the SMSF.

But as you can see from the above, the ANZ isn’t even a particularly attractive yield among some of Australia’s favourite dividend stocks.

Arguably, the only reason to hold Telstra nowadays is the yield, given that it is substantially below its 1997 float price and there’s no particularly rosy outlook for growth in its shares.

A $10,000 investment in Telstra would receive a cash dividend of $1007. If you are in accumulation mode, the SMSF would get back $216, while a pension fund would get back double that, or $432.

One of the ongoing problems for Telstra, however, is that fewer and fewer people believe its dividend is sustainable (for more on Telstra, click here). It is considered likely that the dividend will have to be cut soon, which would place further downward pressure on the stock.

Offsetting contributions taxes

Make concessional contributions to your fund and you’re up for losing 15% of the amount in contribution tax, up to your age-based limit of $25,000 or $50,000.

Those who do make a full $50,000 contribution to super will be up for contribution taxes of $7500 (reducing the net contribution to $42,500).

But those who have investments in franked dividends will be able to neutralise some of that $7500. In order to neutralise the lot (ignoring other events, such as capital gains), fully franked dividends of $35,000 would completely neutralise the tax due to be paid. That is, the $35,000 of fully franked dividends have a grossed up value of $50,000, but would see an accumulation fund receive $7500 back (to make the total income to the fund of $42,500).

It sounds like a lot. But you would only need an equally weighted portfolio (of the shares in the table above) worth about $606,000 for that $7500 of contributions taxes to be wiped out in an accumulation fund. And you’d only need have that investment in a pension fund.

Dividend “certainty” versus capital gains “risk”

The decision of chasing dividends versus capital growth is an easy one for some, but is considerably harder for others.

Without doubt, taking a dividend seems to be less of a risk. You can still reinvest back in the company if you want to. The reason I used high-yielding favourites above is to show how valuable they CAN be. Putting in the likes of a BHP Billiton, or News Corp, wouldn’t lead to much of a franking credit refund because they hardly pay much of a dividend to start with.

Importantly, don’t read this article as a recommendation to chase fully franked dividends. It’s not that simple and the income nature of dividends is not equally important to all Eureka Report readers. Growth is arguably a much bigger priority for many investors.

Bruce Brammall is director of Castellan Financial Consulting and author of Debt Man Walking.