The franking credit fallacy

The DIY super army is under fire again. Now the claim is that they don’t pay tax, or “evade” paying tax.

It’s a flimsy argument, based on the premise that self-managed super funds invest in companies that pay fully-franked dividends.

It’s the second outbreak of this scuffle in about a year. And with so many eyes – including David Murray’s Financial System Inquiry – on the industry, correcting fallacies becomes more important.

How franking credits work

Any argument here requires a quick refresher on what franking is. It is a recognition that income shouldn’t be taxed twice. If a company pays tax on the dividends paid to shareholders, that income shouldn’t be taxed a second time. Whether that is right or wrong is irrelevant. It’s just what the franking laws are based on.

Therefore, when you receive a fully franked dividend of $70, it’s really a $100 dividend, where $30 of tax has already been paid by the company and for which you have a credit. When anyone – not just SMSFs – receives a franked dividend, they get a tax credit associated with it.

Anyone earning a taxable income of less than $37,000 a year will receive an actual refund on a fully-franked dividend. As super funds – all of them – pay tax at no more than 15%; they also receive a portion of that tax back.

A table in one report suggested that if a SMSF got a tax refund, then it had eliminated tax for the fund. In other words, it had paid no tax. Utterly ridiculous. A tax refund means that you have already paid too much tax, so the tax office owes you money.

In the example used, the fund was paying $9,321 in tax for the year, which was 15% of the fund’s net income. However, it had franking credits of $9,643 to claim back. The net result was a tax return of $322. But the fund was still paying $9,321 in tax. The example used had the member contributing $30,000 as a concessional contribution.

Now, if that SMSF was in pension phase, then it would have received back the entire $9,643 in franking credits from the investment’s income. But if the member had paid $30,000 in as a concessional contribution (to his accumulation fund), then $4,500 in income tax was owing on that contribution. So in total, in this case, the SMSF would have received a tax return of $5,143.

Does that mean it’s paid no tax? No. The member paid $4,500 in income tax on his contributions and no tax on the pension fund.

The law applies to all super

That is the law for everybody’s super, not just SMSFs. APRA funds (industry, government, corporate and retail funds) also benefit from the franking credits system in the same way. The rules aren’t any different for a SMSF to all other super funds. But that article only demonises SMSFs on this issue. Why?

Because SMSF trustees make different investment choices. Because they make longer-term decisions. Because they put in hours of work to make decisions to manage their tax. Because they turn on pensions when it makes sense. Because they make conscious trade-offs, often choosing income stocks for the franking credits, rather than growth stocks.

They are paying tax as they go, as does the whole superannuation industry. To say that they’re not is simply a lie, or ignorance. A franking credit is recognition for part tax already paid, not tax avoidance.

If they actually wanted to avoid paying unnecessary tax, it’s easy enough. Here’s how: Buy stocks that do not pay dividends (franked or unfranked) and hold them for a very long time, until the member of the fund turned 60 and turned on a pension. By holding income-less stocks and not selling them, they would pay no income tax on investment earnings along the way. By selling them in pension phase, they would avoid paying capital gains tax. Then, if they wanted to rub salt into the taxpayers’ wounds, they could buy income-producing stocks and pay no tax because they’re on a pension. They would only pay tax on concessional contributions.

But anyone with money in super can do that. If your super fund won’t let you buy individual stocks to help manage your tax, you don’t need an SMSF, as there are plenty of super platforms that will allow you to do this.

Sure, SMSFs tend to have a focus on those companies that pay fully-franked dividends, which include the major banks and Telstra. They are probably overweight these companies. But, based on this, you could argue that SMSFs actually pay more tax on their investments than do the APRA-regulated funds, who invest greater proportions, relatively, in growth stocks that pay low, or no, dividends.

If SMSFs are investing in companies that pay higher dividends, they are paying more tax, not less. Fully-franked dividends have nothing to do with it, as they are available to all.

The information contained in this column should be treated as general advice only. It has not taken anyone’s specific circumstances into account. If you are considering a strategy such as those mentioned here, you are strongly advised to consult your adviser/s, as some of the strategies used in these columns are extremely complex and require high-level technical compliance.

Bruce Brammall is director of Castellan Financial Consulting and the author of Debt Man Walking. E: bruce@castellanfinancial.com.au

• The ATO has identified over 37,000 SMSF members with lost super amounts totalling $19.1 million. The super, which the ATO is holding, includes amounts paid to it by employers, super funds or the government on members’ behalf. SMSF members can have ATO-held super transferred to their SMSF, or if they qualify they can withdraw these amounts.
• The federal government’s decision to again delay the introduction of the superannuation guarantee highlights how superannuation must be removed from the short-term political cycle, says Andrea Slattery, chief executive of the SMSF Professionals’ Association of Australia (SPAA). “Moving the SG rate to 12% as quickly as possible was an important measure to ensure Australians had adequate balances in their superannuation funds on reaching retirement,” she said.