Franking credits: No magic formula for SMSFs

At first glance, franking credits are a compelling proposition for SMSFs. But they’re not the real recipe for success. So what is?

Key Points

  • SMSFs get the same benefit from franking credits as other shareholders
  • Maximising SMSF benefits requires high yielding investments
  • Franking credits can play other useful roles

The Myth

An advantage of SMSFs is the ability to purchase shares that pay franked dividends. Due to their low tax rate and the ability of excess credits to be refunded, franking credits offer significant advantages to SMSFs.

The Motive

Previous articles have highlighted the battle for the fees on your retirement savings between financial advisors and fund managers. SMSFs are a critical weapon in the advisor’s armory. What better way to fight the battle than ascribing SMSFs with the magical power to transform the value of franking credits?

The Pitch

The basic pitch is simple. Franked dividends usually carry a 30% credit and SMSFs pay tax at 15% (0% for those in pension mode). This gives rise to an ‘excess’ credit which can be used to offset other tax payable, or refunded in cash.

The excess credit makes franked dividends more valuable than they would otherwise be to, say, an individual on the top marginal tax rate of 46.5%. Without a SMSF, they would be required to pay another 16.5% tax on top.

The reality

The argument is superficially appealing but flawed. It is a crude blend of the mechanical operation of the dividend imputation (franking) system and the inherent differences between SMSFs and other taxpayers.

Shares paying franked dividends may or may not be attractive to SMSFs, depending on the particular share and the investment alternatives. There is no particular magic in the fact that a share’s dividends are franked.

Before explaining further, let’s step back and consider some franking credit fundamentals.

The basics of dividend imputation

The franking credit system is designed to prevent the double taxation of corporate profits. It achieves this by allowing shareholders a credit for tax paid by the company—the credit accompanying dividend payments.

A dividend carrying credits is said to be ‘franked’. It might be fully (100%) franked if the company has a large enough franking account balance (a running balance of tax paid by the company), or franked to a lesser percentage if it is insufficient.

As an example, if Company A makes $100 of taxable profits it will; Pay $30 of tax; Be left with $70 after-tax profits; And be able to pay a $70 fully franked dividend (carrying $30 of franking credits).

For the system to work, shareholders need to be subject to tax on their share of the pre-tax income of the company. The Tax Act achieves this by requiring franked dividends to be ‘grossed up’ by adding the amount of the franking credit—the grossed up amount is included as income in the shareholders tax return.

A shareholder who owned 1% of Company A above would receive a 70c fully franked dividend. Its taxable income would be $1 (70c plus 30c franking credit) and the 30c credit would be available to offset the shareholder’s tax bill (or refunded).

In essence, the dividend imputation system treats company tax as a ‘prepayment’ of tax by shareholders. For this reason, SMSFs and individuals not only get to offset franking credits against their overall tax bill, they get a cash refund of any amount left over.

There is no particular magic to this process. In the case of SMSFs, the excess franking credit that typically arises is simply a reflection of the SMSF having prepaid ‘too much’ tax. Individuals on high marginal tax rates, on the other hand, need to pay more tax because the franking credit ‘prepayment’ is not enough to cover the entire bill.

In Table 1 we calculate the after-tax returns for an SMSF and individual where Company A, from our example, pays company tax at 30%. Table 2 shows the after-tax returns where Company A doesn’t pay any tax on its profits.

  Individual (46.5%) SMSF (15%) SMSF (0%)
Table 1: After tax returns to 1% shareholder (30% tax paid by Company A)
Company calculations      
Pre-tax profits 100.00 100.00 100.00
Less: company tax -30.00 -30.00 -30.00
Net after-tax profits 70.00 70.00 70.00
Shareholder calculations      
(A) Cash dividend (fully franked) 0.70 0.70 0.70
(B) Gross-up for franking credit 0.30 0.30 0.30
(C) Taxable income 1.00 1.00 1.00
(D) Gross tax payable (C x tax rate) 0.47 0.15 0.00
(E) Offset for franking credit (minus B) -0.30 -0.30 -0.30
(F) Net tax payable/(excess refundable) (D-E) 0.17 -0.15 -0.30
(G) After-tax return (A-F) 0.54 0.85 1.00
  Individual (46.5%) SMSF (15%) SMSF (0%)
Table 2: After tax returns to 1% shareholder (no tax paid by Company A)
Company calculations      
Pre-tax profits 100.00 100.00 100.00
Less: company tax 0.00 0.00 0.00
Net after-tax profits 100.00 100.00 100.00
Shareholder calculations      
(A) Cash dividend (unfranked) 1.00 1.00 1.00
(B) Gross-up for franking credit 0.00 0.00 0.00
(C) Taxable income 1.00 1.00 1.00
(D) Gross tax payable (C x tax rate) 0.47 0.15 0.00
(E) Offset for franking credit (minus B) 0.00 0.00 0.00
(F) Net tax payable/(excess refundable) (D-E) 0.47 0.15 0.00
(G) After-tax return (A-F) 0.54 0.85 1.00

As you can see, in each case, the SMSF ends up paying net tax of 15% (or 0%) and the individual pays tax at 46.5%. The franked, or unfranked, status of the dividend doesn’t change this result.

Reconciling fact and fiction

In Telstra and the NBN cash pie: Will you get a slice? we made the point that the tax benefit of SMSFs are maximised with higher yielding assets. Franked dividends can be good but a higher amount of unfranked dividends, interest or rent is better.

Table 3 shows the after-tax returns to an individual and SMSF from a 3% franked dividend, 5% unfranked dividend, 6% interest and 8% net rent (commercial property, for the record). In table 4 we calculate the relative returns from a 5% and 8% capital gain.

  3% Franked dividend 5% Unfranked dividend 6% Interest income 8% Net rent
Table 3: After tax returns on various types of income
  Individual SMSF SMSF Individual SMSF SMSF Individual SMSF SMSF Individual SMSF SMSF
  (46.5%) (15%) (0%) (46.5%) (15%) (0%) (46.5%) (15%) (0%) (46.5%) (15%) (0%)
(A) Cash dividend (unfranked) 3.00 3.00 3.00 5.00 5.00 5.00 6.00 6.00 6.00 8.00 8.00 8.00
(B) Gross-up for franking credit 1.29 1.29 1.29 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
(C) Taxable income 4.29 4.29 4.29 5.00 5.00 5.00 6.00 6.00 6.00 8.00 8.00 8.00
(D) Gross tax payable (C x tax rate) 1.99 0.64 0.00 2.33 0.75 0.00 2.79 0.90 0.00 3.72 1.20 0.00
(E) Offset for franking credit (minus B) -1.29 -1.29 -1.29 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00
(F) Net tax payable/(excess refundable) (D-E) 0.71 -0.64 -1.29 2.33 0.75 0.00 2.79 0.90 0.00 3.72 1.20 0.00
(G) After-tax return (A-F) 2.29 3.64 4.29 2.68 4.25 5.00 3.21 5.10 6.00 4.28 6.80 8.00
Extra return vs individual   1.35 1.99   1.58 2.33   1.89 2.79   2.52 3.72
Assumptions:  All calculations based on investment of $100.
  5% Capital gain 8% Capital gain
Table 4: After tax returns on capital gains
  Individual SMSF SMSF Individual SMSF SMSF
  (46.5%) (15%) (0%) (46.5%) (15%) (0%)
(A) Capital gain 5.00 5.00 5.00 8.00 8.00 8.00
(B) Less: Capital gain discount* -2.50 -1.67 0.00 -4.00 -2.67 0.00
(C) Taxable capital gain 2.50 3.33 0.00 4.00 5.33 0.00
(D) CGT payable (C x tax rate) 1.16 0.50 0.00 1.86 0.80 0.00
(G) After-tax return (A-D) 3.84 4.50 5.00 6.14 7.20 8.00
Extra return vs individual   0.66 1.16   1.06 1.86
* 50% for individual/33.33% for SMSF

What these tables demonstrate is that SMSFs benefit more from yield than capital gains (all other things being equal) and the higher the yield the better. Whether franked or unfranked, as long as you are comparing after-tax yields (or allowing for the franking credit by grossing up the dividend), the higher number wins.

Franked dividends don’t fare any better than any other type of income. There is simply no magic formula that makes franking credits more valuable in the hands of a SMSF. Franking credits can, however, serve some other useful (although probably not magical) purposes.

The usefulness of franking credits

As well as forming part of your overall after-tax returns from dividends, franking credits (or, more specifically, a company’s franking account balance) can be a handy tool for shareholders.

Firstly, they can sometimes be a sign of company health and risk. A healthy bank of franking credits can indicate a conservative approach to tax affairs and increase the likelihood that reported income equals cash in the bank. Conversely, a declining franking credit balance may indicate a more aggressive approach on tax or lower quality of reported income.

Behaviour such as capitalised expenses, accelerated reporting of income and increased use of tax benefits to generate profits, tends to reduce a company’s tax payments relative to its accounting profits and erode the franking account balance.

Only ever use these tests as a cross-check, or as an indicator that further investigation is required. There are also plenty of good reasons why the franking account balance may be falling—for instance, overseas expansion or increased exploration expenditure—and it may in fact be a sign of the company investing for future prosperity.

The other useful role of the franking account balance is as an indicator of corporate actions—in particular, off market share buy-backs and special dividends. Companies with large franking account balances often come under pressure from major shareholders to take action to distribute the credits to shareholders.

As explained in Telstra and the NBN cash pie: Will you get a slice?, off-market share buy-backs and special dividends can be attractive for shareholders as the value trapped in the franking account is released. Even those shareholders that would prefer capital gains—for instance, individuals or pre-tax focused institutions—benefit from being able to sell their shares on market at (typically) higher prices.

Mythbusted?

Franking credits might help some advisors sell SMSFs, but in reality they offer SMSFs the same benefit as other shareholders—a tax credit to avoid double taxation.

You should certainly take them into account when comparing investment opportunities—they are a key part of your overall returns—but go for the highest yield if you want to maximize your SMSF benefits.

Franking credits as a magic formula for SMSFs? No way. This myth is BUSTED.

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