How To Make Franking Credits Work For A SMSF

It might make SMSF members feel like they are getting 'money for nothing' from the tax office when a tax refund cheque arrives because of franking. The trick is not to over- or under-estimate the importance of franking credits to a fund.
 
Yes, we all love that feeling of getting a cheque back from the tax office but don't fall into the trap of looking upon that refund as 'free' or 'easy' money.
 
A franking credit doesn't mean an SMSF's tax liability is reduced. If an SMSF owns shares in a company and that company issues franking credits, those franking credits represent taxation that the company has already paid at the 30% company tax rate. Dividend imputation was introduced to stop the double-taxing of dividends, first in the hands of the company and then in the hands of the dividend recipient.
 

Funds in Accumulation Phase

Franking or imputation credits work in the same way as other tax offsets. Let's firstly look at a fund that is still in 'accumulation phase' and so, still paying tax on earnings.
 
The shareholder (the SMSF) has to include both the cash dividend and the 'notional' credit for tax already paid by the company, as assessable income. The gross tax payable is then calculated at the SMSF's concessional 15% rate. If the shareholder was an individual and not a SMSF, the tax would be calculated at their personal marginal rate.
 
The franking credit is 'offset' against the gross amount of tax payable and deducted from the SMSF's tax bill. If the franking credit the SMSF is owed is greater than the tax payable by the fund, the SMSF will receive a tax refund. This is often the case with SMSFs because their 15% tax rate is half that originally paid by the company.
 
Let's go back to basics and look at a simple example. A company makes a taxable profit of $5000. At the 30% company tax rate, it will pay tax of $1500 on that profit. It gets to keep $3500, which it might choose to pay to shareholders as a dividend. It is also permitted to attach a $1500 franking credit to that dividend.
 
So an SMSF, as shareholder, receives the $3500 dividend and a $1500 franking credit. The fund (still in accumulation phase) will be taxed on both the dividend and the franking credit, but only @ 15%. The good news is that it gets to claim the franking credit back.
 
To crunch the numbers in the above example:
1. SMSF will be taxed at 15% on $5000 (the $3500 dividend plus the $1500 franking credit) = $750
2. SMSF claims back the franking credit =$1500
3. Total tax outcome ($1500-$750) =$750 tax REFUND to the SMSF
4. So a $3500 cash dividend, after tax, results in a total gain for SMSF of $4250
 

Funds on Pension Phase

The tax benefit of investing in shares that offer fully-franked dividends is obvious. If an SMSF is in pension phase, the outcome is even better. That's because in pension phase, the assets supporting a pension doesn't pay tax on income, namely dividends or franking credits but still gets to claim the franking credit back. So a $3500 dividend is actually worth $5000 to the fund.
 

Mistakes made by Trustees

Now let's look at some of the common misconceptions and traps that SMSF trustees (and some advisers and accountants) fall into at tax time. For starters, even if SMSF members are over 60 and their fund is in full pension phase, it will only retain its tax-free status in any given financial year if members have withdrawn the required minimums as pension payments. Members must have also converted their accumulation account to a pension account, click here to learn how to commence a pension for yourself in your SMSF.
 
An SMSF must also hold the shares 'at risk' for at least 45 days, not counting the purchase and sale days (for ordinary shares) before it is entitled to receive the franking credit. Some preference shares may need to be held for at least 90 days.
 
'At risk' means the SMSF can't use derivatives to hedge the risk of the share investment for that period.
 
Individual shareholders don't have to adhere to this 'holding' rule if the total value of franking credits received in the financial year is less than $5000. However, this does not apply for SMSFs. A self-managed super fund must adhere to the 45-day holding rule, irrespective of how small its franking credit entitlement is. Trading in and out of dividend paying shares during the financial year is still permitted as long as this rule adhered to.
 
Further, a SMSF may not get franking credits from companies involved in dividend streaming or stripping or with a franking credit trading scheme. It has been illegal since 2002 for companies to direct their fully-franked dividends to shareholders who are most likely to gain from those credits.
 
Being over-focused on stocks offering fully-franked dividends can also result in an SMSF portfolio being over-weight in Australian equities, at the expense of other asset classes, and over-weight in stocks focused on paying dividends at the expense of longer-term capital growth.
 
Even in pension phase, it is essential to ensure a fund maintains a reasonable level of capital growth to ensure it can continue to meet, at least, minimum pension payments for members' over total life expectancy of the member.
 
It is also dangerous to overlook Australian stocks that don't offer franked dividends, including those that generate their income through overseas investment. Their income distributions back to shareholders, although un-franked that is without franking credits, may be higher and/or more sustainable than some stocks with full-franked dividends.
 
Lastly, when funds members are in pension and accumulation phase together in one financial year and where the accumulation and pension assets are not segregated, the fund would need an Actuarial Certificate from an Actuary to determine the percentage of income which is supporting a pension and is tax free. We offer these certificates for only $97.50 and have the only instant online form in Australia. Click here to learn more.
 
Also note that the new Coalition Government plans to drop the company tax rate to 28.5%, which will slightly lessen the net benefit of franking credits to SMSFs.from Trust Deed.
 
Posted By David Orth