The bias that many self-managed superannuation funds (SMSFs) have to Australian shares would almost certainly change if the Labor proposal to stop franking credit refunds got through. So say advisers deluged by calls from clients worried about their potential loss of income under the Labor plan.
Franking credits (to take account of company tax already paid on dividends before you get them) are an important component of the overall return for Australian shares, says Jonathan Philpot, partner with HLB Mann Judd Wealth Management. They're used to offset tax on other income and retirees paying little or no tax boost their annual income via unused franking credits being refunded by the Australian Taxation Office.
"The current dividend yield on the Australian market is 4.3 per cent and the franking level is about 70 per cent," Philpot adds. "Therefore the franking credits add a further 1.3 per cent to the return for Australian shares. For a super account that may have 40 per cent exposure to Australian shares, this is adding 0.5 per cent to the overall return."
Effectively this would lower the expected return for Australian shares for super funds not able to make full use of the franking credits.
"This does not necessarily make them a worse investment than, say, US shares, as dividends plus expected growth is the driver of investment returns, but it does have an impact on the expected return," says Philpot. "Perhaps a bias that has existed in many SMSFs towards Australian shares with much lower exposure to other asset classes will become more balanced over time."
Diversify
Nerida Cole, head of advice at Dixon Advisory, agrees. She says under the Labor proposal, those adversely affected would need to "diversify their investments (in line with their tolerance to risk) but look for assets that provide gross income or don't have franking credits and are taxable, eg international shares, property, fixed interest, infrastructure assets".
The higher the level of income from the non-share component of the portfolio, she adds, the lower the potential impact. "All other things being equal, the income from the other investments may absorb the franking credits. Or even where there is no tax benefit, the other income will reduce the impact relative to total income," she says.
The Labor proposal has supposedly been aimed at "hitting the rich". But Philpot – like many advisers and retirees – says it will be retirees with just enough assets to miss out on the part age pension who will be hit the hardest. That's because they will lose a bigger proportion if they're not refunded unused franking credits by the ATO.
Philpot cites someone with a $800,000 pension with 40 per cent invested in Australian shares. Assuming a dividend yield of 4 per cent with fully franked shares, the tax refund up to June 30, 2017, was $5485 – which they would lose under the Labor proposal.
He compares this to someone with a $4 million balance (using the same assumptions) where the tax refund to June 30, 2017 was $27,428. "With the $1.6 million pension cap, now $2.4 million is subject to tax on the taxable earnings [because this amount would have to be in accumulation mode]. Assuming 5 per cent earnings ($120,000), 15 per cent tax of $18,000 will offset the tax refund. This reduces the tax refund to $9,428, so the Labor proposal will only have an impact of $9,428, being the lost tax refund."
Lower balances worse hit
As Philpot says, Labor's proposal would have the greatest impact on retirees who fall just outside the assets test thresholds. "The impact of that lost tax refund on the couple with $800,000 is a far greater proportion than those with the $4 million balance. Those who had large pension balances were hit harder by the $1.6 million pension cap than they would be by Labor's proposed loss of franking credits," he adds.
The first time excess franking credits became refundable for dividends was from July 1, 2000, says Bryan Ashenden, head of financial literacy and advocacy at BT Financial Group.
Dividend imputation had been introduced in 1987 to prevent double taxation.
As Ashenden explains, when a company makes $100 of profits, it has to pay 30 per cent (or $30) tax. This leaves $70 of after-tax profit payable as a dividend. "If your SMSF receives the $70 dividend, it would be taxable to it," he says.
"Before dividend imputation, your SMSF would have paid tax on that dividend. With a tax rate of 15 per cent, your SMSF would have paid another $10.50 tax, leaving you with only $59.50 from the company's original profit. In other words, those profits were taxed twice, and in these circumstances a total tax rate of 41.5 per cent applied."
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