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How SMSFs can utilise franking credits under Labor

Recent political events point to an increased likelihood of a Labor Party election victory in 2019, making the implementation of its proposed changes to franking credits more likely. Much has been written on this change including its impact on SMSF pensioners, its unfairness, its potential impact on equity markets and the perception that an underlying motive is to move people out of SMSFs and into industry funds.

However, in all the heated discussion, one key advantage of SMSFs has been largely overlooked: control. Some SMSF trustees will still be able to exploit this feature of SMSFs to minimise or remove the financial impact of the franking change while at the same time undertaking strategic estate planning, the fruits of which they will enjoy while still alive.

The benefit of control

Most people set up SMSFs because they want to exercise control over key aspects of the fund including its membership, investments, timing of investment sales to maximise tax outcomes, general administration and estate planning. Our students at the University of NSW are taught this early in our SMSF course to demonstrate people are taking responsibility for their retirement.

However, the current franking discourse has lost sight of this major SMSF benefit. This article expands the discussion on one strategy available to SMSF trustees (mentioned in Matthew Collins’ article in Cuffelinks).

Adding adult children in accumulation mode to an SMSF in pension mode

The addition to an SMSF of younger family members who are still in accumulation mode and making taxable superannuation contributions will lead to an increase in the fund’s taxable income. The SMSF is a single taxable entity. Trustees can utilise the combined taxable income of both the pension and accumulation components. This can soak up some, if not all, of the franking credits otherwise lost from 1 July 2019 under Labor’s proposal.

The table below sets out the potential franking credits lost assuming a two-member SMSF in full pension phase, a dividend yield of 5% and an asset allocation of 29.2% to listed Australian shares as per the latest ATO statistics (assume these shares are fully-franked dividend paying).

This stylised example shows the taxable income required to fully utilise all franking credits.

Where does the taxable income come from?

The increase would come from concessional contributions made by adult children added to the SMSF along with investment earnings on any existing accumulation balance rolled over. Given adult children in their 40s have been receiving superannuation contributions for 25 years (since 1992 albeit at lower rates than the current rate) the balances rolled into the SMSF may be significant. The full amount of the concessional contribution is classified as assessable income to the SMSF.

Assuming one child joins the SMSF and rolls over an existing balance of $150,000 and makes maximum annual concessional contributions of $25,000, the SMSF’s taxable income would increase by $32,500 ($25,000 + [$150,000 x 5%]). This would result in all franking credits being used in scenarios 1 and 2 above. Based on investment earnings of 5%, every additional $50,000 of accumulation funds rolled into the SMSF would increase taxable income by $2,500. Compounded over a decade or two (a feasible result given current longevity expectations), the financial result is material.

The outcome becomes more favourable if two or more children join the fund (up to four children could join the fund if the current proposal to increase the limit of SMSF members from four to six commences in 2019). While ATO statistics point to a slight fall in four- and three-member SMSFs in recent years, the increased scope for strategic planning emanating from the proposed change may reverse this trend.

Benefits of the strategy

The addition of children to an SMSF who are still in accumulation mode can be an effective strategy for several reasons:

First, existing SMSF pension members will not want to ‘lose’ money after 1 July 2019, and increasing the fund’s taxable income partially or fully retains the benefit of franking. In effect, the SMSF is achieving the same result as an industry or retail fund which will not lose the ability to use franking credits.

Second, by utilising their parent’s franking credits, children can tax-efficiently increase their retirement savings. This could occur at a time when they are dealing with significant financial commitments like mortgages and school fees thus providing a welcome financial boost.

Third, and perhaps the most overlooked reason, is that the proposed change provides an opportunity for SMSF pensioners to implement an estate planning strategy that takes effect while they are still alive. Effectively, SMSF pensioners will be able to legally and tax-efficiently pass on some of their estate to their children by reducing the tax liability on their children’s super contributions and earnings. Again, the compounding effect over many years may be significant. Furthermore, rather than the usual scenario of their estate being transferred to their beneficiaries after their death, parents will be able to enjoy their retirement years in the knowledge that their children are simultaneously reaping the benefit of their SMSF structure instead of losing some of their retirement benefit to a legislative change.

Potential drawbacks of the strategy

Of course, all strategies come with risks and potential problems.

First, in return for joining the SMSF, children would have to take on the associated trustee responsibilities, although this may lead to greater engagement with their superannuation.

Second, family life can be complex. Marriage breakdowns, estranged children or family in-fighting are common and may prove too much of an impediment to this strategy. No doubt, some people will understandably not want to go anywhere near mixing finances with family life.

Third is the issue of fairness. More of the benefit of franking credits otherwise forfeited would accrue to the children with greater existing accumulation balances or making larger concessional contributions because the franking credits are applied proportionately (i.e. they save the greatest amount of tax). However, this could encourage children to make greater contributions.

Fourth, a risk for children joining the SMSF is that investment returns may be less than those earned in their existing retail or industry fund, or they may sacrifice favourable insurance arrangements.

Such impediments are not insurmountable and may even be a catalyst to ‘professionalise’ the SMSF and take a more holistic, whole-of-family approach, to financial planning. Against the backdrop of the ongoing Royal Commission and other changes occurring in the financial advice industry, Labor’s proposed change represents an opportunity for SMSF trustees and their advisers to consider a more forward-thinking approach. Of course, the policy proposal is facing considerable public opposition, and its final form or timing are unknown at this stage.

 

Dr Rodney Brown is a Lecturer in Taxation and Business Law at the University of NSW Business School, including the Master of Tax and Financial Planning course. He completed his PhD at the London School of Economics after working as a financial planner in Sydney. This article is general information based on a current understanding of tax law and Labor’s proposal, and it does not consider the circumstances of any individual.

23 Comments
Basil Jenkins
March 02, 2019

Replace some shares paying franked dividends with purchases of unallocated gold from the Perth Mint, which attracts no storage fees, pays no dividends but can generate potential capital gains. Increase holdings of foreign funds whose dividends bear foreign tax, which is offset by franking credits. Rather than cling on to shares showing high unrealised capital gains to avoid capital gains tax, trade shares for capital gains without fear of capital gains tax which can be fully offset by franking credits which would otherwise be foregone.

JamesA
December 24, 2018

Thanks Don. The full amount of the concessional contribution is classified as assessable income to the SMSF. These types of contributions are taxed at 15%. Is there any way this contribution tax on concessional contributions can be reduced? Can the franking credits reduce the 15% tax on contributions in the same way the franking credits can reduce the earnings tax on super in accumulation or TTR phase ?

Donal Griffin Legacy Law
December 10, 2018

We would add that, as lawyers who see potential disputes in families, it is important to ensure that the younger trustees cannot outvote the older trustees. One way to manage this is to have voting linked to dollar value of member balance in the SMSF trust deed.

Ramani
December 09, 2018

As much as assumptions of tax minimisation being invalidated through subsequent (sometimes retrospective) rules, some should avoid SMSFs because of the onerous obligations which if breached could result in non-compliance and loss of half the savings. Ageing, longevity, declining mental and physical capacity, grasping inheritors and complexity dictate that many MUST move to a PO fund. This elephant in the room is often ignored.

Balancing the ATO's disadvantages you allude to are its unique privileges which other agencies could only fantasise about: the one-sided Part IVA (but taxpayers cannot attack an ATO 'scheme' to garner revenue through convolution and contrivance); the recent case whereby its own advice relied upon by the taxpayer was overruled because it erred.

The beleagured APRA. ASIC, ACCC & Austrac could be forgiven for saying: ' Could we have what ATO is having...'

The rule of law inverted down-under?

Philip Carman
December 09, 2018

Working as a professional in this area for almost 40 years I have found that for those with less than $1million in super the SMSF route is rarely more attractive than one of the better public-offer funds. The costs of an SMSF are now potentially greater than a public fund, and, as we've seen, there are some disadvantages (treatment of franking credits in pension phase and other tax and treatments amongst them) that mean the best public funds are better, cheaper and far more convenient, with better reporting facility than the SMSF. I've been actively shifting people from SMSFs to better public funds for the past 7-8 years, as the cost differential swung against the SMSF - just as 25 years ago the SMSF emerged as a superior route for those with more than about $300,000 and a preference for choice of assets and strategy.
These things are constantly changing and everyone needs to keep up rather than hold untested assumptions beyond their use-by date.

Pat
December 11, 2018

SMSF admin and audit costs are moving down, not rising. ETF’s are now available from 14 basis point, plus cash and TD’s have no investment management fee. The one million dollar myth is promoted by the public offer (especially industry) funds in their war against SMSFs to the uneducated. Long gone are the days of 5k p.a + admin fees.

Philip Carman
December 12, 2018

Hi Pat. I've not yet found an accountant who'll do SMSF admin for less than $2200pa and with ASIC fees and Audit, etc, I expect the lowest total admin cost to be $3600 pa. The investment options and choices then become moot because you can do all in a public offer fund, at wholesale price rather than retail, AND as public-offer fund trustees gain the tax advantages (saving GST for example, as well as distributing Imputation credits, etc) there's savings to be made of perhaps $600pa there, too. So despite having no vested interest (I charge the same for my time either way) I stick to the view that SMSFs work only where property assets are involved and/or where the funds exceed $500,000, but ideally around $1m.
The admin costs for my clients with $800k in the public-offer fund we use most is less than $3000pa and that includes 24/7 access to all their investment and admin details and reporting online...plus those tax rebate advantages. I'd love to know what could be better security and better value...as well as more convenient.

Ramani
December 07, 2018

The non-refund proposal has stirred up our primal urges to find circumvention options. As in the past, they will range from perfectly legal and unquestionable to barely legal, skirting ATO's Part IVA instincts. Adding accumulation members (subject to the behavioural and economic issues cited) is in the former category.

Others involve:

Getting unrelated parties who would otherwise pay 15% on contributions to absorb wasted credits for an agreed 'fee' - 'members for hire' to traffic in otherwise lost credits.

Introducing non arms length income (NALI) subject to maximum tax against which the credits are set off.

Financial engineering to issue shares that pay franked or unfranked dividends to suit different investors, with the latter being grossed up for franking, subject to transaction costs.

Converting dividends into discounted capital gains through bonus issues, or selling shares cum dividend and repurchasing.

Not that the distinctly unamused ATO would allow all or any of these. So for every gaming move, expect the Newtonian (opposite often disproportionate) revenue response by way of checkmate.

Who said tax is not fun for the so-inclined?

Philip Carman
December 09, 2018

Like your work, Ramini! The "fun" is always in the strategic thinking...but some won't/can't. The ATO is always disadvantaged by the fact that it has to get legislation lined up after the fact, so our industry can (almost) always advance offensive (and sometimes that word can apply in all its guises) strategies within a short period of any defence.
It's always irked me that one of the few things we can know or do with certainty is how to reduce tax payable...when it only benefits those who often least deserve our help.

Robert Goodwin
December 06, 2018

Current discussion is all about impact on SMSF in pension mode (and thats what Labor is targeting currently) however if you are in a fund other than SMSF you are safe? For how long..It seems odd to me that the ATO allows tax due by one member in accumulation stage to be offset/credited to a tax refund of a member in pension stage ( (an unrelated person ?) I dont understand why the ATO allows this..If its all about lost revenue then surely this is the biggest bloody opportunity..??? But of course with Labor there would be lots of union member issues. Pandorras Box awaits

Christopher O'Neill
December 28, 2018

"I dont understand why the ATO allows this"

The superannuation/pension fund is a trust with one tax return for the entire fund.

The government setting up super funds as more or less a trust with a special tax rate was pretty lazy IMHO.

JenniE
December 06, 2018

Jan, you are quite right. My strategy is to close my SMSF and transfer to AusSuper who have a self-directed account (OK it has limitations eg top 300 shares, etc but I'm happy to live with that) if and when the new rules become law. It is also an inexpensive option and you still have lots of control (my SMSF is mainly Aus shares and cash).

What annoys me most about this new rule is that it only affects a minority who have saved hard to be self-funded in retirement and who will end up paying more tax (effectively) than if their pension income was fully taxable. I wrote to the Shadow Treasurer months ago about this and have not even received a reply. The ALP won't ever get my vote again (but neither with the Liberals, who I have never voted for, so guess I'll be spoiling my ballot paper yet again).

Robert Goodwin
December 06, 2018

Transferring to an industry or retail fund will just replace the lost imputation credits with fees to the new fund?

Peter C
December 29, 2018

It all depends what option you choose. I have about 350k in super and deliberately chose Australian Super's index diversified option, rather than set up a SMSF. It is invested about 70% in growth assets and 30% cash and fixed interested. The fees are $78 p.a admin plus under 0.20% of my funds in investment fees. There are no performance fees, as this option uses an indexing strategy. The total fees I paid in 2017-18 were $551. As far as performance is concerned, over the very long term index funds outperform at least 75% of active funds anyway, so that will do me.

I am also comforted by the fact that Aust Super appeared at the royal commission and basically got a tick for its governance. There are several public offer funds today which offer indexing options with very low fees as well, not just Aust Super.
So I have very low fees, good long term performance and none of the compliance and admin headaches of running my own SMSF. A SMSF may be a good strategy for you accountant and financial advisor, but I decided there was a better alternative for me, i.e a very low cost indexed option.

Tony Reardon
December 06, 2018

We have a two person SMSF in pension mode and will be affected by the proposed Labor changes to franking credit refunds so I seriously considered adding my two adult sons to our fund in line with the suggestions in the article. However I concluded that I could not, in all conscience, do this. The stumbling block is the investment strategy. There can only be one investment strategy and it applies to the whole fund. All returns are apportioned across all members in line with their balances.
The appropriate strategy for my sons in their thirties is high growth. The appropriate strategy for my 71 year old self and my wife is something like conservative/balanced. Our existing balances vastly outweigh our sons' so the existing strategy would have to continue but I expect this would seriously under perform the expected returns for them over their 30-35 year investment time frames.
One more complex solution I am considering is to receive my sons' contributions into our fund, thus having the liability for the contribution tax and offsetting this against our “excess” franking credits and then rolling their balances over to an industry fund on a regular basis for their longer term investments.
My sons will continue to be trustees and have an account in the SMSF but would have minimal balances.

Steve Jones
December 06, 2018

Tony,
You need professional advice, as your idea is more costly all round.
Regards.

Kym Bailey
December 06, 2018

There is nothing stopping SMSFs segregating assets for investment purposes, thereby allowing different asset allocation strategies for different member groups. Where this comes unstuck is the income and tax is allocated to the segregated asset pools.
The strategy works well for funds that have a member with a total super balance of more than $1.6m (across all funds) and are taking a retirement phase income stream from the SMSF. Under this factual matrix, the investment portfolio is pooled for tax purposes thus enlivening the potential to offset excess franking credits against other income.
Anyway you look at the ALP policy reveals unnecessary complexity

Donal Griffin
December 10, 2018

Tony, as lawyers who specialise in avoiding family disputes, we suggest you ensure that each son's voting rights are linked to their member balance so that you do not get outvoted at the trustee level. Donal

Jan H
December 06, 2018

This strategy is no good for one member, sole director SMSF already in pension mode as of 28 March 2018. only this SMSF will continue to be singled out under Labor's policy. Does anyone have a strategy for this SMSF type, I wonder?

Rodney Brown
December 06, 2018

Hi Jan H, could you clarify your question please? Do you mean that: (i) you do not have any adult family members in accumulation mode that could join your SMSF; or (ii) you believe that new accumulation members cannot be added to an SMSF in pension mode after 28 March 2018? Kind regards, Rodney

Jan H
January 17, 2019

Rodney: I do not have any children and the idea of adding a 'friend' as Phillip Carman proposes, is IMO preposterous. Can you imagine trying to manage that investment and tax-wise? And, very likely to strain the friendship. The whole value of an SMSF with myself as sole trustee/director is to be independent of other's investment perspectives and risk appetite. SMSF administration is relatively simple, especially when it only holds cash and equities and no loans. My fees are under $2000 p.a. but have risen each year. The cash refunds, which are non-deductible in pension mode offset this cost. So not only will I lose my refund but the fees must be added to the total loss--in effect more than 30%.

To date, all the alternative strategies to offset loss of cash refunds are, IMO, complicated, likely to cost more -- there will be extra expenses in closing the SMSF and transferring assets to a public fund. And, these strategies all look like tax-avoidance schemes to me.

As for Phillip C's criticism that SFRs are just whingers who don't pay, or want to pay, their fair share of tax, he should know that retirees now 70 plus worked in a tax environment where the tax-free threshold was $5400 or less in the Menzies era, marginal tax rates higher, no family benefits, no medicare (introduced only in 1975 and limited to paying customers) and for women, 75% of men's salary. Oh, and no super. So this cohort has saved hard to build a retirement nest egg.

The whole problem with labor's plan is that it unfairly discriminates against self-funded pensioners ineligible for an Aged pension. Many of these have current incomes just above the AP cut-off. Loss of refund could see their incomes fall below the AP, which Paul Keating calls "an anti-destitution payment". So Labor plans to impoverish self-funded pensioners on low incomes while promising more tax cuts for wage-earners. So much for budget repair!
Fair tax principles generally favour progressive taxation. Like the GST, the effective 30% tax is a regressive tax which will fall on elderly people unable to make up the difference. Especially when unions will continue to receive refunds. This is why, Phillip, they are complaining.

Can you imagine the weeping and wailing from wage-earners if they were suddenly slugged with a 30% tax hike. Or the very generous $18,200 tax-free threshold introduced by Labor in 2012/13 was returned to pre-GST levels of $5400. BTW, the cash refunds were part of a GST compensation package (introduced by Howard and supported by Labor at the time). The package also included a rise in the TFT to $6000 and increased family benefits. I would support no cash refunds if the TFT was returned to $5400. IMO, this would be equitable and FAIR.

Philip Carman
December 09, 2018

In my view those who raise Jan's question or making similar assertions are confusing the notion of "singling out" with "consequences"...and in any event are worried about their First World Problem rather than anything of real substance.
Rodney's article quite beautifully demonstrates the contrary notion to many of the shrill comments we've seen so far from those with only self-interest at heart - that if you bother to stop and consider alternatives there is usually a way around a problematic issue that can suit your purposes.
To those with Jan's dilemma: if you don't have adult children or if you did but felt they were not suited to joining your fund, you can also seek out a friend or colleague in similar situation, but perhaps younger and in accumulation phase and invite them to join your fund. BUT - if you don't care to share such things...that's also a choice and we can't expect in life that every corner we turn presents a newer, better opportunity and outcome, nor even a choice we prefer. Sometimes we'll be confronted by challenges and/or problems to solve and occasionally (but rarely) we'll not be able to solve what we perceive to be our problem.
But blaming "Labor" for warning in advance of a return to their policy on franking credits to its original form is perhaps both naive and missing the point, as well as failing their own cause. They probably need to consider their options and move on as an intelligent adult rather than carry on as would a petulant child. Alternatively - paying a little more tax is nothing more than honouring a civic duty... And the obvious, but often neglected question is: Who do we think will pay for the roads (not the transport companies that wreck/use them!) hospitals, schools etc, etc, if not us?

Frank
December 06, 2018

Very useful idea. Now I have a reason to visit my financial adviser.

 

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