Dick Smith admits he’s not a financial genius, and The Sydney Morning Herald reported on 17 July 2019: “The entrepreneur said he had no idea what franking credits were before discovering the payments, and complained to the Australian Tax Office.”
Then on 21 July in The Sun-Herald, influential columnist Peter Fitzsimons kicked the can further down the road, calling franking refunds ‘ridiculous’ and ‘absurd’ but with little attempt to analyse the issue or Dick’s circumstances.
The only conceivable way to receive a $500,000 refund is to hold Australian franked shares in an enormous SMSF, taxed at 0% and 15%. If investments are held on personal account and taxable income is over $37,001 with a marginal tax rate from 32.5% to 45%, there is no refund of a 30% franking.
Dick can simply tell his accountant to switch his franked shares from the SMSF into his own name. Problem solved, and no need to complain to the ATO.
(Dick Smith is a genuine philanthropist and advises he has already donated the $500,000 to charities).
If the real issue here is large SMSF balances, then that has been addressed by reductions in contribution caps and the total superannuation balance rules.
Here is Peter Fitzsimons’ article and two responses from people who have written extensively on franking credits.
Extract from The Sun-Herald, 21 July 2019
It’s franking ridiculous … and Dick Smith says so too
Dick Smith took more brickbats than bouquets this week for his protest at receiving $500K as a government refund for franking credits.
“I found I was getting this ridiculous money from the government,” Smithtold The Sydney Morning Herald. “That’s wrong, I said – I’m wealthy. My accountant said ‘that’s how it works, that’s what you have to do’. I can’t stop it. I think it’s outrageous for wealthy people to be getting money from the government.”
Instead of being lauded for speaking out, Smith took a lot of flak for not speaking out during or before the election campaign, as his case perfectly highlights the absurdity of giving so much money to so many already wealthy people, while so many other areas in desperate need of funding are being cut back. When I asked Dick Smith about it this week, his reply was stark.
“I did not know that my $500k tax saving was due to franking credits,” he said, um, frankly. “I am a car radio installer, not a financial genius.”
He has written a letter to the Herald, in any case, saying he has given every cent of these tax refunds to charity. Either way, let the defenders of the franking credits defend a system that gives a multi-millionaire like Smith that kind of refund! Crickets.
(Then in the next section, he adds)
And just as personalising the issue of franking credits to Dick Smith helps everyone understand the absurdity of it, let me try this on Brexit.
So Peter Fitzsimons calls franking ‘ridiculous’ and Dick Smith calls it ‘outrageous’ without any explanation of how franking works. Our simplest explanation of franking is here (complete with 160 comments) but let’s address Dick Smith’s case.
Tony Dillon is a recently-retired actuary
Peter Fitzsimons recently weighed in on Dick Smith’s predicament of receiving $500,000 in franking credit refunds, saying, “let the defenders of the franking credits defend a system that gives a multi-millionaire like Smith that kind of refund”.
It’s not a matter of defending the franking credits system, which has already proven to be sound and equitable in many forums. Rather, this is a matter of understanding how Dick Smith could actually receive such a large refund.
Assume Dick received his franking credits via an SMSF, because to receive $500,000 in franking credits investing outside super would require taxable income less than $18,200, and that does not seem plausible.
Such a large franking credit refund is possible within an SMSF because of the generous tax concessions of such a superannuation structure. It is possible because the maximum rate at which super fund earnings are taxed is 15%, just half the corporate tax rate. So that in theory, franking credit refunds can increase with dividend earnings ad infinitum, all else being equal. In practice, natural limits will evolve, as tighter restrictions on contributions into SMSFs begin to bite. Funds like Dick Smith’s will run off over time, until very large SMSFs cease to exist. Currently though, franking credit refunds are uncapped within an SMSF structure.
The introduction of the $1.6 million Transfer Cap Balance in 2017/18 at least means that for super funds in excess of $1.6 million, a portion of refundable franking credits will now be required to offset tax liabilities, and so would no longer be returned in full, because funds in excess of $1.6 million are required to pay 15% tax on earnings outside the cap.
While acknowledging we don’t know Dick Smith’s exact circumstances, he has put his franking refund into the media, so we have a right to estimate the underlying numbers.
In Dick’s situation, assuming a dividend yield of 5% before grossing up for franking credits, he would require a share portfolio of about $45 million to enable $500,000 in refundable franking credits.
The first $1.6 million would earn $80,000 in dividends plus franking credits of $34,300. Total income tax free of $114,300.
The next $43.5 million would yield $2.17 million in net dividends and $931,400 in franking credits, for total income on that tranche of $3.10 million. Tax on that at 15% being $465,700, which offsets half the franking credits, leaving $465,700 worth of franking credits refunded. Total franking credits refunded across the SMSF therefore equals $500,000.
Franking credit refunds of that size are indeed possible, but it would take a mighty SMSF to achieve it, the likes of which are rare and will be phased out over time.
So it is the super fund tax concession rules that are the cause of Dick’s bonanza, not the franking credits policy, which is merely a symptom. And the problem with Labor’s approach to treating large franking credit refunds was to treat the symptom and not the cause. Without addressing the cause, symptoms will always persist.
However, as large SMSFs eventually become a thing of the past, franking credit refunds such as Dick’s will no longer occur, which renders futile the calls from detractors to modify the franking credits system. In the meantime, Dick must endure his annual windfall if he leaves his shares in his SMSF.
As a footnote, Dick Smith is a savvy businessman, who would probably have been collecting franking credits since their inception in 2001. Why hasn’t he objected in the past?
Jon Kalkman is a Director of the Australian Investors Association
Dick Smith is outraged that he received a ‘ridiculous’ refund of about $500k from the government when he is already so wealthy. The first response is that if he invested in assets other than Australian shares he would not have such problem, because it is only Australian shares that generate these tax credits.
More seriously, if Mr Smith is getting a cash refund of $500k from his franking credits, that can only happen if his marginal tax rate is lower than 30% and that suggests that his super fund is holding these shares rather than personally. Let’s assume that Mr Smith has all his wealth invested in Australian shares – a very dubious assumption – and that all the shares get the full treatment of franking from the ATO – that too is not always the case. Then the franking credit is never more than 30% of the taxable income. At a minimum, Mr Smith’s taxable income from his Australian shares is $1,666,666 which is comprised of $1,160,6666 in dividends (70%) and $500,000 in franking credits (30%).
If we assume that Mr Smith achieves about 4.5% dividend yield on his shares, we can calculate that his portfolio is valued at almost $26 million. It may have been possible for Mr Smith to have such a large portfolio in a tax-free pension fund before 2017, but it is not possible now because he can only hold $1.6 million in such a fund. If the bulk of this portfolio is an accumulation fund, the maximum refund is only 15% of the total and so the portfolio would need to be twice as big to generate the same refund as previously.
The government has recently legislated that the purpose of superannuation is to replace or to supplement the age pension. Clearly, super accounts larger than $1.6 million held in accumulation funds are not required to replace or supplement the age pension and therefore, since there is no obligation to withdraw money from these funds, they make ideal estate planning vehicles.
Mr Peter Fitzsimons described franking credits as “(an) absurdity of giving so much money to so many already wealthy people”.
If we are looking for an absurdity, we should look at allowing such large balances to remain in the concessional tax area of super accumulation funds in retirement because this is money that will never be used to fund a retirement. These funds will never be depleted with mandatory withdrawals like pension funds and, even if withdrawn after death, these funds will be concessionally taxed, always assuming they are not withdrawn tax-free before death.
If the total super in retirement was limited to $1.6 million per member (we could call that a reasonable benefit limit), and held in a pension fund with its mandatory withdrawals that increase with age, there would be an automatic limit of the cash refund of franking credits and there would no need to cap or grandfather them.
Mr Smith’s outrage is no doubt galling to younger people because they will not be able to accumulate more than $1.6 million in super due to the cap on non-concessional contributions. They will not have the luxury of paying only 15% tax on income from super money in excess of $1.6 million.
Wealthy funds like Mr Smith’s allow uninformed commentators to distort the debate about franking credits by assuming that all SMSFs are high balance. Mr Smith and Mr Fitzsimons should do some homework and learn that (according to the ATO) SMSFs have a median balance of $693,000 shared between an average of two members. In other words, there are as many SMSFs with balances less than that as there are with balances above it. Moreover, only 0.7% of SMSFs with balances above $10 million.
It is absurd to suggest that Mr Smith’s annual cash refund of $500k for franking credits in his SMSF is typical of the refund received by SMSFs used by an average retired couple to generate their retirement income.