To say franking credits have been a talking point in recent months, would be an understatement. It seems everyone we speak with is growing increasingly concerned about the potential implications of this policy, even though it is a proposal from opposition with some 8 months before another election.

Given the publicity and borderline hysteria around the subject, we thought it worth outlining our views and understanding for our readers.

What are the facts?

According to Shadow Treasurer Chris Bowen website, the proposals are as follows:

  1. To cut the cash refund of excess franking credits for most investors from 30 June 2019;
  2. To exclude those receiving a Government Pension from this change;
  3. To also exclude charities and the politician’s own superannuation scheme, the Future Fund, from this proposal;
  4. To exempt members of self-managed super funds (SMSFs) if they were receiving a pension on the 28th of March, being the date of the announcement.

As you can see, the original proposal was quite straightforward, however, the backpedalling and exemptions began almost immediately which complicated matters. Before delving into our analysis, we believe it is important to address a few common misconceptions regarding the proposal.

  1. It is apparent that the cost savings proposed by this policy (which refers to some SMSF’s receiving refunds of $2.5m) are likely to be substantially lower following the implementation of the individual $1.6m cap on exempt pension balances;
  2. The proposal applies to all investors and superannuation funds identically, it is the exemptions that discriminate against SMSF investors;
  3. All investors will still be able to utilise their franking credits to offset any tax payable, including those with over $1.6m in an SMSF; meaning the number of people impacted is not as wide as initially thought;

What are the fallacies?

As is generally the case with such a hot issue, every journalist, adviser and investor has an opinion on the implications. Unfortunately, many of these people either don’t understand the inner workings of the superannuation or franking systems, which leads to less than useful advice. With this in mind, we have attempted to address what we believe to be the major fallacies around this proposal.

Fallacy No. 1 – The cancellation of refunds will only affect SMSF’s

As is seemingly always the case, the financial media sells this story as a war against wealth SMSF trustees, suggesting they are more heavily impacted than the alternatives. This proposal will impact every person in Australia that invests in shares and is not receiving an Age Pension. Yes, it will have a substantial impact on those with between $800k and $1.6m in the pension phase of superannuation, however, it is more widespread than that.

One little considered issue with this proposal, is that fact that many of Australia’s small businesses, who employ close to 50% of the population, operate their businesses either through a family trust or a company structure. If that company makes a profit and pays tax, it will receive franking credits, which can then be distributed with a dividend to shareholders. This proposal means it isn’t just those buying ASX shares, or the $2.6 trillion in superannuation but anyone running a business that will be impacted in the long-term.

Fallacy No. 2: The richest will be the hardest hit

The core sales pitch of this policy has been that it targets the fat cats, the 1% or the ultra-wealthy; those receiving $2.5m franking credit refunds. Again, unfortunately this is not the case. Such is the complexity and poorly considered nature of the policy, that it actually those people who have sought to fund their own retirement that will be hardest hit.

For example, those with over $1.6m in superannuation will still be able to offset any tax payable on the accumulation component that exceeds $1.6m with the franking credits they receive. The introduction of this cap essentially made franking credits valuable to these people once again. On the other hand, two retired families with less than $1.0m in superannuation will be put in vastly different positions according to an analysis provided by the SMSF Association, available here.

The SMSF Association’s analysis looks at two different couples, one with $700,000 in an SMSF, who receive a part Age Pension and another with $900,000 in an SMSF who do not. It assumes they both invest 40% of their portfolio in ASX-listed shares and receive a 5% dividend income plus franking credits. The results of the proposed policy are stark:

 

Owns home and SMSF worth $700k

Owns home and SMSF worth $900k (before)

Owns home and SMSF worth $900k (after)

SMSF Income

$35,000 $45,000 $45,000

Franking Credits

$6,000

$7,700

$0

Age Pension

$9,900

$0

$0

Total $50,900 $52,700

$45,000

Under the proposal, the couple who have saved $200,000 more over their lifetimes end up with less income than the couple of who saved $700,000. In our view, Government policy that results in one family who have saved more being in a worse position to one that has saved less is inefficient and poorly planned. This is likely to significantly reduce the incentive to save in superannuation and place increasing pressure on the Age Pension.

Fallacy No. 3: The member-direct loop hole

There is a growing misconception, in both the media and DIY investor circles, that you may be able to get around the proposal by moving your superannuation balance to an industry super fund. They suggest that even if you are not receiving an Age Pension, if you buy shares through an industry super ‘member direct’ option (that allows you to invest in ASX shares directly, the trustee is required to allocate the associated franking credits to your account regardless. Interestingly, before this proposal was announced, very few superannuants investing in an industry fund actually understood that any franking credits they received were actually used to offset the tax payable on the other millions of members within their fund in accumulation phase.

It was only last week that I was reviewing the comments of a similar article to this, to which an industry super fund representative was responding. The most enlightening point was that he could not expressly confirm that it was or wasn’t possible. It seems he wanted to keep the issue as grey as possible in the hope that the inflows to industry continued.

To our understanding, and according to the trust deed of most industry super funds, we do not believe there is a rule, or clause that specifically allows this refund to happen. Of course, it is the trust deed that governs each of these funds. If such a clause did exist, we are confident that it would be quickly removed, or the legislation amended accordingly. In this event, the decision to rollover to an industry fund would effectively be handing your franking credits over to the accumulation members in your fund whilst going through the hassle and cost of having to close your own SMSF.

Fallacy No. 4: High yield stocks will fall

One of the most worrying reactions to the proposal that we have seen, is the idea that investors should sell of their high yielding stocks because they are likely to fall. If anything, the slightly reduced value of franking credits may lead to some of Australia’s business making the long-needed decision to reinvest in their own business rather than paying out all their profits as dividends.

We are confident that this proposal will have a limited impact on the Australian sharemarket. For one, some 60-70% of ASX companies is owned by foreign investors or institutions, who have no use for franking credits. Secondly, the largest portion of the $2.6 trillion invested in superannuation is held in accumulation phase, which will continue to receive the full benefit of franking credits given they are taxed at a rate of 15%. In addition, anyone with an income exceeding the tax-free threshold, or with over $1.6m in super, will continue to benefit.

In the long-term, it may mean Australian companies are starved of stable capital from domestic investors, as they seek yield elsewhere; however, we hope this is not the case. In the short term, we may see an increase in off-market buy-backs, such as that announced by Rio Tinto this week, in an effort to distribute excess franking credits and effectively bring forward future years dividends for investors.

Fallacy No. 5: You are better off rolling back to accumulation

One of the more concerning strategies that has been raised, is the idea that investors should roll their superannuation back to the taxable accumulation phase. These experts were of the view that moving back into a taxable position would mean your franking credits can be used to offset any tax that would be payable; hence their value isn’t completely lost. This really only applies to those with less than $1.6m in pension phase.

In the case where you don’t require the regular pension income from your super fund and where you are currently receiving a substantial refund, this may make sense. Particularly so if you have taxable income in your own name. However, in general the idea is counterintuitive and will likely be difficult to implement. One issue we see with this strategy is the impact of realising substantial capital gains in any given year. These gains would be included in your funds assessable income and taxable at the standard superannuation rates of 15% (and 10% for assets held for over 12 months). What happens if the realised gains exceed the franking credits available within your fund? Or if you decide to change your investment strategy? In these cases you will likely end up paying additional tax for no reason.

To conclude

Whilst those with $3.2m in their super fund will be impacted by these proposals, it will be those with less than $1.6m and generally less than $1.0m that will be the most heavily hit. The aim of this article was to increase our readers understanding of the changes, so they can both be prepared in advance but also to understand the long-term implications of this proposal. As with any change to superannuation law, it will affect millions of people in different ways, across the entire $2.6 trillion in assets held in all types of funds; this will not be a simple process.

In my personal view, I do not believe this policy, once understood by voters in its entirety will have sufficient support to be passed in its present form. I believe the most appropriate solution will likely involve placing a cap on franking credit refunds, say $5,000 per person, rather than simply exempting those who are on the Age Pension. The policy will simply have too much of an impact on people seeking access to the Age Pension and a disincentive for future generations to save for their own retirement.

In terms of our advice, we do not recommend taking any action until a real proposal is put to Parliament. In the event the legislation passes, and you feel your portfolio is overweight to ASX-listed shares (which many are), then you should seek global diversification using many of the world class managers that now exist in Australia. Alternatively, you may wish to ask your children to become members of your SMSF, which would allow your franking credits to offset any tax on their taxable balances. This may represent a better option than the interest rate sensitive assets that represent a large portion of industry fund balances today.

To summarise, we believe all investment decisions should be based on their merit as an investment, not on the potential tax benefits that they provide. If you are concerned about the implications for your portfolio, don’t hesitate to contact us for a review.