Franking credits are an important investment tool for self-managed super funds, not only because of their income potential, but because they can sometimes result in your SMSF becoming eligible for a tax refund.
Franking credits – also known as imputation credits – effectively eliminate the double taxation of company profits. When a company decides to pass on part of their profit to investors through dividends, they can also attach a franking credit to it – this is commonly known as a fully-franked dividend. The franking credit represents the proportion of profit that the company has already paid tax on, and therefore investors can use franking credits as a tax offset in their annual tax return.
Between January 1983 and December 2009, companies listed on the S&P/ASX 200 paid an average dividend of 4.1% per annum. If franking credits were taken into account, the average dividend paid to super funds on a 15% tax rate increased to 4.5% per annum. For funds that don’t pay income tax (such as those receiving a pension) the average dividend received was 5.4%.
It’s vital you understand what franking credits are and how they work, so let’s take a look at an example.
Suppose Big Buffet’s Bank is a listed company that earns $200,000 over the course of a year and has expenses of $180,000 in that same time. Big Buffet’s has made a profit of $20,000 ($200,000 – $180,000 = $20,000), and that’s the amount it will be taxed on. Companies pay 30% tax on their profits, so Big Buffet’s will need to pay $6,000 in tax ($20,000 x 30% = $6,000). Its net profit after tax is therefore $14,000 ($20,000 – $6,000 = $14,000).
Now that the amount of tax payable is known, the company’s accountant credits its ‘franking account’ with $6,000 – that is, an amount equal to the tax to be paid by the company. This is the amount that Big Buffet’s will later distribute as franking credits to its shareholders.
Let’s assume Big Buffet’s distributes its entire $14,000 net profit to its shareholders through dividends.
Let’s also assume that the Hathaway family’s SMSF owns 50% of all Big Buffet’s shares, meaning, this SMSF will receive a total dividend payment worth $7,000 ($14,000 x 50% = $7,000). It will also receive a 50% share of Big Buffet’s franking credits, valued at $3,000 ($6,000 x 50% = $3,000).
Finally, assume that $5,000 has been contributed into the Hathaway family’s SMSF during the year and that the fund doesn’t have any administrative expenses that need to be taken into account.
The SMSF will therefore have a taxable income of $15,000 (which is worked out by adding the $5,000 contribution, the $7,000 in dividends, and the $3,000 in franking credits).
So how does the SMSF end up with a tax refund? Stick with me.
The Hathaway family’s SMSF has not yet entered the pension phase and is therefore taxed at a rate of 15%. Without taking the franking credit offset into account, it would owe $2,250 tax ($15,000 x 15% = $2,500).
However, when the $3,000 in franking credits is applied as an offset, the Hathaway family’s SMSF will actually receive a $750 refund from the Tax Office (–$2,250 + $3,000 = $750).
If a super fund only pays pensions, then the tax rate is nil and all of the franking credits will be refunded.
Ideally, any super fund with lots of franking credits should try to get their income tax return in as quickly as possible to get this money back from the government.
One trap to be aware of: there’s a rule commonly known as the ’45-day rule’ that essentially means you must own a share for at least 45 days before you can take advantage of the franking credit. So, you can’t ‘dividend strip’ shares – that is, buy a company before it goes ex-dividend and sell it immediately after.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.
Also in the latest Switzer Super Report:
- Peter Switzer: Why I expect to get a Santa Claus rally for Christmas
- Roger Montgomery: Why I own JB Hi-Fi
- Paul Rickard: Commonwealth Bank is a good fit for SMSFs