How does a fund pay no tax overall or even get a tax rebate?
By Paul Rickard
The dividend imputation system makes investing in shares that pay franked dividends particularly popular with self-managed superannuation funds (SMSFs). Many funds will pay reduced tax, some will pay no tax, and others will end up with a tax rebate – that is, a cheque back from the tax office!
The system is unique to Australia, and helps to explain why, when compared internationally, Australian superannuation funds tend to be overweight equities as an asset class.
What are franking credits?
Dividend imputation was introduced in 1985 to correct the anomaly whereby company profits were effectively being taxed twice. The company paid tax on the profit it made, and the shareholder then paid tax on the dividend they received. Potentially, profits were being taxed at up to 62.55 per cent.
To address this problem, the dividend imputation system allows companies to pass on to the shareholder a notional amount that represents the tax that the company has paid on its profits. This is called an “imputation credit”, more colloquially referred to as “franking credits”.
The company tax rate is currently 30 per cent. So if a company makes a profit of A$100, it will pay A$30 in company tax. If it then pays a dividend of A$70, it can pass on imputation or franking credits of A$30 to its shareholders, representing the tax the company has already paid.
How do franking credits work?
Franking credits act like a tax offset. However, to ensure that the actual amount of tax collected by the government is consistent with the shareholder’s marginal rate of tax, a three-step process is applied:
The shareholder includes both the dividend in cash and the imputation credit in their assessable income.
The gross tax payable is calculated at the shareholder’s marginal rate of tax.
Step 3: The imputation credit is then applied like a tax offset, and deducted from the gross tax payable.
If the imputation credit is greater than the gross tax payable, then the excess is refunded back in cash to the taxpayer. Not only does the taxpayer pay no tax on the dividend, they actually get cash back!
Franked dividends and SMSFs
A superannuation fund in the accumulation phase (when the monies are going into super) pays tax at 15 per cent on its investment earnings. It also pays tax on concessional contributions made by its members at 15 per cent (there is a higher rate for members who earn more than A$300,000). In the pension phase (when monies are coming out), the fund pays no tax on its investment earnings.
Using the example in Figure 1. of a A$70 dividend which carries with it franking credits of A$30, the tax treatment will be as follows:
In this case, an SMSF in accumulation earns A$85 after tax (the dividend of A$70 plus a tax refund of A$15), a super fund in pension earns A$100. If the same dividend was “unfranked” (that is, it had zero imputation credits), the after-tax position for the fund in accumulation would be A$59.50 (A$70 less 15 per cent of A$70), and in pension phase, A$70.
Effective tax rates
Other investment income such as interest, rent or unfranked dividends, are taxed at 15 per cent for a fund in accumulation, or 0 per cent for a fund in pension.
To show the power of dividend imputation, the table on the left compares the after-tax returns for both franked and unfranked investments.
For example, for a super fund in accumulation, if the gross (pre-tax) yield on an investment is 5.0 per cent, this translates to an after-tax yield of 6.07 per cent if the dividend is franked, or 4.25 per cent if the dividend is unfranked.
How does a SMSF pay no tax overall, or even get a tax rebate?
Let’s consider an example to see what happens inside the fund as a whole.
John’s SMSF has A$600,000 in assets – with A$400,000 invested in shares, paying an average fully franked dividend yield of 5.0 per cent per annum, and A$200,000 in a term deposit earning interest at 4.0 per cent per annum. John makes the maximum amount of concessional contributions - A$25,000. The SMSF also has tax-deductible administrative expenses of A$4,000. How much tax does the SMSF pay?
John’s SMSF is paying no tax. His fund has saved the tax payable on the concessional contributions (A$3,750), and all his investment income is tax free. If John’s fund was in pension phase (rather than accumulation), all the imputation credits would be refunded – he would get a cheque back from the ATO of A$8,571.
A word of caution – this investment strategy (approximately two thirds in Australian equities) is not going to suit all funds and may not be appropriate for your fund.
Why aren’t all dividends franked?
Not all company dividends are franked as the system only recognizes tax paid to the Australian Taxation Office. Some companies listed on the ASX have operations overseas, and although paying tax in other jurisdictions, they are not paying tax in Australia and can’t “frank” their dividends. Also, some companies that are now profitable and paying dividends may have carried forward tax losses and aren’t paying any company tax.
Should you only buy shares that pay franked dividends?
Both capital returns (through asset price increases) and income returns are considerations for investing. A company that pays an unfranked dividend will need to produce a higher capital return than a company that pays a franked dividend.
Ignoring any capital gains tax (which is going to be fairly trivial or non- existent), if company A pays an unfranked dividend of 5 per cent, and company B pays a fully franked dividend of 5 per cent, a superannuation fund in pension will be better off investing in company A if its share price outperforms company B in the first year by 2.14 per cent - not that much! Obviously, over time, it has to keep doing this.
Fortunately, most of the major companies listed on the ASX pay company tax to the ATO and can frank their dividends. That said, you shouldn’t discount companies shares that pay unfranked dividends.