If there was one single issue that dominated the discussion at our Invertor Strategy Days in Brisbane, Melbourne and Sydney last week it was the loss under a Shorten government of cash refunds of unused franking credits. Some self-funded retires will see their incomes slashed by thousands of dollars.

Shorten’s “retiree tax” will require the passing of legislation through both houses of Parliament. With the ALP and Greens unlikely to command a majority in the Senate, support from the cross benches will be needed. Given the retrospective nature of the ALP proposal,  most cross benchers have said that they will oppose the plan.

While Bill will claim that he has a “mandate”, some form of compromise is likely. One option would be to cap the cash refund at $10,000 or $20,000 per taxpaying entity, which would spare the majority of self-funded retirees from the pain of the change, while still impacting the handful of retirees getting “millions of dollars” in cash refunds.  A victory of sorts for Shorten.

We will have to wait and see how this plays out.  However,  if you are worried about the change, here are some options that you can consider to “lessen” the impact.

There are three broad options. Firstly, make your SMSF a “taxpayer”. Secondly, invest outside super. And thirdly, within your SMSF, diversify and invest in other asset classes/securities that pay unfranked distributions.

Importantly, these options are not mutually exclusive. Nor are they going to suit all SMSFs, and in many cases, the benefits are going to quite marginal. But, they are ways you can potentially respond.

One option that I’m not going to suggest is an idea by some advisers to close your SMSF and move your monies to an industry super fund. As I detail below, I think this action is premature and subject to a number of risks.

Option 1: Make your SMSF a “taxpayer”

Superannuation funds are assessed for tax at 15% on investment earnings on monies in the accumulation phase and 15% on the value of concessional contributions received. Cash refunds are paid by the ATO because the franking credits can’t be fully utilised as tax offsets – there is not enough tax to pay. If you increase the tax payable by the fund, more of the franking credits can then be used.

There are three ways to do this. Firstly, make concessional contributions to the fund. You will need to be under 65, or if aged between 65 and 75, be able to meet the work test. This is defined to mean working for a period of 40 hours or more over any 30 day consecutive period (such as working full time for one week, or one day a week part time for a month). Concessional contributions (the employer’s 9.5%, salary sacrifice and personal contributions you claim a tax deduction for) are capped at $25,000 per annum. The tax on $25,000 of concessional contributions is $3,750 (which could potentially be fully off-set by the unused franking credits).

You can also add new members to your SMSF (such as sons, daughters, grandchildren etc). The maximum number of members is 4. They can then make concessional contributions, and potentially, will have monies in the accumulation phase where the earnings are taxed at 15%. While it is not yet clear under super law who will be entitled to the benefit of utilising these “wasted” franking credits, as a family unit, there will be a net tax “saving”. Potentially, this may translate into a “refund” for you. One thing to be mindful of is your SMSFs investment strategy and investment mix, as the financial needs and objectives of your son/daughter/grandchild could be quite different to yours.

You can also fully or partly commute your pension and transfer the monies back to the accumulation phase, where earnings will be taxed at 15%. You obviously don’t want to become a net taxpayer, so you will need to do your sums carefully to ensure that any tax is offset by the franking credits, but you won’t have to draw down the minimum pension on the amount commuted. You won’t get a cash refund, but you will have more flexibility with your retirement nest egg.

Option 2: Invest outside super

You can withdraw monies from super and invest in your own name to take advantage of the $18,200 tax free income threshold. With the SAPTO (Seniors and Pensioners Tax Offset), this increases to $50,119. While you won’t get the cash refunds, you won’t have to make any minimum pension withdrawals. Further, the amount outside super when bequeathed to a non tax-dependent (such as an adult child) won’t be subject to any tax (the taxable component of a super lump sum death benefit paid to an adult child is taxed at 17%).

You could also consider investing in investment (insurance) bonds. These are tax paid investments which pay tax at a rate of 30% prior to the application of any franking credits. If held for more than 10 years, there is no tax to pay when the bonds are cashed in. Two of the advantages compared to super is that there is no limit on how much you can invest, and when you die and the bonds automatically pass to your nominated beneficiary, no tax is payable. Issuers include Centuria, Commonwealth Bank, AMP and IOOF.

Option 3: Diversify, and change the investment mix

If there is one “positive” from Bill Shorten’s retiree tax is that it might encourage some  SMSFs to diversify and change their investment mix. Australian Taxation Office (ATO) data shows that the typical SMSF is overweight Australian equities, cash and term deposits; and underweight overseas equities, property and bonds. Within the Australian equity component, many funds are way overweight the major banks and Telstra.

Broadly, you can consider the following:

• Invest in other assets, such as overseas shares, property, bonds, collectables etc. One of the great advantages of an SMSF is that you can invest in any asset provided your investment strategy makes provision for it. This is in your hands (and any other trustees) to amend and change;
• Invest in “real asset” trusts, either ASX listed or unlisted. These are trusts that own and operate a physical asset such as a commercial building or toll road. Typically, they act as “pass through agents” where you receive a distribution of their net income and become liable for the taxation. Yields (unfranked) range from 4.5% to 7.5%, with lower yields generally associated with higher quality/prime assets and higher yields with lower quality assets. Examples include:
  • The ASX listed A-REIT sector (property trusts). Names include Scentre Group (SCG), Dexus (DXS), GPT (GPT), Centuria Metropolitan (CMA) etc;
  • Utilities such as pipeline operator APA or electricity network provider Spark Infrastructure (SKI); and
  • Infrastructure owners and operators, such as Transurban (TCL), Sydney Airports (SYD) and Auckland International Airport (AIA);
• Invest in “financial asset” trusts (listed or unlisted). These are trusts that invest in corporate bonds, mortgages, debentures and other financial securities. Yields range from 4% to over 8%, with distributions paid quarterly or monthly. Examples on the ASX include the Neuberger Berman Global Corporate Income Trust (NBI) and the soon to be listed Perpetual Credit Income Trust (PCI); and
• Invest in unfranked shares. Typically, these are companies that earn most of their income outside Australia and although paying tax to foreign governments, don’t pay tax to the ATO and hence can’t frank their dividends. There is a wide variety of companies in this category coming from most industry sectors. The following table shows some of the larger companies (by market capitalisation) that pay unfranked dividends:

Larger companies paying unfranked dividends

* As at 10/5/19. Source: FNArena. Consensus broker forecasts and target prices

If you want to compare a franked dividend to an unfranked dividend, the “grossed up” rate will fully account for the benefit of the cash refund. 7% fully franked is equivalent to 10% unfranked, or 3.5% franked is equivalent to 5% unfranked. In fact, it is marginally less because the income from the unfranked dividend is received right away, whereas it can take up to 12 months to get the cash refund. The following table shows the comparison yields.

Franked vs unfranked – gross up

Don’t rush to close your SMSF and move to an industry fund

This suggestion has gained currency because most industry and retail funds are net taxpayers. Some offer self-directed investment options where  you can select a high proportion of shares paying fully franked dividends. As  a net taxpayer, they can utilise “your” franking credits and can then pass on the benefits back to you, putting you in roughly the same position as if you were getting a cash refund in your SMSF.

There are two problems with this suggestion. Firstly, you want to be sure that the chosen super fund will be a taxpayer in 5 or 10 or 15 years’ time. As the fund “matures” and more members move from the 15% tax rate accumulation phase to the 0% tax rate pension phase, the tax bill drops and the fund is less able to use the franking credits as a tax offset. In the extreme case where thousands of SMSFs move their monies to a particular super fund, there could be so much money invested in franked shares and franking credits to go around that the fund won’t have a tax bill. It will cease to be a taxpayer.

But there is also a bigger problem. Fund trustees are required by law to act in the best interests of all their members. If refunds of excess franking credits are canned, that is, they become “illegal”, on what legal basis can a trustee allocate a “refund” to the member in pension phase at the expense of the member in accumulation phase?. Who is to say that the member “paying the tax” isn’t entitled to some of the net benefit?

Sure, the fund’s overall tax bill will be reduced, but who gets the benefits and in what proportions is a different ball game. This is a whole new area of super and trustee law.

I am not aware of any super fund, industry or retail, that has stated that it can guarantee that the benefits will flow to the pension phase member. And they are unlikely to do so, because until the law is changed, they are dealing with a hypothetical.

Until you know with a high degree of confidence that the fund will be a taxpayer in the long term and the trustees confirm in writing that they can “refund” the benefits, this strategy is a non-starter. Don’t rush into this.

Important: 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. Consider the appropriateness of the information in regard to your circumstances.