How might you be affected by Labor's proposed Franking Credit changes?
This article is the first of a two-part series that considers a) the effect of Labor’s proposed changes to franking credits on superannuation funds and b) the benefits of a self-managed superannuation fund compared with alternative superannuation investment structures (more generally).
Franking Credit Policy Changes in Context - Anticipation is often worse than reality
… and so it is with Labor’s proposal to abolish imputation or ‘franking’ credit refunds[i].
If you currently receive regular franking credit refunds, you may be wondering:
- What is the proposed policy change?
- How might it affect me?
- In what ways can the impact be managed?
Allow us to take you through these matters in the context of your self-managed superannuation fund.
Franking Credits 101
But first, a brief discussion of how the current system works …
Franking credits are tax credits attached to dividends you receive (as an Australian tax resident) when investing in Australian shares. They represent the tax that the company (whose shares you own) has already paid on your behalf. The franking credit can be used to offset your tax liability in the year the dividend is received and therefore, adds to your ‘after-tax return’ in that year. In the event the franking credit is greater than your tax liability, the surplus is refunded to you. This is common with superannuation funds that are in pension phase (with a tax rate of 0%).
The Proposed Policy Change
Labor has proposed limiting franking credit refunds to the amount of tax you owe each year. That is, franking credits you receive from your investments after 1 July 2019 may reduce your income tax to zero, but any surplus would no longer be refunded.
It may be worth noting that the change will need to pass both houses of Parliament before becoming law. We have already seen Labor announce that the changes will not apply to those in receipt of a government pension or allowance before 28 March 2018. Additional compromises cannot be ruled out.
The Potential Impact
The effect of the proposed changes will depend on your circumstances. Subject to the underlying asset mix, the change is unlikely to impact self-managed superannuation funds that are in accumulation phase (especially those in receipt of regular concessional superannuation contributions).
For self-managed superannuation funds in pension phase, the impact of the proposed changes will depend upon:
- The fund’s tax rate (which is determined by the ratio of pension assets to accumulation assets). The lower the fund’s tax rate, the more likely it is that the entitlement to franking credit refunds will be lost.
- The value of your total superannuation member benefits. This determines your tax rate (once a pension has commenced) as well as other factors such as how much you regularly draw from superannuation each year.
- Your underlying investments. Franking credits are attached to dividends from Australian shares. Most superannuation pension members are not invested exclusively in Australian shares and so are less reliant on franking credits to boost after-tax returns.
There is no universal way to quantify the impact that the proposed change will have on your financial position. For example, if you invested exclusively in Australian companies that pay out all of their profits as fully franked dividends, the loss of franking benefits will be greater than if you had a more diversified portfolio. And First Samuel clients will already know that an appropriate investment strategy for a superannuation member in pension phase will likely include a range of investments and asset classes.
We have conducted an analysis to determine the potential impact on three portfolios that are representative of our clients’ circumstances. In each, we have assumed a ‘Balanced’ investment portfolio that has a 50% allocation to an Australian shares index investment (i.e. an investment that replicates the performance of the broader Australian share market). And while it may be tempting to consider only the short term impact of the proposed change (like many media reports have done), with all investment matters, a long term view is needed. Accordingly, our analysis considers the potential impact over a period of 25 years (consistent with other financial modelling we provide for clients' retirement planning).
Our findings are summarised in the table below (note that amounts up to $1.6 million are in pension phase with the balance in accumulation phase):
|Superannuation Member Balance||$1,000,000||$2,000,000||$3,000,000|
|Average Annual Franking Credit Refund over 25 Years (in today's dollars)||$3,573 p.a.||$4,885 p.a.||$2,205 p.a.|
|After-Tax Return Required to Neutralise Impact of Policy Change||0.65% p.a||0.45% p.a||0.13% p.a.|
We consider the impact of the proposed change to be modest in the broader context of investment performance (keeping in mind First Samuel’s Australian share portfolios have historically outperformed the broader Australian share market by around 4% p.a. before fees).
Key take-aways from our analysis include:
- Self-managed superannuation fund members with pension benefits of $1 million would only need to outperform the broader market by 0.65% p.a. (net of fees) to neutralise the effect of the proposed changes. This “required rate of return” diminishes as member balances increase.
- Franking credits represent a minor component of overall returns and the value of franking credit refunds diminish over time. The following graph shows the proportion of overall return comprised by franking credits on a $2 million portfolio over 25 years:
- Superannuation pension members with larger balances can utilise franking credits to offset tax payable in relation to their accumulation benefits. In the case of a member who has superannuation benefits of around $3 million, the loss of franking benefits is negligible (information the Shadow Treasurer is unlikely to volunteer).
Managing the Change
We are yet to see if companies we invest in on your behalf will change their behaviour to better meet shareholder needs (e.g. pay less of their profit as dividends and return capital to investors in other ways).
Importantly, your First Samuel Strategists will be able to assess the impact of the proposed change as it relates to you and help you to develop strategies to manage the change (if it becomes law). Possible strategy responses include:
- Assessing the appropriateness of your current investment structures and strategies for all your entities taking into account the potential impact of the change (and other factors such as your estate planning intentions).
- Changing your mix of Asset Sectors and investments in favour of investments that do not pay franked dividends (taking into account your income needs and investment risk tolerance).
- Considering the appropriateness of introducing new members to your SMSF who are in accumulation phase (who can utilise surplus franking credits).
In summary, it is clear to us that:
- The benefit of franking credits and the proposed limitation on franking credit refunds will have a minimal impact on your financial wellbeing when considered in the broader context of your financial position, including underlying investments and asset mix.
- If you currently have a self-managed superannuation fund, you will likely be in a better position to manage these changes given the level of transparency and control offered under this structure (including the ability to identify and trace franking credits). This level of transparency is not available under a pooled superannuation structure (such as an industry superannuation fund) where there will continue to be a measure of unpredictability around how pension members will benefit from franking credits attached to franked dividend income.
- The key is to seek guidance from those who can assist you manage the frequently evolving superannuation and taxation environment. Let us do the worrying for you so you can continue to Live Well. Sleep Well.