Be perfectly franked, and pay no tax
The former media tycoon, Kerry Francis Bullmore Packer, would have loved superannuation and franking credits. In 1991, he was subpoenaed to appear before a Parliamentary Committee enquiring into the print media, and it was wonderful theatre. He bellowed out his responses and left most of the Committee members cowering. But his most memorable response came when asked about his company’s tax minimisation schemes:
“Of course I am minimising my tax. And if anybody in this country doesn’t minimise their tax, they want their heads read, because as a government, I can tell you, you’re not spending it that well that we should be donating extra!”
You may not feel quite as critical as Mr Packer, since our taxes pay for health, schools and pensions, but the superannuation system has been designed to encourage people to finance their own retirement, so it makes sense to use it.
Income in superannuation is taxed at 15 per cent in the accumulation phase, and personal marginal tax rates rise to 19 per cent when taxable income exceeds $18,200, so income in superannuation is tax effective for anyone earning above this amount. The tax rate in a pension account in superannuation is nil.
How do franking credits and dividend imputation work?
But that’s only half the story. Let’s put franking credits into the mix by understanding how dividend imputation works. Companies pay tax on their profits at a rate of 30 per cent before dividends are paid to shareholders. In the hands of an investor receiving the dividend, the tax paid is called a franking credit or an imputation credit. For tax purposes, the shareholder receives both a cash dividend plus the imputation credit, and is treated as if they paid tax equal to the imputation credit.
The system operates like this to avoid double taxation of income. In effect, the shareholder receives back the tax that has already been paid by the company and instead pays tax at the investor’s own tax rate.
Let’s consider a simple example. A company earns a profit of $10,000, and pays tax of $3000, leaving $7000. It pays this amount as a franked dividend to its only shareholder, which is a super fund. In its tax return, the super fund adds the tax already paid by the company to the cash dividend received. The ‘grossed up dividend’ is $10,000, and the super fund pays tax on this at 15%, or $1500. However, it receives a credit worth $3000 for the amount of tax already paid by the company, leaving a tax refund of $1500. Neat!
Franking credit can mean no tax is paid by a super fund
Many retirees who are trustees of a self managed super fund (SMSF) pay no tax even in the accumulation phase, because the franking credits offset the 15 per cent tax on the fund. In fact, for those mathematically minded, it’s possible to calculate exactly how much in fully franked dividends is needed to offset the income tax due on the rest of a super fund’s portfolio, and therefore pay no tax. The same applies outside super on other investments.
For example, if an SMSF portfolio includes a 6 per cent fully franked dividend yield on the Australian shares component, and an unfranked yield on the remaining portfolio of 4 per cent (for example, paid on term deposits, bonds or property), the overall portfolio would need to contain only 32 per cent of Australian shares to have a zero tax rate. And without entering into a discussion on portfolio construction, most Australian super funds can justify an allocation to Australian shares of at least one-third (this calculation ignores the impact of any realised capital gains and expenses from running the portfolio).
The combination of favourable tax rates and dividend imputation shows the power of saving in superannuation. Once a fund converts to paying a pension, there is no tax payable by the fund on earnings. In this case, imputation credits are refunded in cash. Furthermore, if the pension recipient is aged over 60, then pension drawdowns are also tax free.
Kerry Packer would have loved it. All that income and no tax. And later, a refund from the government. Kerry probably learned a lot from his father, and maybe it’s no coincidence that this powerful process carries the same name as that equally powerful man, Sir Frank.
What are your thoughts on franking credits?
Graham Hand is Managing Editor of Cuffelinks, a free financial newsletter. This article is general information and specific personal circumstances should be checked with a financial adviser.