Many ASX 200 companies, the banks, miners and Telstra in particular, are known for paying franked dividends of between 4% and 8%, on average. These offer SMSFs substantial tax benefits. While it’s expected these concessions may become more muted should there by a change of government, franked dividends remain an important part of many funds’ returns.
What are franked dividends?
Franked dividends are dividends or profits paid to shareholders by a corporation that has paid company tax in Australia on part or all of the profit being distributed as a dividend. To avoid the income or profit stream being taxed twice, the shareholder receives a franking credit for tax already paid by the corporation.
A shareholder who receives a franked dividend is able to claim a tax offset for the franking credits, otherwise known as imputation credits, attached to the franked dividend. The franking credit represents the amount of company tax that has been paid. The corporate tax rate is currently 30%, or 27.5% for companies with a turnover of less than $25 million.
If a shareholder’s marginal tax rate is less than the company tax rate of 30%, he or she would be eligible to receive a refund of the difference between the franking credit and the shareholder’s tax payable.
“This is why superannuation funds are so attracted to Australian companies that pay fully franked shares,” explains Andrew Yee, director of superannuation at accounting and advice firm HLB Mann Judd. “Superannuation funds pay a top income tax rate of 15%. When they paying retirement pensions they pay no tax. So refundable franking credits boost the income yield of an investment,” he explains.
There’s pressure on Australia to reduce the corporate tax rate, which is one of the highest in the world. Should this happen it could be assumed companies will pay less tax and therefore be able to pass on fewer franking credits. But that’s not necessarily the case, says Evan Tsipas, a partner with auditing and accounting firm RSM Australia.
“If companies pay less tax and all else is equal, they may be able to increase cash dividends as taxes not paid could instead be paid to shareholders as cash dividends,” he says.
It’s important to understand franking credits have different impacts depending on whether the fund is in pension or accumulation phase. Rhiannon Kanoniuk, director of financial planning firm Pekada, explains how they work in practice.
“Franking credits are applied at a fund level, so for an SMSF, factors such as whether the members have funds in accumulation or pension phase, or a combination of both, should be taken into account. It’s also important to understand the fund’s other income like concessional contributions and whether there is a pooled or segregated investment strategy. This will drive the amount of credit that is offset against other tax payable and actually refunded,” she says.
Kanoniuk gives a simple example. “For a fund receiving a fully franked dividend of $700 from a large company paying the 30% tax rate, this will come with an associated $300 franking credit. The total income the fund will need to declare is $1,000, $700 actually received and $300 already paid by the company in tax.”
If this fund is fully in pension phase, and has a marginal tax rate of zero, this $1,000 of income would be deemed to have zero tax liability, and the $300 already paid by the company would be fully refunded to the SMSF.
“If this fund is fully in accumulation phase, and has a marginal tax rate of 15%, this $1,000 of income would be deemed to have a tax liability of $150 and the $150 already paid by the company would be refunded,” she says.
It’s also important for SMSF trustees to appreciate what are known as the 45-day and 90-day rule.
Tsipas explains as an individual, a number of conditions must be met for the member to be entitled to franking credits in excess of $5,000. “Typically a holding period of 45 days, not counting purchase or sale days, is one criterion, for some preference shares the holding period may be 90 days.” There is a small shareholder exemption if the total franking credit entitlement is under $5,000.
Retirement income strategy
There are a number of ways SMSFs can put together a retirement income strategy that’s centred around dividends and franking credits.
As Tsipas explains, as cash returns and net residential property rental yields are low, typically between 2.5% and 3.5%, some retirees use a portfolio of shares to boost their retirement income, perhaps as part of a diversified portfolio, noting shares are always subject to the risk of loss.
“A portfolio that pays an average fully franked dividend of 4% pays the retiree gross income of around 5.71% when franking credits are considered and before tax is applied. The extra 1.71% is considerable and represents the value of the franking credits.”
On a $1 million portfolio, this equates to $17,000 a year, as $40,000 worth of unfranked dividends are worth $40,000 before tax, which is a fully franked income stream of $40,000, which equates to around $57,000 before tax.
Kanoniuk has a different take on this. “The theory is that you never need to sell shares and still get capital growth. But you need to consider minimum pension payments and lack of diversification risk. This strategy may not work as well now because of the $1.6 million transfer balance cap and might become impossible if excess franking credits are banned.
“Choosing shares purely based on the dividend income or tax benefit rather than looking at the fundamental value and future growth or profit of the investment is a dangerous game and may be putting your capital value under pressure.”
Doing due diligence
It’s important to understand not all listed businesses pay dividends in the same way, with some historically paying higher distributions than others. There’s lots of ways to find out which companies pay franked dividends.
“Look for dividend information in ASX announcements for a company, which stipulate franking associated with past dividends. Most broker reports, discount broking accounts, financial advisers or even a Google search can give you an estimate of the franking to be expected with an upcoming dividend. Very profitable companies with a history of retaining profits taxed in Australia tend to be able to consistently pay fully franked dividends,” says Tsipas.
Accessing information on which companies pay dividends and how much has never been easier with really detailed data available on sites such as marketindex.com.au, Morningstar and even most online share trading accounts allowing you to run searches and filter for this information. In most cases you can even filter for information on associated franking percentages.
Without a crystal ball it’s impossible to tell how rules around franking credits may change in the future. The message for SMSF trustees is to keep a watching brief on how different political parties approach franking credit rules and be prepared to re-think the fund’s strategy subsequent to any change. But for now, dividends still offer plenty of opportunities for investors.
Three recent dividend yields*:
- Woolworths: fully franked 3.2%, grosses to 4.57%
- BHP: fully franked 5.5%, grosses to 7.85%
- Telstra: fully franked 4.7%, grosses to 6.7%
(Source: RSM Australia)