Indeed, so popular have Australian equities offering franking credits, such as the “big four” banks and Telstra, become with SMSFs, that they are somehow being perceived as getting a tax advantage. Nothing could be further from the truth (quite simply, franking credits are applied against the tax payable by all resident taxpayers), but I suspect it is one reason why franking credits are back on the public agenda with arguments being mounted for their abolition.

The SMSF Association’s position on this issue is unequivocal – the reasons given by Keating in 1987 when he introduced the system are as a valid today as they were then. They are an important part of the investment landscape and should remain.

So what is dividend imputation? In its interim report, the Tax White Paper made the following comment: “The inquiry notes that, due to refundable imputation credits and tax-free superannuation in retirement, a growing proportion of company tax collected could be refunded to superannuation funds and retirees over time. Although this is of enormous benefit to retirees, it may erode one of the largest sources of revenue for the Government at the same time expenditure pressures are increasing.”

The Association begs to differ. As we said in our submission to the Tax White Paper, it is our firmly held belief that this comment misinterprets how the dividend imputation system interacts with the taxation of superannuation funds.

It is worth being reminded why dividend imputation was introduced – to remove the double taxation of corporate profits. Under the classical taxation of corporate profits, earnings are taxed once in the hands of the company and again as a dividend received by the shareholder.

Dividend imputation removes this double taxation by passing on the benefit of tax already paid by the company to the shareholder via a franking credit. Effectively, this makes company tax a withholding tax for corporate profits that are intended to be ultimately taxed at the shareholder’s marginal tax rate.

There is an assertion that the use of franking credits by superannuation funds with a low or zero (where a fund is totally in pension phase) marginal tax rates undermines the revenue derived from company tax. This is a misconception that company tax is a tax on the company’s earnings rather than a withholding tax on corporate dividends which are ultimately taxed in the hands of the shareholder.

The low or zero tax rate of superannuation funds results in company tax paid on their behalf being refunded to them. As the taxation of superannuation funds dictates those funds should be paying a concessional tax rate on income which includes corporate profits paid as dividends. Lower or concessional tax rates for super funds is a fundamental part of Australia’s super system and is an important incentive for savers to lock away their money in super to save for their retirement, a policy that largely enjoys bipartisan political support. Expect dividend imputation to remain.

Typically, it is large, well-established companies that pay franked dividends, although not all of those will pay fully franked dividends. Also, franking credits are only available on Australian-based companies and their Australian-based activities.

The question fund trustees have to consider is this: is it better to invest in companies paying franked dividends in preference to those that don’t. On balance, I think “yes”. Data from countries that have franking credit systems is that dividend payouts are higher compared to those where such a system is unavailable.

For all superannuation funds (including SMSFs), the tax rate on the fund’s ordinary taxable income in accumulation phase is 15% and the maximum franking credit available for offset against the tax payable is equal to 30% of the gross dividend - the same as the company tax rate.

The net result is that the fund’s net tax bill may be reduced significantly where its investments include a substantial proportion of franked dividends.

But there are some limitations on claiming franking credits against the tax payable by a superannuation fund. They may not be available where the company paying the dividend is involved in a dividend streaming or stripping arrangement or where there is a franking credit trading scheme in place.

Also, to be eligible for the franking credit offset, shares must satisfy the holding period rule requiring fund to retain the shares ‘at risk’ for at least 45 days, excluding the days of acquisition and sale, and for some preference shares for at least 90 days. An exemption to this rule applies to small shareholdings where the total franking credit entitlement is less than $5,000.

Irrespective of whether a fund is in accumulation or pension phase, there is a clear benefit from franking credits. In the accumulation phase any excess franking credits are offset against other taxable income earned by the fund and any amount remaining after that is refunded. Where the fund is wholly in pension phase, the ordinary income is tax exempt and the full benefit of the available credit increases the income of the fund available for distribution to members. Keating was right – franking credits are super.

Graeme Colley, director, technical and professional standards, SMSF Association