Taking an SMSF offshore

International shares do not generate Australian income tax credits (‘franking credits’ or ‘imputation credits’). This is one of the specific reasons that the franking or dividend imputation system was developed: to encourage Australian investors to preferentially invest in Australian shares.

As a result, one of the common failings that we see is where a SMSF is advised to invest, either directly or indirectly, in international shares, without informing the client that such an allocation may be sub-optimal when it comes to taxation.

Shane Oliver, the head of Investment Strategy and Chief Economist at AMP, has calculated that franking credits alone add 1 percentage point to the overall return of Australian shares, and that they result in an outperformance by Australian shares of 2.5 percentage points over the performance of international shares.

Franking credits work to avoid a ‘double taxation’ of company profits. Companies themselves pay tax at a rate of 30%. When those companies distribute dividends from after-tax profits, those dividends come with a franking credit for the 30% of tax that has been paid. So, if a shareholder receives a fully-franked divided of $7000, they will also receive a franking credit for the $3,000 in tax that the company paid on the original $10,000 of profit.

When calculating the total tax paid by the shareholder, the dividend received plus the franking credit is added to taxable income. This amount is then used to calculate the shareholder’s total tax liability. This liability is then adjusted by the amount of the franking credit, as this represents tax that has already been paid.

In the case of a SMSF, which has a marginal tax rate of 15%, this means that the SMSF actually receives a tax refund from the ATO when it receives fully-franked dividends. Consider the following worked example reproduced from the Switzer Report:

Dividend $12,500  
Franking credit $5,357 Dividend x 3/7
Grossed up dividend $17,857 Dividend + franking credit
Tax payable by SMSF $2,679 15% x Grossed up dividend
Less franking credit -$5,357  
Tax refund back to SMSF $2,678 Tax payable les franking credit

For international shares, no franking credit is available. Understandably, Australia’s Tax Office is not that interested in giving credit for tax paid overseas. This substantially reduces the after-tax performance of international shares in the SMSF environment. Advisers may still see a case for advising that such shares be invested in, but they need to inform their clients that the international share has to substantially outperform a comparable Australian investment to offset the tax benefit that is lost.

The Dover Group