Income within superannuation
A super fund can have several sources of income. One is contributions, which are discussed here.
The other main source of income is from the investment activities of the fund. As with most investments, there are two types of return: somewhat confusingly, one of these is called the income return. The other is called capital return.
Income return is the return that the super fund receives while it continues to hold assets. Typical income includes rent from properties, dividends from shares and interest or other payments from loan-type investments (including those traded on secondary markets, such as bonds).
Capital return is the return that the fund receives when it disposes of an asset. The return is the difference between the purchase price for that asset and the sale price. Accordingly, the capital return can be negative or positive.
Capital return is treated as income for the fund in the financial year in which the disposal takes place.
As a starting point, all income for the fund is taxed at 15%. This includes income return and capital return. However, there are some notable exceptions:
Capital gains on assets that have been held for more than 12 months. These are discounted by one-third, meaning that the effective rate of tax on such gains is 10%. Consider an example:
The Smith SMSF buys $100,000 of shares on 30 June 2015. On 1 July 2016 (ie twelve months and one day later), the SMSF sells the shares for $110,000. The capital gain is $10,000. The applicable rate of tax on this gain is 10%. So, the fund pays $1,000 in tax. This tax is payable in the 2016/2017 year, meaning that the actual tax is likely to be paid after the fund lodges its tax return for that year. That will be sometime after the 30 June 2017.
Income received and capital gains realized on assets that are being used to finance an income stream (‘pension’). This income is not taxed at all. This is the case regardless of when the assets were acquired by the fund. Consider an example:
The Smith SMSF has one member. The SMSF buys $100,000 of shares on 30 June 2015. One the 1st of July 2016, the fund commences paying an income stream to its member. These shares form part of the assets used to finance that income stream. On the 1st of January 2016, the fund receives $5,000 in dividend income. It then sells the shares on the 1st of June 2016 (that is, within 12 months), for $110,000.
The SMSF will not pay tax on either the $5,000 of dividends nor the $10,000 capital gain. This is because the fund was paying a pension when these two returns were realized, and the relevant assets were funding that pension.
Strategies for optimizing the tax treatment on superannuation earnings
There are two main strategies that can be applied here. These are discussed in the following sections.
Prefer capital gains to income returns while assets are in accumulation (that is, pre-pension) phase.
Capital gains are taxed more favourably than income, provided that the assets is held for more than 12 months. This is deliberate social policy, designed to encourage longer-term investment vehicles (such as superannuation) to invest with a view to holding investment assets for at least 12 months.
So, when a super fund takes advantage of this policy, it reduces its tax liability.
Everything else being equal (which is a common assumption rarely met in real life), this strategy will reduce the tax payable on the member’s earnings by a third.
Commence a pension from your fund as early as possible – and especially before you realise capital gains.
Once superannuation assets are used to finance a pension, no tax is paid on earnings related to the assets being used for that pension. Therefore, the payment of a pension can lead to a substantial tax benefit.
This can be especially the case for assets owned by a super fund and on which a substantial capital gain is likely to be realised. If the fund can commence a pension before it realizes this gain, it will not have to pay tax – even if the increase in value of the asset happened well before the pension commenced.
Timing the sale of assets in this way is often easiest when using a self-managed super fund.
Consider the following example:
The Jones SMSF bought 10,000 shares in the NAB on 6 of March 2009. This was perfect timing, as this day coincided with the lowest price for these shares during the entire GFC. The shares cost $16.80, making the whole purchase price was $168,000.
The fund’s only member, Joan Jones, turned 60 on October 1 2017. She commenced a transition to retirement pension immediately. On November 1 2017, the fund sold its entire parcel of NAB shares at a price of $32.88. This realized $328,000 or a capital gain of $160,000. Most of the rise in the value of the shares preceded the commencement of the pension, but because the pension commenced before the shares were sold, there was no tax payable on the capital gain.
Another thing that should always be considered: the dividend imputation system
Once again, everything else being equal, super funds should prefer to hold shares in Australian companies. This is because of the dividend imputation system that applies for shares in Australian companies.
For many years, company profits were taxed twice in Australia, once in the hands of the company when they were derived and once again in the hands of shareholders when and if they were paid out as dividends. There was no imputation of tax already paid by the company on those profits when they were paid out to the shareholders. This meant there were very high effective rates of income tax on company profits. The 1985 reform of the Australian taxation system identified this as a major inefficiency and, consequently, recommended a change to a partial imputation system of taxing company profits. This system started in 1987 and has now been extended to a full imputation system of taxing company profits. This system relies on a complex system of record-keeping to track income tax paid by companies and to allow their shareholders to claim a credit for that tax i.e. an imputation credit or a so-called ‘franking credit’ when they include those dividends in their assessable income computations.
The basic logistics of taxing franked dividends are as follows:
- The company pays tax on its taxable income at the company tax rate (currently 30%) and records this tax as a credit in a notional account called a ‘franking account’
- When the company pays a dividend, it determines the extent to which the dividend is paid out of taxed profits, debits its franking account and advises its shareholders via a written dividend statement of the amount of the cash dividend and the attached franking credit
- The shareholder includes both the cash dividend and the attached franking credit in their assessable income computation; and
- The shareholder claims a tax offset in their tax payable computation, equal to the value of the imputation credit; this tax offset, unlike most tax offsets, can generate a refund of tax.
This means that ultimately the amount of income tax paid on the company’s profits depends on the income tax profiles of its shareholders. A super fund has a maximum tax rate of 15%, and the tax rate is 0% for funds paying pensions. This means that, when the shareholder is a super fund, the tax paid by the company at the rate of 30% will either be fully or partly (50%) reimbursed to the super fund when it lodges its tax return.
Very simply, the logic is this: the company paid tax at 30%, but the shareholder’s tax rate is only 15%. So, the tax office gives the extra 15% back to the shareholder.
If the shareholder’s tax rate is 0% (the super fund in pension mode), the tax office gives the whole 30% back to the shareholder.
This means that the level playing field identified as a major policy goal in the 1985 reform of the Australian taxation system has largely been achieved. This, and particularly the removal of the structural tax bias against companies through the imputation system, is recognised as a major factor fuelling Australia’s economic growth and, in particular, the strong growth in share market values since 1985.
The Australian Investors Association have some comprehensive information available on their website regarding franking credits.