Chapter 14 – SMSFs and shares

Often, shares are the investment of choice for SMSFs. For the same reasons as for any other investor, buying shares directly is typically the most efficient way for an SMSF to invest into the share market.

However, there are some specific aspects to SMSFs that warrant particular consideration.

Written investment strategy

SMSFs must have a formal investment strategy. Investments must therefore be made in accordance with this strategy.

Financial advisers are of obvious benefit here. They can provide the investment strategy for the SMSF as well as conduct the regular review of that strategy with the client on an ongoing basis. The statement of advice can simply be adopted by the trustees of the SMSF as the SMSF’s investment strategy. 

In terms of the mechanics of advising an SMSF to buy shares, these are the same as for any other investor. A written statement of advice is required, and the broking facility that is used by the investor must be registered in the name of the (trustees of the) SMSF.

Capital gains tax treatment

Individual investors and investors via trusts can typically make use of the 50% exemption from CGT for assets held for longer than 12 months. This includes shares such as assets.

SMSFs receive a smaller, 33% discount for gains on shares that are held for more than 12 months. However, the remaining gain is only taxed at the marginal rate of 15% within the SMSF. Essentially, this means that shares held for more than 12 months within a SMSF are subject to a CGT of 10%.

Shares held for a period shorter than 12 months are taxed at the full marginal tax rate of 15%.

For many investors, the SMSF marginal tax rate of 15% is well below their personal marginal tax rate, which can be as high as 45%. This can make the SMSF the best vehicle to use for an investment into shares.

This can be particularly the case where the capital gain is delayed until after the SMSF commences the payment of a pension to the member. At this point in time, the rules for super funds state that the earnings of the fund used to pay the pension are not taxed at all. This includes capital gains. Therefore, if the SMSF delays selling a shareholding until after the member/s commence receiving a pension, then any capital gain on that shareholding will not be taxed.

Trading costs

Buying and selling shares imposes a cost on the buyer or seller. Typically, this cost is limited to the brokerage on the transaction (capital gains tax is not really a cost of selling, so much as a tax on the profit realised at the time of the sale. That said, as outlined above, it is possible for the realisation of capital gains to be timed such that CGT is avoided).

SMSFs need to be audited each year and, in most cases, this means that an auditor has to peruse each share acquisition or disposal. That is, every time that a SMSF buys or sells, the costs of administering the SMSF rise. (Some auditors charge by the group of transactions. For example, they may charge a certain fee for up to ten transactions, another fee for between 11 and 20 transactions, etc. The concept is the same though: the cost generally increases as the number of transactions increases).

This can create (another) good argument for SMSF investors taking a long-term view of their investment. Taking a ten year plus time horizon should minimise the amount of trading and thereby keep the administration fee as low as possible.

Franking credits

As we discuss elsewhere, it typically makes sense for Australian investors to invest in Australian shares, thereby making use of the franking credit system. This system provides shareholders with a credit for tax paid by the company before the company paid out its dividends.

The company tax rate is 30%, meaning that fully-franked dividends come with a 30% franking credit. That is, for every $70 of fully-franked dividends received, the shareholder also receives a franking credit of $30.

Where the marginal tax rate of the shareholder is less than 30%, the shareholder will therefore receive a credit that exceeds the amount of tax they have to pay. The net effect of this is a tax return, which has the effect of increasing the cash flow to the shareholder.

An SMSF has a marginal tax rate of 15%, meaning that an SMSF will always receive a tax return when it receives a fully-franked dividend.  This improves the cash flow of the SMSF, and provides a compelling reason for the SMSF to prefer shares in Australian companies that pay franked dividends.

This becomes even more the case when the SMSF is in ‘pension mode,’ at which time the marginal tax rate falls to zero and the tax rebate rises to the full value of the franking credit. At these times, the SMSF is also typically looking to maximise cash flow so as to finance the pension, making the higher effective yield of fully franked dividends even more attractive.

Borrowing to invest in an SMSF

While a SMSF can theoretically borrow to buy shares, in practice few do. This is because of some of the limits that are imposed on borrowing within an SMSF. These limits include things like the need for the borrowing to be used to finance a single acquirable asset. While a parcel of shares in the one company can constitute such a single asset, shares in different companies do not.

Similarly, once the parcel has been bought, it cannot be divided (that is, the SMSF cannot sell some of its shares while holding the rest).

Accordingly, people who borrow to invest in shares typically do so outside of superannuation. People who invest in shares within a SMSF do so using their own money, not borrowed money. 

The Dover Group