A tax-effective alternative

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The tax breaks available to SMSFs when investing in an early-stage innovation company might just be the opportunity members are looking for if they end up losing franking credit refunds, writes Stephen Crowe.

In this article we discuss how SMSFs can benefit from investing in early-stage innovation companies (ESIC) despite the significant clouds of uncertainty prevailing over superannuation, its role in creating wealth and providing income for retirement.

When it comes to portfolio construction, an effective asset allocation strategy should be front of mind for investors.

Early-stage investing is a new and accessible asset class with unique features. The program was designed by the Australian government and has bipartisan support to direct investor attention to the opportunities available for wealth creation from early-stage investing within a balanced portfolio.

Investors who have allowed themselves to be caught up chasing shares with high dividends have often encountered poor growth prospects.

Stephen Crowe

An early-stage investment is suitable for consideration by those with their eyes wide open to the possibilities created by investing in early-stage businesses seeking to exploit a market opportunity by building innovation, technology or other high-growth potential into a new market with global potential.

Tax credits earned by any member of the SMSF are available to offset the tax liability of other members of the SMSF because it is the fund, not the individual, that is the taxpayer. This allows members flexibility in terms of how this new asset class sits within their individual asset allocation and enables investment decisions in this segment to be tailored to suit. Members of the SMSF who wish to invest in ESICs with capital growth prospects within a longer investment time frame can do so and reduce the tax paid by the fund. This is a significant feature given Labor’s commitment to disallow cash refunds for excess dividend imputation credits.

Labor’s intention to deny excess franking tax credits to some SMSF members in the pension phase has created considerable uncertainty among the nearly 600,000 funds and 1.12 million members in the $760 billion SMSF sector.

This is unsurprising given the profile of shares in SMSF portfolios. Before refunds of excess franking credits became popular, the major SMSF investment was business property owned by fund members.

As of last September’s most recent ATO SMSF statistics, SMSFs owned $223 billion worth of Australian listed shares, which represented just under 30 per cent of all their investments. It’s their major investment category thanks to the attraction of dividends and the dividend imputation tax credits they can earn. Investing for dividends and excess tax credits is a strategy that has steadily grown since the introduction in 2000, now nearly 20 years ago, of excess franking tax credit rebates. It is a strategy that now requires a reset and investors need to seek alternatives.

How might SMSF trustees tackle the prospect of losing excess dividend franking tax credits?

Some commentators are proclaiming SMSF investors, in their relentless quest for dividend yield and tax credits, especially in the pension phase, may have missed the opportunity to earn tax-free capital gains by having more global equities in their portfolios.

Investments in companies such as Google, or Alphabet as it is now known, would have delivered a better return than holding on to Australian shares like Telstra for its franked dividend, which has halved in value.

With such investments investors must learn to overcome inhibitions about larger companies being safer investments. Investors who have allowed themselves to be caught up chasing shares with high dividends have often encountered poor growth prospects. Now could be a good time to start thinking about this.

Attractive current dividend yields can be the silver lining disguising the clouds and can lead to value-trap investing. Value traps are set off when investors are lured by high dividend yields of businesses that do not have sustainable initiatives to grow earnings. Capital growth, when investing for the capital growth opportunities, is offered by businesses that reinvest shareholder funds within their return on equity matrix.

ESIC investments are, by their very nature, more likely to generate capital gains than franked dividends generated by other more mature businesses. Commensurate with the risks involved, investors gain access at valuations reflective of the early stage of the venture. By nature, not all these investments will succeed and become the next investment unicorn. But those investors fortunate to have exposure to the unicorns will reap the diversity and tax-free capital gains offered to their portfolio within the first 10 years.

There are shares that pay token dividends, such as CSL, which can reward investors with exemplary capital gains that can be converted into tax-free income and capital gains if they qualify as an ESIC at the time of investment.

Not every early-stage investment will qualify, so it is important your planning and exposure to this asset class are performed properly and with an eye on the prize.

The next step for an educated investor

Identify an ESIC specialist and early-stage manager who can actively assess early-stage ventures and make decisions on their appropriateness using a rigorous process of investigation, due diligence and assessment. ESIC specialists can also provide you with suitable investment opportunities into companies that fit the early-stage innovation criteria.

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