Is this imputation credit inevitability?

Although Labor must win the next federal election in order for its proposal to scrap imputation credit cash refunds to become reality, Krystine Lumanta writes advisers need to be on the front foot to prepare for the excess credits to be abolished eventually.

When federal opposition leader Bill Shorten announced Labor’s policy proposal on cash refunds for excess imputation credits in March, it caused a strong and perhaps justifiable reaction from the SMSF sector.

Shorten declared 200,000 of the 600,000 SMSFs in the country were the policy’s main target and that 92 per cent of the 12.8 million Australians who lodge tax returns would be unaffected.

Under the original proposed policy, dividend imputation credits, or franking credits, would only be able to be used to offset existing tax liabilities and no refund from the ATO would occur if the retiree in question paid no tax.

According to Labor, axing the dividend refund would create a budget saving of $11.4 billion over the final two years of the current forward estimates and $59 billion over the medium term. However, the Parliamentary Budget Office data used to formulate and justify the policy proposal dated back to 2014/15, and also failed to consider superannuants who have already been affected by the introduction of the $1.6 million transfer balance cap and total super balance measures introduced on 1 July 2017.

In response to strong public and political backlash, Labor then returned with a carveout that would spare SMSFs with at least one member receiving the age pension.

But the collective response pointed out further anomalies, distortions and complexities to retirement planning and savings under this move.

At an SMSF Association local community event in Sydney, held after Labor’s original policy was announced, Verante Financial Planning director Liam Shorte recommended advisers begin talking to their clients about what their SMSF would look like without the cash refunds, in preparation for the potential change.

It’s a hard pill to swallow, but I Love SMSF founder Grant Abbott expects imputation credit cash refunds to be scrapped altogether, and thinks it’s just a matter of time.

“Back in 2015 I said this is as good as it’s going to get for SMSFs and from here on in it’s only going to get worse,” Abbott recalls.

“Treasurer Scott Morrison’s 2016 federal budget changes already limited the imputation credits anyway by having the $1.6 million cap. Now it will go down further.”

He says Australia has undergone immense change since the dividend imputation system was devised 30 years ago – where franking credits were designed to eliminate dividend double taxation – and every year more money is going into the pension side of super funds.

“In 1999, there was about $150 billion in SMSFs and now there’s about $600 billion more, so that’s a lot of money, by any stretch of the imagination, to be given a tax shelter,” he says.

“I know of clients who aren’t paying tax and getting $300,000 to $400,000 of imputation credit refunds because they’ve been able to utilise the system. That’s not sustainable.”

He also predicts it’s just the start of more measures aimed at tapering down superannuation even further. So when it comes to the current imputation debate, it’s time to “use it or lose it”, as Abbott puts it.

“The government’s running a deficit, so they’re going to start hitting people up and the easiest ones to target are, of course, SMSFs to a certain extent unfortunately,” he says.

“You will definitely lose your franking credit refunds.

“Next on the chopping block will be higher taxes on the distribution of benefits from the super fund on the death of a member, and then also the limitations on the tax-free amounts that come out of super, so looking at the old reasonable benefit limits.

“But the big one we’ve got to worry about is tax-free super post-60 because if the government starts putting limits on that, like the current government’s done with the pension element, that’s when people will really start to scream.”

Self-managed Independent Superannuation Funds Association (SISFA) managing director Michael Lorimer says investment in companies paying franked dividends – inside and outside of an SMSF – has been a sensible investment strategy for self-managed funds with interest rates at record lows. “On average, SMSFs devote 29.5 per cent of their assets to Australian shares,” Lorimer says.

“Some have a much larger allocation to shares and, indeed, may not invest much in anything else.”

Feedback from SISFA members with a high concentration of their assets in shares has identified some trustees expect to lose close to 30 per cent of their retirement income.

“This is unsurprising because in effect a new tax of 30 per cent, the company tax rate, will be applied to them,” Lorimer notes.

“Let’s be clear. Franked dividends are not a tax concession, nor a tax lurk for the rich.

“They are a tax credit for the owners of shares whose dividend income has already been taxed in the form of company profits.”

SMSF Association chief executive John Maroney has voiced concerns about the adverse effects this policy will have on SMSF trustees and members, who have saved to be self-sufficient to avoid relying on the age pension. Maroney says cashbacks weren’t part of the original imputation system, implemented by the Hawke-Keating Labor government in 1987, but were supported by both sides of politics in 2000.

“Cash refunds have been around for 18 years on a bipartisan basis, so from that point of view they are a well-established, long-standing part of the system,” he says.

“Taking them away is a significant cut to a lot of people’s income.”

Equity market impact

A broader result of axing imputation credits could see distortion of capital markets, which in turn will make superannuants less inclined to invest in Australian companies.

Maroney warns of the potential negative impacts of this outcome. “Effectively all other investments will become relatively more attractive and that will include overseas shares, property, unlisted investments, fixed interest investments,” he says.

“It distorts the whole investment risk/return trade-off so there’d be significant means for trustees to review and adjust investment strategies and asset allocations.”

Bell Direct equities strategist Julia Lee explains imputation credits can be used in other ways, but as companies can’t necessarily refuse to distribute them, either they go to waste or the government pockets them.

Lee says given the baby boomer generation is moving into their retirement and pension phase, along with the growing popularity of SMSFs, a reduction in the cash refunds will be problematic.

She therefore predicts action from companies renowned for dividend-paying stocks ahead of the next election. “Australia has one of the highest dividend yields of any stock market in the world,” she says.

“Companies will be looking at ways to distribute those franking credit refunds, given they don’t benefit in holding them.

“They can do that through things like share buybacks where the structure is in such a way that a small portion of that buyback is capital and the rest is made up with a fully franked dividend.

“Labor’s not talking about getting rid of imputation credits altogether, but the reduction in the credit refunds may mean, in an overall sense of how people invest, there will be a switch to growth-focused investing from income-focused investing.”

However, SMSFs in pension phase will still need income and thus need ways to replace income lost from the refund axe.

“They’re probably already too overweight in property and, of course, they’re looking at fixed interest,” Lee says.

“So they’ll be on the hunt for income-style assets, maybe just not from the share market.”

Commenting on trustee preferences outside the share market, she doesn’t expect a huge shift away from investor home bias.

“There are other alternative options out there at the moment, but we’re still seeing Australians with a huge preference for domestic assets,” she notes.

On potential trustee asset class appetite and portfolio weightings, Abbott adds: “Are SMSFs going to go into bonds? If you have a look, smart investors, particularly if they have a planner, once they’re aged 65 or 70, they’re taking pensions and they’d probably look at bonds anyway as a cash-flow source.

“Admittedly rates are low. Those sorts of people are probably not going to go into property. People are either shares or property, they’re not in between.”

According to Australian investment manager DNR Capital, the proposed policy change highlights the importance of both capital preservation and the diversification of income sources for retirees. “Before investors flock toward higher-risk asset classes that, in our opinion, have stretched valuations – for example, unlisted and listed property, infrastructure and utilities – there are alternatives to generating income,” the firm says.

“In our view, income-seeking investors need to look beyond any single asset class and specifically consider a higher allocation to Australian equities with strategies focused on tax-advantaged, reliable and growing income generation.”

DNR believes a diversified equities strategy focused on sustainable and growing income generation better protects retirees against downside risk, sequencing risk and portfolio drawdowns, and increases the compound total return over time, conserving capital and protecting against inflation.

Strategic advice opportunity

The move to abolish imputation credit cash refunds will affect new and existing SMSF strategies, prompting a rethink of new approaches by advisers.

“From an SMSF point of view, there will need to be a reconsideration of the investment strategy because there’s going to be an earlier access to capital requirement due to the previous income that came from the imputation credits,” Miller Super Solutions founder Tim Miller says.

Large funds also have high-growth investments and generate income from Australian-listed securities as much as SMSFs do. “It’s just that SMSFs will feel the impact of this policy more immediately because trustees are in charge of their own investment strategy and will therefore have to react quicker,” Miller adds.

According to Abbott, a key strategy to get around the scrapping of the cashbacks is to keep it in the family by gifting the credits to any children in the SMSF.

“It’s always been the elephant in the room – you don’t pay tax on the pension side of your fund, you don’t pay tax on the way out and you get a refund,” he says.

“So this is a pretty basic strategy: franking credits generated on the pension side and utilised by the children will reduce their contributions tax, and the children’s side of the fund would then pay for the use of franking credits.

“The idea is to jump in front of it and implement strategies or minimise the risks of it because you know it’s coming. That’s what a good adviser would start doing and talking about with their clients.”

Prevention better than cure

The SMSF Association doesn’t expect any immediate reactions from practitioners just yet.

However, it says the first task for advisers is to ensure trustees are across the policy proposal.

“It does take a while for messages to get to individuals about their own situation, so the first thing to do is generate awareness,” Maroney suggests.

“Trustees need to speak to their advisers about it and if they don’t have an adviser, they should seek information around what their options are.

“Effectively we have about 12 months to think about it, perhaps longer depending on when the next federal election is held, and I’ve read a number of senators will oppose it. So it’s one of those areas that make it difficult for people planning for their retirement because of the uncertainty.

“As there are quite a number of steps before it becomes policy, it would be premature to give any firm advice or for people to make decisions too soon.”

Alternatively, Abbott calls for early action and for advisers to anticipate the change to their advantage, that is, a chance to engage with clients. “As soon as something is on the cards, it’s going to pop its head up at some point, so why not plan for it?” he says.

“It’s a great strategic opportunity to get out to clients and lay out the issues: what would happen if this was the case? How should we manage this process?

“If it doesn’t happen, you were on the front foot with your clients. And at the end of the day, people want an adviser who’s on the front foot.”

Whatever side of politics it comes from, SISFA cautions it’s bad economics to dip into savings for the future to pay for recurrent spending today. “This can only lessen the volume and value of savings to help the current generation of workers pay for their own retirement without passing the cost on to the next generation,” Lorimer says.

SISFA has long argued direct changes or changes that impact on super should only be made in the context of a coherent framework for a retirement savings system, starting with a proper definition of the objective of superannuation and setting performance benchmarks for the system.

“Without the discipline of such a framework, governments will be free to plunder Australians’ retirement savings at will,” he says.