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Comment on franking and ‘direct investment’

Matthew Collins writes in his article on ‘direct investing options’ (DIO): The cost-effectiveness of this strategy depends upon a host of tax and investment considerations.”

This comment draws out other issues, some of which Matthew probably avoided for space reasons.

If the changes to franking credit policy do occur, the relative attractiveness of an industry fund DIO essentially represents a structural advantage. There are other examples of structural advantages that SMSFs hold, such as the ability to:

  • Invest in almost any asset. The DIOs do not cover all shares, ETFs or LICs.
  • Access the government guarantee on deposits, as this is available ‘per entity per ADI’. That is, the DIO only has one claim for $250,000 which is irrelevant given its scale
  • Borrow using Limited Recourse Borrowing Arrangements (albeit now diminished)
  • Include more than one member and therefore spread the cost.

No doubt a skilled financial adviser can add many more ways an SMSF can be used for planning and they are welcome to add more comments.

Similarly, send through any material criticisms of the DIO not mentioned in either article, other than political arguments that it’s all a union-inspired plot by Labor.

What is best for the investor?

Advisers and investors should focus on achieving the best outcome for the individual and should be agnostic to the products or vehicles used.

It is likely that few financial advisers have used the DIO option, although many in the industry are working on responses to Labor’s proposal. A sensible outcome might be that advisers and businesses serving the superannuant consider industry funds and DIOs as one of many attractive weapons in their arsenal.

But they are not mutually exclusive. It might be reasonable to run an SMSF and a DIO as well as other vehicles such as insurance bonds, retail funds, money outside super, managed accounts or whatever. Together, they may better meet the objectives of the client, as long as it does not become too complicated.

Maintaining an industry or retail fund account might be viewed as an 'end of life' transition strategy out of an SMSF as the members age or if their needs change such that the SMSF is no longer required. It is not one versus the other, as the two can co-exist.

The industry funds also have the motivation to improve their DIO product. For example, Matthew highlights the inability to transfer shares from an SMSF to a DIO ‘in specie’, requiring shares in an SMSF to be sold first. This capability could be built.

The relevance of the DIO limitations 

The article also touches on a number of constraints or limitations that might act as a disincentive for an SMSF superannuant or their adviser. These include (but are not limited to) the product rules, especially the maximum amount that can be invested in the DIO, and the limited approved product list (APL).

Whilst these rules might be construed as unnecessarily paternalistic, they are designed by industry fund trustees in exercising their fiduciary duties. They need to consider the appropriateness of their products and services for the members for whom they are the custodians. There is judgement that an unfettered offering could result in sub optimal outcomes for inexperienced members who don’t have an appropriate appreciation as to the risks.

There are other restrictions which Matthew does not mention, such as a maximum 20% of the total super balance in a single stock.

Again, this is an opportunity for DIO development, as the rules are imposed by the trustees, probably because they know the type of members they have. They could offer a more relaxed set of rules where a member is transferring from an SMSF and can demonstrate an understanding of the risks involved. Or where a member is under the advice of an appropriately qualified adviser. This may remove a friction point for many trustees.

It’s another vehicle option

All segments of the wealth management industry should realise that the DIO may become a more serious competitor to the SMSF, especially if industry funds improve the product and engage more with financial advisers. As a result of the Royal Commission and the removal of commissions under FoFA, more advisers accept they must act in the best interests of their clients. SMSFs will then need to stress and develop the advantages they offer over DIOs.

 

Graham Hand is Managing Editor of Cuffelinks. This article is general information and does not consider the circumstances of any investor.

19 Comments
Theo
April 20, 2019

If SMSF members move to a DIO en masse thereby defeating Labor’s plan, won’t they just legislate this option away?

Graham Hand
April 20, 2019

Hi Theo, there's a legal structure issue to overcome. Industry funds that offer DIOs operate under one tax entity, (as with multiple members of an SMSF), and the accumulators are generating the taxable income to absorb the franking credits. More of a problem would be if those in pension mode outnumber accumulation, reducing the proportion of taxpayers. Also depends who is in government. Labor is unlikely to introduce rules that disadvantage industry funds.

Theo
April 20, 2019

Hi Graham, I understand the single taxing entity issue, but surely laws could be drafted to target the benefits accruing to individual members.

As for the pension mode members exceeding accumulation members, the problem will probably arise before that point due to (a) the greater value of a typical pension account over an accumulation account and (b) the 30% franking rate v 15% Accumulation tax rate.

Graham Hand
April 21, 2019

Hi Theo, indeed, but remember it's the contribution tax plus the tax on earnings in accumulation.

Theo
April 21, 2019

Actually, wouldn’t the Government just deny a proportion of Franking Credit claims in the Super Fund entity tax return based on the % applicable to Pension Phase.

Chris M.
April 22, 2019

Full marks to Matthew Collins for his article.
I've been using the AustSuper DIO known as Member Direct for some years now.
In terms of clarification, these DIO systems are the 'rebranding' a solution that is typically provided by banks and brokers - UBS in this case.
I believe it is better to explain the DIO systems as being a segmented component of one's Super Account - as such it is a share trading account with an associated cash account. The elegance is that CGT is calculated, that Dividend payments include the Imputation credit and the 15% Withholding tax is performed at the time of payment. Compared to my share trading outside of my Super, this DIO solution works well for me.
For clients who feel comfortable with share trading I find the DIOs to be a cost effective answer to having an SMSF, particularly if you are prepared to undertake real property ownership outside of an SMSF.

Pete Latham
April 17, 2019

Bill Shortens idea in doing away with the Franking Credit Rebate is to do a Robbing Hood; take from the rich, and give to the poor. The problem is that politicians are so well paid and superannuated these days that they have absolutely no idea what rich is anymore! Even though it looks likely that Labour will win Government, I sincerely hope that they don’t get the numbers that entitles them to take from those who have been planning their future financial security for decades, only to have a Billy come along and change the rules.

Dudley
April 19, 2019

"take from the rich, and give to the poor":

With Labor's proposal enacted:

. for direct shareholders, the poor 'give' more and the take from the rich is unchanged;
https://docdro.id/0nzjM6G

. for super fund members 'it depends' but in any one fund retiree ('pension') accounts rich and poor are equally affected.

Ian Arthur
April 17, 2019

It is sad to see how few people seem to care about increased equality and fairness in Australia and that ralatively affluent people are fixated getting money back on tax they haven't paid. Personally I would like to see dental treatment added to the Medicare system. pre school made free as it is in much of Northern Europe. Our school system would be fairer if private schooling was not subsidised by the government, our health care system made more equitable if the government stopped subsidising private health. Government services require funding and removing much middle class welfare would
make our country more equal and a better place to live.

g philip
April 18, 2019

Dear Ian,
Yes it is fair that careful and prudent people who have saved more than enough for their retirement should share their wealth with less fortunate people.
But it is not fair that those who have their savings invested in SMSF are taxed and those who have their funds in Industry funds (which includes politicians and religious organisations) are not taxed.
The imputation credits are not giving money back, they are refunds of tax already paid. To withhold such payments can only be seen as stealing.

Dudley
April 19, 2019

"fixated getting money back on tax they haven’t paid":

Employees get "money back on tax they haven’t paid". Their employers paid. ATO imputes tax paid by employers to employees as tax credits. If the tax credits exceed the employee's tax liability, the over paid tax is refunded to the employee.

It is the same with shareholders and companies.
https://cuffelinks.com.au/franking-credits-made-easy/

Christopher O'Neill
April 21, 2019

How is it that high income earners can pay their tax using "tax they haven’t paid"?

i.e. Labor says shareholders don't pay company tax but somehow they can pay their personal tax bill using this "tax they haven’t paid".

Allan
April 24, 2019

Precisely Christopher. High income franked dividend recipients get to fully offset their personal income tax liability on those dividends with the imputation credits. Meanwhile, genuine low income earners forfeit those same imputation credits to the ATO, thereby incurring an extremely regressive flat tax rate of up to 30 percent.

Perhaps those commenting here on the so-called Robin Hood value of this proposal should take a much closer look at just who the money is really flowing from and to.

Labor are either clueless as to what they are proposing, or it is an easy "rich vs poor" sell against a poorly understood bit of tax law.

Mossy
April 17, 2019

I've used the Direct Investment Option of a couple of large industry funds for a few clients over the last couple of years. My main criticisms are:

- the lack of an adviser transaction portal. All trades need to be done by the client logging into their online account. You first need to move money to the DIO and then (generally) the next day you can trade. Most clients would prefer the adviser just make the trades as some clients can be a little nervous when placing trades as it can be a bit foreign to them. Normally I'd have the client with me and we'd do it together, but sometimes it's not convenient for the client to see me two days in a row to place trades so we can't necessarily buy when we want to; and
- when contacting funds for updates on client portfolios they'll quote the total invested in the DIO but not provide the breakdown (eg number of shares etc) which seems a little crazy (as an aside, the discussions with one particular fund suggests only the client can sell assets within the DIO, so we're not 100% certain what would happen in the event of death of a client in terms of transacting. The DIO guide of this particular fund was very light on the detail about that situation).

Other than that, for the clients that are seeking direct equity/ETF/term deposit exposure the DIOs of some of the big players are normally ok to deal with.

There's a couple of other large industry funds that I wish had direct equity capability - hopefully soon.

I've been speaking to a number of clients already about what we may need to consider if the ALP's franking credit changes become law. Clients certainly appear to be appreciative of the fact that we may have a solution for being able to retain some of their franking credit refunds. We do however wonder if the revenue the ALP is banking on will be received (we tend to think that the discussions we're having would be replicated around the country so the revenue is likely to be a fair bit less than expected).

Interesting times ahead.

A Stuer
April 17, 2019

Re:”"If you are getting a tax credit when you haven’t paid any income tax, this is a gift .””
Mr Shorten is conveniently ignoring the fact that shareholders are part owners of the company in which they have shares and any tax paid is thus paid on their behalf.
Thus Mr Shorten, a refund is by no means a gift. Get that fact right. But that’s an inconvenient truth , isn’t it?

Robert Craig
April 17, 2019

I have two comments one on my autonomy and the other on my continued understanding our financial and economic situation. As a trustee I manage the money I have contributed to our SMSF. Over many years I have performed well enough compared with the big funds with lower fees. When I have made bad decisions at least it is my own responsibility and I try to learn from them. Regarding the requirements of a trustee as well as an individual taxpayer they have stimulated me follow the markets and try to understand changes in micro and macro economics and tax law. It has seemed to me that woeful ignorance of such matters contributes greatly to our current state of politics and social disharmony.

Matthew
April 17, 2019

This is the circular which tells trustees how to handle their responsibilities under 'member direct'. Paragraph 50.

https://www.apra.gov.au/sites/default/files/superannuation-circular-ii-d-1-managing-investments-and-investment-choice.pdf

Chris M.
April 22, 2019

Hi Matthew
Unfortunately the link you provided did not work. Could you check it and resend it?

Graham Hand
April 22, 2019

Thanks, Chris. Matthew has provided a new link. G

https://www.apra.gov.au/sites/default/files/superannuation-circular-ii-d-1-managing-investments-and-investment-choice.pdf

 

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