Maximising franking credits in SMSF's using Instalment Warrants

By using Instalment Warrants (Westpac SFIs) to purchase high-yielding, fully franked stocks, you can earn higher franked dividend income and potentially generate excess franking credits in your SMSF. 

Excess franking credits may be used to offset tax payable in the fund on other income, leaving the fund with more money to invest.

Peter’s super investment

Peter is 42 years old. He manages his superannuation, with his adviser, through his SMSF. His yearly contributions of $25,000ˆ attract a contributions tax of $3,750 p.a. Peter currently has more than $100,000 invested in his cash account in his SMSF.

Peter believes there are currently good buying opportunities in the Australian share market so he is keen to increase his exposure. At the same time, he wants to manage his contributions tax so he has the maximum amount available to invest.

A tax-effective strategy

Peter and his financial adviser think that shares in Australia and New Zealand Banking Group Limited (ANZ) have good growth and dividend prospects over the medium term so, in his role as Trustee of the SMSF, he chooses to invest $100,000 from his SMSF cash account in ANZ shares.

By investing with Westpac SFIs:

  • Peter, as Trustee of the SMSF, is able to increase exposure to ANZ shares and any dividends paid on those shares.
  • Dividends and attached franking credits (grossed up dividend) form part of assessable income of the SMSF.
  • The franking credits can offset the tax payable on the grossed-up dividends (subject to satisfying the holding period rule, which requires the shares to which the dividends relate being held for a certain period).

There is also the potential to generate excess franking credits which could be used to:

  • Offset taxable contributions; or
  • Offset tax payable on earnings from other investments within the SMSF; or
  • Obtain a refund of any excess credits after offsetting tax on other income within the fund.

Why use Westpac SFIs?

  • The investment of $100,000 creates $146,482 exposure to ANZ shares.
  • The additional exposure provided by the gearing in the Westpac SFI has the potential to generate excess returns if the ANZ share price rises.
  • Franking credits ($1,046) can be used to reduce tax payable on the forecast dividend grossed up for franking credits less the deductible interest to $0.
  • Excess franking credits ($2,149) can be used to offset tax payable on other income including contributions tax liablity.
  • As the annual interest cost ($2,641) is lower than the forecast dividend yield ($7,454), the investment can be self-funding.

^ Individuals earning more than $300,000 will have an additional 15% tax on deductible superannuation contributions.

The table below provides a summary of the outcomes

Year 1                      Buy ANZ SFIs
(ANZSWG1)
Invest amount $100,00
SFI Price (2) $20.39 (2)
Number of SFIs 4,904
Share exposure (based on share price of $29.87) $146,482
Historical dividend income p.a. (3) $7,454 (4)
Historical franking credits p.a. (3) $3,195 (4)
Forecast taxable income p.a.  $10,649
Potential interest deductions p.a. (5) $3,678
Tax payable at SMSF tax rate of 15% nil
Excess franking credits $2,149
Future earnings in the fund or taxable contributions that can be offset by excess franking credits $14,327

Important information

This example is for illustrative purposes only and uses rates and figures that we have selected to demonstrate how the product works. It cannot be relied upon as any indication of the outcomes of the investment. While every effort has been taken to ensure that the assumptions on which this case study is based are reasonable, any projection may be affected by incorrect assumptions or by known or unknown risks and uncertainties. The results ultimately achieved may differ from those shown. A number of these assumptions also rely on historical analysis. Past performance is not indicative of future performance, and the outcomes may be materially different from those reflected in the assumptions. The following assumptions also apply:

1. Prices sourced from IRESS and Westpac SFI Indicative Pricing Sheet dated 13 August 2013. ANZSWG was geared at 35% and expires on 30 June 2016.
This example does not contemplate changes in market value of the securities.
2. The first instalment includes prepaid interest for year 1 and the cost of protection for the life of the loan.
3. Calculated using historical dividends per share of $0.79 (ex date 8/11/2012) and $0.73 (ex date 9/5/2013) and based on the current company tax rate of 30%. Past performance is not a reliable indicator of future performance.
4. Dividends are used to pay down the second instalment so whilst they form part of assessable income, they are not received by the investor. Franking credits form part of assessable income. The entitlement to franking credits is subject to the holding period rule.
5. Initial Interest Rate applicable on the Loan Amount for the SFI is 5.17% p.a. – this is current as at 13 August 2013, but is subject to change. The RBA indicator lending rate for standard variable housing loans plus 1% (currently, 6.20% for July 2013, adding 1% equals 7.20%) has been used to determine if the projected interest is deductible.
* The SMSF has absolute beneficial ownership of the securities and there is no bare trust; there are no corporate actions during the holding period of the SFI by the SMSF; any contribution by Peter including for the second instalment or maturity payment could count towards the contributions cap. Adviser Service Fees and transactions costs are assumed to be nil in the above example.

With Westpac SFIs you can:

  • Build a portfolio of shares and ETF exposure for less initial outlay.
  • Use a conservative gearing strategy to accelerate your returns without margin calls or the need for a credit assessment.
  • Enjoy the benefits of direct share ownership** including the potential for capital growth, dividends and franking credits.
  • Access a low maintenance investment. There are no annual payments to make as interest (offset by any dividends) is added to the loan amount each year.
  • Buy and sell SFIs on the ASX.

But you can’t ignore the risks

  • If the price of the underlying security falls, the price of the SFI will generally fall. Gearing can magnify losses as well as gains.
  • The interest that Westpac capitalises to the loan may be higher than the dividends received from the underlying securities, causing the loan amount to increase.
  • Any rise in interest rates will increase the amount added to the loan as interest.
  • Tax legislation may change and affect any tax benefits or obligations.
  • These are not all the benefits and risks of investing in Westpac SFIs. Please see the Product Disclosure Statement (PDS) for more information.

** Based on the ATO’s current view that even though the underlying securities are held by the Security Trustee on trust for the investor, the investor is to be treated as holding the securities for CGT purposes.

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