Instalments within SMSF

Are you looking to create a tax shelter in your SMSF?

Instalments have special appeal for superannuation funds. As Self Managed Super Funds (SMSF) generally may not borrow to invest, the possibilities of geared exposure are limited.

Instalments are one of the few eligible forms of gearing within a Self Managed Super Fund (SMSF) as outlined by APRA and the ATO.  The enhanced income and franking credit stream generated by instalments can also be attractive for a SMSF. The additional franking credits can be used to offset tax on other income earned by the fund, and/or tax payable on contributions made to the fund.

Example

You have a SMSF and are considering to invest $50,000 in CBA shares, as a way to achieve a tax shelter for further contributions that are expected during the year. However, you decide to compare the impact of substituting CBA shares for instalments on the size of the tax shelter.

CBA shares   CBA instalments  
Purchase price (1 July)* $34.50 $17.15
Loan amount - $18.50
Prepaid interest (12 months)^ - $1.03
Forecast dividend (next 12 months) $1.83 $1.83

^ SMSFs may only claim interest on an amortised basis (for tax deductibility purposes) over the period that they were holding the instalment.

* The shares and instalments are held for a full financial year.

Investing $50,000 in CBA shares would result in  a dividend income stream of $2,651.67, representing a grossed up yield of 7.6%.  Alternatively, instalments allow you to generate $5,334.45 in dividends with a grossed up yield of 15.2%.

CBA shares    CBA instalments   
No. of shares/instalments 1,449 2,915
Dividends received $2,651.67 $5,334.45
Franking credits* $1,136.43 $2,286.19
Gross dividend yield (%) 7.6% 15.2%

*100% fully franked with a company tax rate of 30%

By comparison, the instalment's net income would be $4,618.19 (gross dividend income $7,620.64 less prepaid interest $3,002.45), to the shares of $3,788.10. The tax payable on the instalment's net income would be $692.73 (15% of $4,618.19). This tax liability may be offset against the franking credits received from the instalments holding.

CBA shares    CBA instalments   
Taxable net income/loss $3,788.10 $4,618.19
Tax payable within a SMSF (15%) $568.22 $692.73
Excess franking credits $568.21 $1,593.46
Earnings and contribution tax shelter $3,788.07 $10,623.09

The instalment's excess franking credits ('unused' franking credits after off-setting the tax liability of $692.73 against the $2,286.19 available) can now be used to shelter additional income generated by, or contributions to, the fund.

This tax shelter would amount to $10,623.09 within the fund compared to $3,733.07, if you used shares. Hence, you could earn or contribute an additional $10,623.09 before the tax liability would exceed the available excess franking credits (i.e. $1,593.46).

With the lower tax rate (15%) imposed on a SMSF, this may result in excess imputation credits on fully franked dividends being available for the fund. This enables you to earn or contribute more to the SMSF, effectively building on the SMSF, before incurring additional tax payments.

Taxation and Superannuation rules are constantly under review.  You should consult your tax accountant and the warrant issuer before implementing this strategy.

Main benefits of the strategy

  • Enhance earnings and contributions shelter - offsetting tax paid on additional earning and contribution on the fund
  • Enhanced income stream
  • Leveraged returns, given a positive move in the share price

Main risks of the strategy

  • The income stream is not as forecasted, reducing the income stream and the earnings and contributions shelter
  • Dividends are not fully franked
  • The share price may fall, leading to leveraged losses

You should seek independent professional taxation advice. A general commentary on taxation treatment of warrants is also available.

Disclaimer
The information is for educational purposes only and does not constitute financial product advice. ASX does not represent or warrant that the information is complete or accurate. You should consider obtaining independent advice before making any financial decisions. To the extent permitted by law, no responsibility for any loss arising in any way (including by way of negligence) from anyone acting or refraining from acting as a result of this material is accepted by ASX.