Labor's plan to abolish cash refunds for excess dividend imputation credits has sparked warnings that self-managed super funds will dump local stocks in favour of overseas equities.

The average SMSF member would be 15 per cent worse off under Labor’s policy, according to SuperConcepts chief executive Natasha Fenech.

A SuperConcepts survey of 632 SMSF trustees found that 72 per cent would change their investment strategy as a result of the policy change, with nearly 62 per cent saying their share portfolio would shift away from local to overseas equities.

franking credits Labor election dividend imputation

Seven out of ten people would change their investment strategy if Labor's plan is made law

Managed funds, term deposits, fixed interest and property were also cited as potential investment alternatives to Australian shares that pay fully franked credits, according to the December survey by the SMSF service provider.

Labor is now $1.14 to win the election, which is tipped to be held in May, while the Coalition has drifted out to $5, according to Sportsbet.

Labor's franking overhaul

Opposition Treasury spokesman Chris Bowen argues the concession that allows individuals and super funds to receive a refund if their imputation credits exceed their tax liabilities will "make the tax system fairer" and save the budget up to $56 billion "over the medium term".

SMSFs are seen as a major beneficiary of this concession, which according to Labor sees 50 per cent of the benefit accruing to the top 10 per cent of SMSF balances, with some receiving cash refunds of more than $2.5 million a year.

"This change only affects a small number of shareholders who have no tax liability and use imputation credits to receive a cash refund," Labor argues.

"While those people will no longer receive a cash refund, they will not be paying additional tax."

In March, Labor responded to criticism by amending its policy to exclude some 300,000 low-income retirees, comprising full and part-time pensioners and others, as part of its so-called "Pensioner Guarantee".

However, critics such as Wilson Asset Management's Geoff Wilson have warned of a recession induced partly by the "retiree tax", claiming it is ill-timed amid the final stages of an equity bull market, and would also deny retirees crucial income while forcing them into higher-risk asset classes.

Others argue that the policy would harm tax neutrality, with some investment structures continuing to benefit from refundable franking credits, but others including SMSFs denied access.

Diversification drive

SMSF specialist adviser Liam Shorte said trustees had already started diversifying away from highly franked stocks into high yield, but unfranked shares such as Sydney Airport (ASX:SYD) and Transurban (ASX:TCL), or even growth stocks such as CSL (ASX:CSL) and Resmed (ASX:RMD).

"Whilst we also expected the Labor announcement to drive a move into more direct property, this has been put on hold as people fear the current correction may get worse. They are however looking at listed and unlisted commercial, industrial and healthcare property, but staying clear of retail where possible," he said.

"They are also looking cautiously at high yield corporate debt funds, bond ETFs [exchange-traded funds] and direct bonds."

Nevertheless, Shorte said SMSF trustees had just started "testing the waters" on their investment switch.

"With the banks now delivering 7 per cent plus yield before franking, investors are not rushing out the door, but any significant weakness in dividend payouts in the next year will be a call to action," he said.

Alternative solution

However, with speculation that Labor's planned tax changes including to franking credits, capital gains tax and negative gearing could be blocked by the Senate, Morningstar's head of equity research Peter Warnes proposed an alternative.

'There are some funds rorting the system, which is not fair. Super is not an inheritance plan and should be aimed at reducing or eliminating the need for welfare," he said.

"A fairer method of fixing this issue would be putting a ceiling on the amount of cash refunds they can receive, perhaps to around $100,000 a year, rather than Labor’s plan to offer exemptions, such as for pensioners."

Warnes said the franking credit measures would encourage SMSFs to pursue higher-risk structures offering unfranked income, such as real estate investment trusts or utilities.

"This isn’t what the government should be trying to do – these people are in retirement and should be trying to make sure the investments they hold are less risky," he said.

Ultimately the Senate will likely decide on the fate of Labor's planned tax changes. But in the meantime, Warnes suggested investors "batten down the hatches" in anticipation of expected stormier weather ahead for financial markets in 2019.

The author of this article owns shares in CSL.