Until a few months ago, the tax on dividends, which creates franking or imputation credits, was not on some investors’ radars. It possibly still isn’t.
But those relying on franking credits to supplement their income in retirement were definitely jolted into paying attention after the Labor Party announced it planned to overhaul current tax breaks.
The ALP’s plan to abolish cash refunds on excess imputation credits, announced in March, has created great consternation among many older Australians.
Dividend imputation was introduced some 30 years ago, to avoid the double taxation of company income. Because most Australian companies are taxed at 30 per cent, when a fully franked dividend is paid it comes with a tax credit attached for the 30 per cent of tax already paid by the company.
Some companies pay a partly franked dividend, in which case the credit is for less than the full tax liability.
Currently, if you are in Age Pension mode who owns shares, and are not paying on your income, franking credits are returned to you as a cash rebate. The ALP had planned to abolish them for good, but has now stated it would create a Pensioner Guarantee if elected to exempt people fully or partly on the Age Pension from its proposal..
This will do little if anything for close to one million Australians who are members of self-managed superannuation funds (SMSF) and other self-funded retirees who fall outside the Age Pension safety net.
That means many people who had created a retirement strategy around stocks paying out fully franked dividends, whose share prices had effectively been inflated as a result of investor demand for their tax credits, could be looking further afield if the ALP is elected.
A new research report by Macquarie Wealth Management points to a likely major shift in Australian equity asset allocations by retirees and others should the ALP’s contentious policy be passed in the future.
Despite the ALP’s recent backflip on who its franking credits crackdown would apply to, Macquarie notes that those in the firing line, including retired SMSF trustees receiving dividend tax credits, will likely shift capital into higher-yielding stocks paying unfranked dividends.
A Treasury review of the proposal earlier this year, found that the expected $10.7 billion in additional tax revenue the ALP had calculated it would receive from the policy over the forward estimates would not eventuate because many retirees will likely move into other assets paying better returns, including foreign stocks.
Investors who buy those retirees’ stocks will be able to use the associated franking credits to reduce their own tax liability, thus Treasury would still be forgoing tax revenue.
In an update based on franking credits data to the end of December last year, Macquarie says that another outcome of the ALP’s plan could be an acceleration of capital management initiatives by companies with large franking account balances, including special dividend pay-outs.
But the investment bank has added that given the relatively small proportion of investors overall who would be impacted, it was unlikely companies would be incentivised to alter their dividend policies.
Australia’s second-largest company, BHP, holds more than $14 billion in franking credits, followed by Rio Tinto ($4.7 billion), Woodside ($2.6 billion), Woolworths ($2.6 billion), and Commonwealth Bank ($1.1 billion). Westpac also holds around $1.1 billion in franking credits, followed by Caltex with $868 million.
The response, therefore, is more likely to be on the investor side, potentially with a rotation out of stocks paying 100 per cent franked dividends (where there would no longer be cash refunds available) into high-quality companies paying attractive yields.
Macquarie’s research suggests there could be a rotation into companies currently paying unfranked yields of between four per cent and seven per cent, from those currently paying higher grossed-up fully franked dividends.
On an unfranked basis, the yields from these companies are compatible with those of companies paying unfranked returns.
For older Australians, it’s a case of staying tuned for now rather than taking any direct action one way or another.
Tony Kaye is the editor of Eureka Report, which is owned by financial services group InvestSMART.