Dividend washing dries up

The ATO has outlawed the practice allowing investors to double-dip on franking credits.

Summary: The Tax Office has moved to outlaw the practice of “dividend washing”, which has allowed some investors to effectively double-dip on franking credits paid by a small number of Australian blue-chip companies. The franking credits are unused credits on shares owned by foreign investors, who are unable to use them outside of Australia.
Key take-out: The ruling only will apply to investors who have franking credit tax offset entitlements in excess of $5,000 across their portfolio.
Key beneficiaries: General investors. Category: Shares.

Self-managed super funds and private investors will be among those targeted in the federal government’s move to stamp out so-called “dividend washing”, according to tax and market experts.

Under new rules announced last week, the Australian Taxation Office aims to make the practice of double-dipping into franking credits – which Treasury estimates costs the budget roughly $20 million a year –redundant by ensuring taxpayers won’t get the second lot. The ruling isn’t intended to affect typical ‘mum and dad’ investors and only will apply to investors who have franking credit tax offset entitlements in excess of $5,000 across their portfolio.

But what’s most concerning is that investors may have engaged in the practice without their knowledge via their brokers, says David Pring, partner in corporate tax at Deloitte.

Not to be confused with dividend stripping (the purchase of shares just before a dividend is paid, and the sale of those shares after that payment), dividend washing is where an investor sells their shares in a stock after the ex-dividend date (after holding them for the required 45 days). They then buy the same number of shares back immediately (still during the cum-dividend period, when they are entitled to receive a dividend on shares purchased) on a special market, enabling them to double the amount of franking credits they receive.

For example, an investor selling their shares at an ex-dividend price of $5 and a dividend entitlement of 20 cents buy the stock back at the cum-dividend price of $5.20. They receive two dividend payments of 20 cents each (with one cancelled out by the capital loss) and two sets of franking credits at about 8.6 cents each.

The practice can only be used on blue-chips stocks such as Telstra and the big banks because the ASX allows these stocks to trade for two days cum-dividend after the ex-dividend date. Originally, the period was intended to facilitate the distribution of dividends from short selling.

But before the new rules, brokers had been setting up a special market allowing foreign investors to sell their franking tax credits (which they are unable to use outside of Australia) to their domestic clients including institutions, SMSFs and wealthy private clients.

Simon Lindsay, head of distribution at Aurora Funds Management, says the new rules effectively bring an end to the practice. He says that while no one will make money on it any longer, they will still be able to pick up the franking credits over the two-day period if they had missed the dividend.

Pring agrees that the rules will be effective in clamping down on double-dipping, but he believes they could have adverse consequences to institutions and retail investors alike.

For one, reaching the $5,000 limit is incredibly easy for retail investors. The rule you must hold a stock for 45 days only applies to those investors with at least $5,000 in franking credit entitlements already, meaning those under the limit can buy a stock the day before its ex-dividend date to be eligible.

“The big question I have is whether private investors even know that it’s happening, or whether their advisors are simply doing it on their behalf to tweak returns,” Pring said.

Pring’s other main concern with the changes is how the ATO’s new rules apply retrospectively: investors who have engaged in the practice from July 1, 2013, will be asked to return any money made using the strategy.

The ATO would be entitled to go back to 2009 under existing legislation for more sophisticated investors, and back to 2011 for investors with simpler affairs, as they can chase tax returns in the amendment phase, Pring says.

For more on dividend franking credits, read Scott Francis' article today How franking pays off.

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