More than the bare share essentials

The strategy of 'dividend stripping’ is understood by share market traders and investors, but the consensus is that it’s not a reliable or effective way to make a short-term profit.

But at a minimum, dividend stripping can be a tax-minimisation strategy even if the shares fail to recover at all from the expected drop on the ex-dividend date, by offsetting the capital loss against capital gains obtained from other investments.

Firstly, though, it’s worth reviewing the basic concept of dividend stripping.

In simple market terms, the price of a share will fall on the ex-dividend date by an amount equal or close to the dividend value. Conventional dividend stripping involves buying the share before the ex-dividend date, holding it for a short period, and then selling it after the ex-dividend date. The hope is that market sentiment will mean that the fall in the share price will not be as large as the dividend, or that the shares will recover in a reasonably short time, providing a quick profit.

Many investors I talk to seem to believe the chance of a share price recovering is only a 50:50 bet, and the transaction costs (for example, brokerage on the buy and sale) are going to defeat the strategy. Furthermore, any profit is likely to be small compared with the exposure, given that half-year dividend yields might be around 2% to 3%.

Fully franked, please

Dividend stripping is enhanced if the dividend comes with imputation (franking) credits, as these can be used to provide a benefit at tax time. In particular, for self-managed superannuation funds (SMSFs), the tax payable on the dividend (at a tax rate of 15%) is less than the franking tax offset, leading to a likely tax refund if the shares are highly or fully franked.

For transactions outside of an SMSF, the tax will be calculated at the individual’s marginal tax rate. For tax rates 31.5% and higher, the franking credits (derived from company tax paid at a rate of 30%) don’t provide enough benefit to avoid tax being paid on the dividend.

In order to claim franking credits provided with a share dividend, ordinary shares need to be held for a period of 45 days or more (not including the day of acquisition or disposal). This 'holding-period rule’ or '45-day rule’ applies to individuals who wish to claim more than $5000 in franking credits.

It’s not all lost

The concepts discussed above are where the general understanding of dividend stripping ends. It’s widely believed that if the share price fails to recover close to or above the pre-dividend level, then the strategy is not profitable.

However, in these booming times on the share market, many investors have already realised capital gains and are facing income tax bills due to these gains (CGT). In response to larger CGT liabilities, investors may turn to various tax-minimisation strategies, such as managed investment schemes, pre-paying interest on investment loans, or 'tax-loss selling’ (selling shares that are trading lower than their purchase price, to crystallise the loss).

At best it's a win-win situation because if dividend stripping works directly – and the shares do recover and provide a quick profit – then an investor will have to be content with paying a tax bill on these gains as well! If, on the other hand, the shares don’t recover and the sale realises a capital loss, then this loss can be offset against realised gains from other investments to reduce an individual’s overall tax liability, and consequently provide an improved net position.

A worked example

The Commonwealth Bank (CBA) paid a fully franked dividend of $1.30 on 5 October 2006, that went ex-dividend on 14 August 2006. On the ex-dividend date, the share price dropped from $45.75 to $44.57 (closing prices), a drop of $1.18 (91% of the dividend). Note that the dividend yield (this dividend alone) was just 2.84% fully franked.

General dividend stripping analysis, including franking benefits, is shown in the left-hand side of spreadsheet 1. A share purchase of $30,000 is made to gain the 2.84% dividend yield ($30,000 is chosen since it provides the best result against the brokerage costs, where these are minimised by using an online broker without advice.

The 2.84% dividend yield provides a dividend of $852, plus franking credits worth $365. At a tax rate of 31.5%, and after accounting for the franking tax offset and brokerage, the conventional strategy results in a $6 loss.

Table 1 shows the result for different tax rates:

Table 1. General understanding of dividend stripping, using CBA example.

Clearly, at the higher tax rates, the conventional concept of dividend stripping is ineffective, even though the CBA share price did not fall the full amount of the dividend.

The right-hand side of the spreadsheet shows the hidden value of dividend stripping. Where there are realised capital gains from other investments (for example, the sale of shares or an investment property, or a capital gains distribution from a managed fund), the capital loss from the dividend stripping can be used to reduce total tax payable.

The cost base for the shares in the example is $30,066 (the cost of the shares plus brokerage on the purchase and sale), and the sale proceeds are $29,226, leading to a capital loss of $840.

Assuming a separate realised capital gain of $840 from other investments, the net capital gain is reduced to zero. For higher capital gains, the benefit remains the same in absolute dollar terms, so further analysis is not needed. For lower capital gains than the realised capital loss from the dividend stripping, the losses can be carried forward to offset capital gains in later years.

Spreadsheet 1. Dividend stripping analysis, using CBA example.

For capital gains that cannot be discounted (the asset was held for less than 12 months), the effect of dividend stripping is greatest. The tax payable on an $840 realised (non-discountable) capital gain at 31.5% marginal tax rate is $265, but this is reduced to zero by the capital loss from dividend stripping, leading to an improvement in net position by $259.

In other words: despite the small loss ($6) in the dividend stripping, the individual is $259 better off due to reduced tax payable following CGT calculations.

In cases where the realised capital gains are discountable for CGT (the investment asset was held for more than 12 months), the effect of dividend stripping is reduced, but still effective. Note that the CGT discount rate is 50% for individuals, and 33% for SMSFs.

Table 2 shows the result for different tax rates:

Table 2. Improvement in position after CGT reduction, using CBA example.

It can be seen that after CGT considerations, there are potential benefits across the tax rates, although the greatest benefits still occur for low marginal rates.

An interesting comparison can be made with off-market share buy-backs, where the price paid by a company consists of a large fully franked dividend and only a small capital component. Here, too, the lower tax rates and SMSFs are significantly advantaged, and such buy-backs often end up over-subscribed and sell at a discount to the share market price. Why would people choose to sell their shares at typically up to 14% discount to the price they can achieve on-market? In order to achieve franking credits and a capital loss to offset against other capital gains.

What happens if the shares drop further than the dividend?

What are the chances of a share price crashing on the ex-dividend date, leaving the strategy looking like a dud; alternatively, what happens if things go well?

Of course, it is impossible to predict the direction that the market may take on the ex-dividend date, and even more difficult to predict the movements over a period of at least 45 days. But there is still a potential benefit to be gained, even if the share price falls further than the dividend amount.

First, let’s look at the recent CBA dividend history:

Table 3. Recent CBA dividend history.
Interim dividends in black, and final dividends in blue.

If we restrict our dividend stripping to the final dividends (since these are consistently higher yield than the interim dividends), then the worst results were in 2005 and 2004, and the best result was in 2001 (in terms of the percentage fall in share price compared with the dividend on the ex-dividend date).

The 2005 result (final dividend, ex-dividend 15 August 2005) was a $1.12 dividend (100% franked, at 2.93% single dividend yield), but the share price dropped $1.43 on the ex-dividend date. If we run the numbers again at $30,000 purchased, we get the results in Table 4:

Table 4. Performance in the worst CBA final result since 2000 (2005).

This data shows that even when the market price drops further than the dividend, the strategy can still be effective against non-discountable capital gains.

In October 2001, a 75-cent dividend was paid, at 2.47% single dividend yield, but the share price dropped only 35 cents on the ex-dividend date (27 August 2001). If we run the numbers again at $30,000 purchased, we get the results in Table 5:

Table 5. Performance in the best CBA final result since 2000 (2001).

In this case, the results are useful profit across all tax rates.

Summary

By including the tangible benefit of a realised capital loss that is likely when dividend stripping, the strategy can generate profit, by reducing the tax payable on realised capital gains from other investments.

Some other points to note:

• The cost of holding the shares must be considered – this fact alone can negate the effectiveness of the strategy. If the franking credits to be claimed exceed $5000 for an individual, then the shares must be held for 45 days.
• Anyone subject to the 45-day rule, and keen to try dividend stripping, will need to opt to buy the shares some weeks in advance of the ex-dividend date, or be prepared to hold onto them for some time after. Rather than attempt to analyse which is a better option, I simply say that it’s smarter to buy on a day the market is down compared with recent weeks, which requires some planning in advance of an ex-dividend date. Fortunately, companies give advance warning of the dividend value, franking percentage, and the record date for the dividend. This information is generally enough to indicate if the dividend is worth exploiting, and a 'dividend stripper’ can start planning and looking for a buying opportunity.
• CBA is used as an example simply because it pays consistent, high-yield, fully franked dividends. Other companies may provide improved opportunities.
• All prices quoted are closing prices. Sources: www.bourseinvestor.com.au and www.tradingroom.com.au