PM playing with fire on super tax
Those arguing against changing the tax rules on super have been endlessly talking about tax effective schemes such as family trusts and negatively geared property investments.
But filling superannuation funds with stocks with high-yielding, fully franked dividends is a very effective way to ensure earnings will be minimally taxed.
Franking was introduced in the 1990s to avoid shareholders being double taxed. If the companies in which they hold shares have paid corporate tax then the dividends would not be taxed as income in the hands of shareholders.
Under the current super rules, the earnings from any investments inside a fund are taxed at 15 per cent while the fund is in its accumulation phase.
Investing in companies with franked dividends has been a handy way to lower income tax to less than 15 per cent. (Given most balanced super funds have a third or more in listed companies that pay franked dividends, the average tax rate gets watered down to about 10 per cent.)
If the government increases the tax rate to 30 per cent for all earnings inside the super fund (for people with balances over a certain amount), superannuants will be looking for more tax effective investments to reduce this rate.
This would lead to a focus on fully franked dividends and away from the lower yielding stocks that don't pay fully franked dividends - particularly resource stocks.
There are a few stalwarts in this regard that stand out. The first is Telstra. It has been particularly popular over the past few years because it has effectively guaranteed its dividend - which removed the risk that it would fall if the earnings hit a glitch. Its dividends are fully franked.
Australian banks are also standout providers of fully franked dividends with reliable earnings. They too have become favourites with investors looking for tax- effective yields. Some property trust and infrastructure investments also fall into this category.
Even without the threat of changes to the super tax, investors have been engaged in a love affair with high-yielding shares - and in Australia those companies with franked dividends are particularly popular.
The increased interest in these companies will have the inevitable effect of pushing up their share price - which could put them into territory of being overvalued.
Morgan Stanley strategy guru Gerard Minack reckons relative valuation on stocks with above-average dividend yield already looks a bit rich on some measures. But he notes that the factors pushing investors into equity yield seem likely to persist for the foreseeable future.
Minack says one of the reasons is that ageing baby boomers, who control a disproportionate share of invested capital, are moving from the stage of building their nest egg to living off the nest egg.
The trouble with investors getting set for a new super tax regimen is that no one really knows how the government will change the rules.
Gillard may increase the tax paid on money as it goes into the super fund for people earning income over a certain but unspecified amount. Under this scenario there will be some move to keep super contributions to a minimum and instead use other more tax-effective means such as family trusts.
Higher-earning individuals have been particularly clever at ways other than superannuation to reduce tax.
Negative gearing is another popular way to reduce an investor's tax bill and will attract more investment interest.
From a political perspective, tinkering with superannuation has major risks. From a practical perspective, any additional tax on super earnings has to be retrospective or it won't add enough to government coffers.
Frequently Asked Questions about this Article…
Franking credits were introduced in the 1990s to prevent double taxation of company profits. When a company pays tax on its earnings and then distributes fully franked dividends, shareholders (including super funds) receive a credit for the tax already paid. That can reduce the effective tax on earnings held inside superannuation funds, lowering the fund’s overall tax rate below the statutory 15% in the accumulation phase.
Fully franked dividends carry tax credits for corporate tax already paid, so when super funds receive those dividends the tax payable on that income is reduced. The article notes that because many balanced super funds hold a substantial amount in companies that pay fully franked dividends, their average tax rate can be watered down from 15% to roughly 10%.
The article suggests funds and investors would look for more tax-effective investments to offset the higher rate, leading to greater demand for fully franked, high-yield shares. That shift could reduce interest in lower-yielding, unfranked stocks (for example some resource stocks) and increase allocations to dividend-paying sectors like banks, Telstra and certain property or infrastructure trusts.
The article highlights Telstra as a standout, noting its historically reliable and fully franked dividend, and points to Australian banks as another major source of fully franked, reliable dividends. It also mentions some property trusts and infrastructure investments can provide tax-effective, dividend-style yields.
Yes. Increased interest from super funds and retirees chasing after tax-effective yields would likely push up share prices for high-dividend companies. Morgan Stanley strategist Gerard Minack is quoted as saying valuations on above-average dividend-yielding stocks already look a bit rich on some measures, and a bigger shift into these stocks could raise overvaluation risks.
The article suggests higher-earning individuals could reduce salary-directed contributions to super and instead use other tax-effective structures such as family trusts. It also notes people have historically used methods outside super, like family trusts or negative gearing, to manage tax liabilities.
Negative gearing is mentioned as another popular way investors reduce their taxable income by offsetting investment losses against other income. If super rules become less attractive, the article suggests negative gearing and other non-super tax-effective investments may attract more interest from investors seeking lower tax bills.
Politically, tinkering with superannuation carries significant risks because it affects many voters. Practically, the article argues any additional tax on existing super earnings may need to be retrospective to raise meaningful revenue; otherwise changes that only apply prospectively won’t add much to government coffers.
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