Nathan's View: The long and Shorten of franking credits

Earlier this year, Bill Shorten said the Australian Labor Party would end dividend franking refunds for individuals on tax rates lower than 30% if Labor won the next election. This would reverse the policy introduced by the Howard/Costello government in the lead up to the 2000 election and restore Paul Keating’s original franking imputation system launched in 1987.   

Recently in an article in the Australian Financial Review titled Why franking credit refunds have to go, Shadow Treasurer Chris Bowen tried to debunk numerous arguments in favour of keeping the current system.

For example, he responded to claims that eliminating franking refunds would hurt some of Australia’s lowest income earners; ‘Those retired Australians with the lowest wealth and income receive either a full or part pension. Every one of these 2.5 million Australians is exempted from the change.

Distributional analysis has shown that for people of retirement age more than 80 per cent of the benefit of imputation refundability goes to the wealthiest 20 per cent of households. Analysis from the PBO shows that for self-managed super funds, more than half of all cash refunds accrue to people with balances over $2.4 million.

To use taxable income figures, as these people do, is just fundamentally dishonest: our highly concessional treatment of superannuation means people can be of significant wealth and still have no or little taxable income.’

Whether you agree with Bowen’s views or not, the article is worth reading as it clears up some misunderstandings that I’ve recently been hearing from investors. For example, some people think that corporate profits would be taxed twice under the new policy.

This is incorrect. If Woolworths, for example, pays 30% tax on its profits, and then an investor gets a full refund for that tax paid by Woolworths in the form of franking credits, then effectively no one has paid tax. Note nothing is expected to change for investors on 30% tax rates or higher.

Like Keating, today’s Labor party wants to ensure that corporate profits are taxed once at the requisite corporate tax rate. There are many beneficiaries, though, such as charities, that won’t be affected by the change. I expect more criticism as it becomes clearer which Labor-associated institutions will be exempt from the policy, but that’s a discussion for another day.

How will you be affected?

Assuming Labor wins the election, and the policy is enacted without being watered down, it’s expected to take effect in June 2020. That’s nearly two years away, so high-dividend paying stocks will keep their allure at least until then. You’d also expect some big dividends from companies with large banks of franking credits in the interim.

Be careful, though. Some companies, like The Reject Shop, have large banks of franking credits but are facing serious operational and financial issues.

There wouldn’t likely be any change to your distributions from InvestSMART or any other fund manager. The only difference is that you wouldn’t be entitled to a franking refund, which you’d show in your tax return.

Many expect that eliminating franking refunds will have a big impact on share prices, as more Australians invest abroad, for example, or start favouring A-REITs and infrastructure stocks where after-tax distribution yields become comparatively more attractive.

This is possible, but A-REITs and infrastructure stocks are already heavily owned by individuals, and their current valuations make them vulnerable to recessions or higher interest rates (see my discussion of interest rates in How will you deal with zero interest rates).

I’m not expecting much change as franking credits are only one part of the investment equation. As Portfolio Manager of our Australian Equity Income Portfolio and active ETF, ASX:INIF, my strategy is to continue the time-tested strategy of building a portfolio of high-quality businesses paying increasing dividends as their earnings grow, with or without franking credits.

Over time we expect to outperform the market by 2% annually, which makes up for any loss of franking credits assuming you earn the same as the market. Keep in mind that the returns of most investors fall well below the market, as they buy and sell at the worst possible time i.e. they sell in fear when the market is falling, and don't get back in until markets have recovered and stocks are no longer undervalued. 

Low interest rates have also eradicated better investment alternatives. Investments related to interest rates currently offer dismal returns, and few investors want to invest their money abroad in unfamiliar markets and companies. As long as the Australian stock market is offering a 4-5% dividend yield before franking, your dividend yield is nearly double the 2.8% you’ve historically received in the US, for example.

The US market is also around the most expensive it’s been in history, and emerging markets are too volatile for typical retiree portfolios. It would be interesting to see if any companies drastically reduce their dividends and reinvest more to grow their businesses, though.

I doubt any company with a large shareholder base expecting large dividends would be so brave, but this could produce higher company values for businesses that can invest more at high rates of return. But if such opportunities exist, wouldn’t they be pursuing them already?

Nextgen investors

Lastly, Labor also plans to halve the long-term capital gains discount from 50% to 25%.

In Bowen’s article he lamented that ‘The current system encourages people to be overweight Aussie shares, meaning they have not adequately spread their risk and may suffer significantly in a downturn because of this overweighting.’

In contrast, I’m more concerned about the shrinking pool of investors. Less Australians are investing in shares since the GFC, which compounds the growing financial divide made worse by high property prices.

If you don’t own growth assets, such as stocks or property, then over time you’ll get left behind financially. We must encourage the next generation of long-term investors, particularly when low interest rates dramatically increase the savings threshold for a comfortable retirement.

Maybe it’s just self-interest talking, but decreasing the long term capital gains discount only reinforces the sort of short-term thinking that already dominates our markets. Sometimes the signal you’re sending to the public is more important than the figures.

For more analysis on the propsed change to franking refunds, see below the articles:

• Soothing the franking credits sting
• Franking credits, the banks and AMP
• The franking error must be fixed

UPCOMING RELATED EVENTS

Live webinar with Nathan Bell: Opportunities for Income & Growth

Wednesday, 21 November, at 10:30am 

Join InvestSMART Portfolio Manager Nathan Bell as he provides some case studies and current examples of the types of stocks and special situations that he's looking to drive the performance of the Growth and Income portfolios irrespective of the macro economic environment, plus have your questions answered.

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Live Adviser Q&A webinar: The super franking question

Thursday, 22 November 2018, at 12 noon.

Join licensed financial advisers Bruce Brammall and Max Newnham, with editor Tony Kaye, as they discuss the ALP’s proposed change to franking credit refunds.

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