Franking credits: Don't push the envelope

The Australian market is experiencing insatiable investor demand for franked dividends. If a share pays a decent yield it’s getting lapped up. In this environment there’s a danger investors might push the boundaries to get more franking credits, particularly if dividend imputation) and warned you not to get too carried away chasing it. All other things being equal, an unfranked dividend of 8% is better than a franked dividend grossed up to 8%, since you don’t have to wait for the franking credit refund to arrive.

If you’re holding shares short term, hedging your positions or doing complicated trades you also need to take care. You might not be entitled to the franking credits you expected.

To explain, let’s start with some history.

Introduction of dividend imputation (franking)

Franking was introduced in 1987 to allow shareholders a credit for tax already paid at the company level. Before that Australia had a ‘classical tax system’, which resulted in double taxation (since both company profits and dividends to shareholders were fully taxed).

At the time, Treasury anticipated a portion of franking credits would go to ‘waste’ each year – for instance, when dividends are paid to overseas shareholders. Since it’s fairly easy for companies and shareholders to avoid wasting franking credits, the Tax Act contains a number of anti-avoidance measures to ensure it occurs.

Many of these rules apply to the company paying the dividend. But there are some key measures targeting investors themselves.

The rules

Investors tend to be aware of the 45-day rule but it’s a lot more extensive than that.

The franking anti-avoidance rules relevant to investors come in a three-pronged package. Two specific rules and one general. The specific (and most commonly known) rules are:

1. Holding Period Rule. The 45-day rule is better referred to as the ‘holding period rule’ since it actually requires you to hold shares ‘at risk’ for 45 or 90 continuous days over (including) an ex-dividend date. Whether it’s 45 or 90 depends on whether they’re ordinary shares or preference shares. So don’t fall for the trap of thinking you need to hold a share for 45 days, when you really need to hold it for 90. Make sure also that you don’t include the day of purchase or sale, since they don’t count.
   
   The holding period rule is a ‘once off’ test. You just need to qualify for the first dividend, not every dividend. It also doesn’t matter whether the bulk of the days are before or after the dividend date, so long as they’re continuous.
   
   If you buy and sell multiple parcels, the holding period rule will treat the last parcel purchased as the first one sold. This is known as the LIFO rule (last in, first out).
   
   Let’s say you own 100 Telstra shares, buy 150 more just before the ex-dividend date, and then sell 100 a week later. This will be treated as a sale of 100 of the 150 purchased last, not a sale of the original 100. So you will fail the 45-day test on 100 of your shares.
   
   The ‘at risk’ part says you can’t enter into derivatives (for instance, options or CFDs) or any other arrangements, which reduce your risk of loss beyond a certain threshold. Broadly you can't hedge more than 70% of your investment, but it's a lot more complicated than that. If you’re hedging your investments, the full details are in this off-market share buybacks, the ATO accepts that you’ll get the franking credit so long as you hold the ordinary shares at risk for 45 days prior to accepting the buyback offer. This is despite the obvious focus on the franked dividend component of these offers.

   At the ‘high risk’ end of the spectrum you’ve got transactions designed to technically comply with the holding period and related payment rules, but which result in the investor double-dipping franking credits or simply getting more credits than their economic interest dictates.

   We don’t want to rain on anyone’s parade, but these transactions probably come loaded with section 177EA risk. The viability of the trades discussed in the Sydney Morning Herald article might come down to how they’re executed. Some we’ve seen discussed on public share forums simply don’t work.

   If you’ve never held an economic interest in more than 100 Telstra shares, but you’re receiving franking credits as though you held 200, then you might be relying as much on the ATO not finding out about it than it being able to withstand a section 177EA challenge in the courts.

   In between these two spectrums lies everything else. Each situation will depend on its merits but a useful rule of thumb is that the more you reduce your risk (both in time and amount), and the more blatant the risk reduction, the more chance you’ll lose your franking credits.

   For instance, if you’ve got a long-term portfolio and are in the habit of selling ASX 200 Index CFDs to hedge a small portion every time you think the market has got ahead of itself, then you’re unlikely to encounter problems. You may have effectively reduced part of your exposure to your Telstra shares but you shouldn’t lose your franking credits (so long as you’ve satisfied the holding period rule).

   But if your SMSF suddenly starts making short-term trades of Telstra shares at dividend time, or buying huge chunks of shares hedged by CFDs, then you’ve got more to worry about.

   The penalties

   The problem with falling foul of these anti-avoidance provisions is that it exposes you, firstly, to paying back the tax saved plus interest. Secondly, the Tax Office can require you to pay an additional 50% shortfall penalty.

   As these matters tend to get picked up years down the track, investors often find themselves faced with bills that are a multiple of the tax they originally saved.

   In a nutshell

   We’re not saying you shouldn’t ever take tax risk. But be aware that franking credits are in a special category of risk. 

   For most investors there’s no need to worry. But if you're aggressively chasing franking credits make sure you're being brave, not foolish.

   IMPORTANT: Intelligent Investor is published by InvestSMART Financial Services Pty Limited AFSL 226435 (Licensee). Information is general financial product advice. You should consider your own personal objectives, financial situation and needs before making any investment decision and review the Product Disclosure Statement. InvestSMART Funds Management Limited (RE) is the responsible entity of various managed investment schemes and is a related party of the Licensee. The RE may own, buy or sell the shares suggested in this article simultaneous with, or following the release of this article. Any such transaction could affect the price of the share. All indications of performance returns are historical and cannot be relied upon as an indicator for future performance.