Investment Implications of franking credit changes.
The proposed changes announced by the Federal Opposition to the way franking credits operate will have significant implications for some investors; but will have little to no impact for the majority of investors.
Under the existing framework, franking credits exist to ensure that the dividends paid by companies to shareholders are effectively taxed at the marginal rate of the shareholder. As such, credits are passed through to the shareholder for the company tax already paid prior to the distribution of a dividend. For example, let's say a company makes a gross (before tax) profit of $100 per share and seeks to fully pay out that profit to shareholders in the form of a dividend. Once company tax of 30% is paid, then $70 is available for dividend distribution. For a shareholder on a 47% tax rate, the franking credit attached to the dividend means that only an additional $17 in tax is payable on the distribution - as $30 in company tax has already been paid. In this way, the government receives $47 in total tax from the $100 profit made by the company i.e. the marginal tax rate of the shareholder determines the effective rate at which the $100 company profit is taxed. In the case where the marginal tax rate is 0% (which may be the case for superannuation funds when the investor is in retirement phase), then no tax is effectively payable on the $100 profit made by the company. Therefore the $30 in company tax that has been applied is refunded in "cash" to the shareholder on the 0% tax rate.
Under the Opposition's proposed changes, the franking credit system will remain. However, cash refunds will generally not be payable. Shareholders will still be able to use franking credits to offset other tax that may be payable within the same tax paying entity (e.g. other income tax or superannuation contribution taxes); but the practice of issuing cash refunds will cease. Some exceptions to the cessation of refunds have been foreshadowed by the Opposition, with those on government pensions and charities expected to be exempt from the changes.
How likely are changes?
Although the proposed changes appear to be a central element of the Opposition's policy, investors should not assume that the changes are guaranteed. In addition to securing a Lower House majority in the forthcoming Federal election, the ALP will need to have the relevant legislative changes approved by the Upper House (Senate) in order for the franking regime to be altered as planned. If there is no ALP majority in the Upper House, then some of the detail of the changes may need to be negotiated. For example, proposals for a monetary cap on franking credit refunds, rather than their outright removal, are already being floated by industry participants.
Will share prices react to the changes?
In line with the changes being proposed, there may be less demand for shares that have franking credits attached to their dividends and more demand for investments without franking credits. Theoretically, therefore, the market price of shares could be impacted by this change in demand. However, because the change impact on a relatively small proportion of shareholders, then changes in the relative price of shares are expected to be marginal. In addition, as the proposed changes have already been announced by the political party widely anticipated to form government at the next election, then at least some of any price response would already be expected to have taken place. For example, there was some evidence of an adjustment in the price of bank hybrid securities when the changes were first disclosed.
It should also be noted that a large proportion of shareholders in the Australian market place already do not qualify to benefit from franking credits. Most notably, overseas residents, who represent a substantial proportion of the share registry of many listed Australian companies, generally don't benefit from franking credits. Therefore, the price of Australian shares is already reflective of a demand from buyers mixed between those who can and can't use franking credits to reduce tax payable. As such, the proposed changes should be seen as marginally altering demand dynamics, rather than fundamentally changing them.
Potential investment strategy responses
For investors currently benefiting from the receipt of franking credit cash refunds, the proposed changes may warrant a significant response. Firstly, structural changes to the way in which investments are held could be considered. There may be advantages in investment structures that "co-mingle" investors with different marginal rates of taxation. This is because investment structures that pay some tax may be able to continue to benefit fully from the franking regime as their tax expenses are high enough not to rely on cash refunds to gain the implicit franking value. Pooled superannuation vehicles, or self-managed super funds with a combination of tax paying and non-tax paying members, are two examples of structures that may have more investment merit post the changes to the franking system. In addition, for some investors, consideration could be given to retaining some investments in the accumulation phase of retirement structures, rather than shifting all investments to "pension" phase.
Outside of any structural change, should investors find that they are no longer able to benefit from franking credits, then it may be appropriate to alter the approach to investment selection. Fundamental to the consideration of different investment options is the fact that the market price of shares with franking credits should take into account that a large proportion of buyers do benefit from the franking credits. That is, two shares with equal risk and return prospects will have different market prices if they have different rates of franking. For example, if company A pays tax and has franking credits and company B is a non-tax payer with no franking credits, then the share price of company A will be higher than company B all else being equal. As a result, the future or expected rate of return from company A will be lower (as the price is higher relative to underlying earnings) unless the shareholder can benefit from franking credits. Another way of describing this effect is that the market price adjusts so that the post-tax / post franking returns between the two companies is the same. This is because the majority of the market is able to add the franking benefit to the return they receive from company A. This will be the case both pre- and post the changes currently being proposed by the Opposition.
In the above example, therefore, should a shareholder no longer be able to benefit from franking credits, the return they receive from company A will be lower than that received from company B. A logical response, therefore, would be to own more of company B and less of company A. A real world example of such a change in approach may be a switch away from bank shares (which are typically high dividend payers with full franking) towards listed property trusts and infrastructure stocks (which typically provide low or zero rates of franking). Overseas listed shares, which also don't offer franking credits, may also become more attractive on a relative basis. Changes in investment approach, such as those described, should be balanced against the need to continue to hold a diversified range of investments, which will no doubt require some ongoing exposure to higher franked shares.
Should the proposed changes be implemented, it is also likely that the industry will respond with products specifically designed for the needs of investors no longer able to receive cash refunds of franking credits. Investment funds that hold shares for a period of time and then sell prior to the ex-dividend date (and thereby potentially receive the implied franking benefit component in the sale price of the share) may be one area of product development.
Individual advice should be sought
The investment strategy responses described in this paper are just examples of considerations that may be appropriate should the proposed changes to the franking regime come into effect. There are no doubt many others that may be relevant and beneficial in certain situations. These changes can be highly complex, and their suitability will inevitably be subject to individual circumstance. As such, it is important that professional financial advice be sought when assessing options on how best to position and respond to the proposed changes.
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