Under Australia’s system of dividend imputation, shareholders receive franking credits to account for tax paid at the corporate level, which in most cases is 30 per cent. Credits can be used to offset tax owed by the shareholder.For people who pay little or no tax (such as superannuation funds and retirees), excess franking credits are paid out as cash refunds. Labor will end those refunds, except for people covered by its “pensioner guarantee”. The guarantee means anybody receiving a Centrelink age pension will still be eligible for refunds. A limited exclusion for SMSFs applies only if one member was receiving a part or full pension before March 28, 2018.
Wealthier shareholders will be less affected because they tend to have tax liabilities and can therefore fully use imputation credits. People with more than $1.6 million in superannuation will have moved any excess into their accumulation account, where it is taxed at 15 per cent. They will be able to use their tax credits to offset this liability. But for those who pay no tax, the credits will go to waste.
While investors with larger balances (paying tax) won’t be hit, Hamilton Wealth Management managing partner Will Hamilton says the changes will leave investors with smaller balances (paying no tax) in the lurch. As the table shows, those paying higher levels of tax won’t be worse off under the proposed change but those on zero or 15 per cent tax will be worse off because they will no longer receive a tax refund.
“We’ve had new clients that have come to see us and it’s a big discussion,” Hamilton says. “The sophisticated investor can prepare for this. Some people have a lot of money and have still struggled with this conversation. It’s the impact on smaller balances where I do feel the shadow treasurer doesn’t quite realise what he’s done.”
Mason Stevens portfolio manager Alwyn Hung says those with taxable income are better protected from the proposed changes while lower-rate taxpayers would be hit hardest.
“The community of net losers if the Labor party were to win office and implement this change would be, for the most part, those that have tax liabilities less than the value of the franking credits. Broadly speaking, these are not-for-profit organisations, self-funded retirees, self-managed super funds (SMSFs) and income earners earning less than $18,200 and exempt from tax.”
The Australian equity market returns far more to shareholders through dividend distribution than other global marketsand the complacency of local investors has meant they are often unaware of other investment options.
“The one positive will be that there will be some discipline towards asset allocation,” Hamilton says. “I don’t agree with people having 100 per cent cash and Australian equities.
“There’s a familiarity that sometimes does breed contempt. They’re using the system and supplementing their income by investing long in Australia equities. [But] people have made plans based on the laws that have existed and these people do things themselves. If they look to diversify, there’s going to be another cost from that.”
Hamilton says many smaller investors have expressed concerns about trying to readjust their portfolios, particularly those unable to pay for professional advice.
“They’re really worried. Suddenly that tap [of refunded franking credits] is going to be turned off and it’s really sad. They can’t go and [reallocate assets] to the same extent.”
Despite concerns the changes will force investors away from assets they know and understand, advisers believe there could be some unintended positive consequences.
Where to invest instead
The implementation of Labor’s franking policy would be just the latest hurdle for dividend-chasing investors.The blue-chip dividend stars of yesteryear have disappointed in the last few monthsand while the big iron ore miners have paid generous dividends in the past few months, they areheavily exposed to the fluctuations of the commodity cycle.
“What people have to do is change the focus. Stop looking at the yield and start looking at the total returns,” Hamilton says. “Look at growth companies, international equities or, if their risk appetite is correct, some alternate debts products.”
Sentinel Wealth financial planner Jon James believes investors need to have a strong objective and find the right portfolio to match that objective.
“It really does come back to your asset allocation and having a strategy,” he says. “One of the concerns we have is people abandoning their investment strategy because they’ll introduce some additional risk into their portfolio.”
Advisors say bond proxy stocks, such as infrastructure and real estate investment trusts (REITs), are a good option for investors looking for regular income and are already well understood by equity investors.
REITS and infrastructure stocks are closely linked to the bond market due to their high levels of debts, with investment spurred by lower interest rates.
They can offer predictable returns, with revenue streams similar to bonds. Due to the defensive nature of infrastructure stocks, they can typically offer a greater level of certainty for investors than other sectors.
“Some of the infrastructure stocks on the ASX and the real estate investment trusts are certainly options clients might look at,” Sentinel Wealth’s James says.
Providence’s Patterson says both sectors are likely to provide good income. “[Infrastructure] has its own dynamics but it traditionally pays a reasonable income because it’s very highly geared. The real estate investment trust sector might also attract more interest because of the distribution yield.”
According to data from Factset, the dividend yield of the S&P/ASX 200 is about 4.6 per cent and 6.1 per cent after franking, making it relatively attractive compared with real estate investment trusts at 5.5 per cent with no franking and utility stocks at 5.1 per cent with no franking.
Were franking credits to be removed, stocks like Transurban, Sydney Airport, Spark Infrastructure and Atlas Arteria would look significantly more attractive from an income perspective relative to the S&P/ASX 200.
Corporate bonds could also provide a reasonable level of income to investors, although advisers are cautious on the risks surrounding them.
“People might look at corporate debt instruments,” says Sentinel’s James. “However when people move into the corporate bond world, the overall risk is a concern.”
Corporate regulator the Australian Securities and Investments Commission says it is vital investors know the risks associated with corporate bonds.
“The main risk with corporate bonds is that you may not receive interest payments or get your money back if the company issuing the bonds goes out of business,” it highlights.
ASIC recommends assessing the business environment the company operates in, including looking which country it is in, what the outlook for the industry is and the strength of management.
Providence’s Patterson agrees, saying that while debt markets can diversify a portfolio, investors need to be aware of the elevated risks.
“The potential positive in returning the franking is Australian shares become less attractive at the margin and portfolios might become more diversified,” he says. “It may mean investors focus more on corporate bonds but they need to understand the risk of credit markets. As we saw in the global financial crisis, credit markets basically imploded.”
Hybrid securities are another asset class often used by not-for-profit organisations, SMSFs and self-funded retirees as a proxy for fixed income, with the added benefits of franking.
Hybrids are also set to be impacted under franking changes, with the dividends being paid out from them subject to the same rules as equity investments. Mason Stevens’ Hung says: “The proposed tax changes may mean they need to rethink this strategy.”
A note from Bell Potter analysts Damien Williamson and Barry Ziegler in early February suggested investors in hybrid securities could shift some of their investments to an income trust to avoid losing their tax refund.
“In quantifying the impact on an SMSF with a $600,000 investment in Westpac Capital Notes 5 generating $22,050 cash and $9,450 in franking credits, the SMSF would lose a surplus franking cash rebate of $4,725 under the ALP policy,” they said. “To maintain the same level of after-tax income, this investor may reallocate half their Westpac Capital Notes 5 holding into an investment such as NB Global Corporate Income Trust.”
They added the move by investors away from the capital structure of banks to offshore investments would likely increase bank funding costs and limit government revenue. “This investment strategy also brings into question the quantum of revenue this policy will generate,” the Bell Potter analysts add.
Buying overseas shares, where the total returns and prospect of share buybacks are greater, could also be another option for investors searching for income.
Hamilton says overseas markets are becoming better understood by investors. “If you spoke to people 15 years ago about international equities, they weren’t as popular.”
Most advisors agree that international equities should form a part of any diversified portfolio but say the income stream isn’t as simple.
“[International equities] have got to be part of your overall investment strategy,” says Sentinel’s James. “You shouldn’t just be going overseas to search for dividend yield. So by going to the US market, you’re not necessarily going to get a very high yield but they generally have higher capital growth. You’re also exposed to currency movements.”
Providence’s Grant is more sceptical. “Investors are unlikely to go to international equities because it won’t provide enough income,” he says. “Overseas companies’ excess capital is used to buy back shares rather than dividends. I don’t see it as a replacement for people requiring income.”
Additional reporting by Joanna Mather.