Part A: The Proposal
The Labor Party has proposed to change part of the imputation system by disallowing cash refunds on imputation credits. It is understood that an exemption will exist for charities, Not-for-Profit organisations and pensioners. The proposed commencement date is 1 July 2019 (and only if the Labor Party win the next election and the policy passes both Houses of Parliament).
The imputation credit system under current laws allows a taxpayer to be entitled to a credit for the tax paid on dividends paid by companies to shareholders. This means a taxpayer who receives the dividends can either use those credits to reduce their tax payable or, if there is no tax payable, obtain a cash refund. This system effectively avoids the double taxation of earnings distributed by the companies (tax at the company level and again on the individual).
Why are the changes being proposed?
Up until the late 1990s, imputation credits could be used to offset other tax payable but could not result in a refund situation. In 2000, the Liberal Government changed the rules to allow taxpayers to claim a refund of any excess franking credits. This provided a significant benefit to individuals and super funds on low or zero tax rates. The crux of the Labor Party argument is that this policy is overly generous and is now costing billions each year. The whole purpose of collecting taxes is to pay for public infrastructure (roads, schools, hospitals) and welfare. Under the existing policy, the net revenue to the government in certain circumstances is nil. This is best illustrated by the below example.
In the above example, BHP pays 30 cents in the dollar company tax. BHP then pays a fully franked dividend to a SMSF where the sole member is in pension phase. The SMSF then gets the 30 cents cash back as a refund when the fund’s tax return is processed. This results in a rather curious outcome where net government revenue is effectively nil.
If the policy is changed, BHP still pays 30 cents in the dollar company tax. BHP then pays a fully franked dividend to a SMSF where the sole member (retiree) is in pension phase. The retiree will no longer get the benefit of the franking credit refund. Under this scenario the net effective revenue to the Government equals 30 cents in the dollar.
The reality is that tax issues of this nature cannot be viewed in isolation. The arguments for retaining the policy are based on issues of perceived inequity due to the convoluted system already in place. Some of these arguments are not unreasonable when viewed through that prism (e.g. public offer super funds that can utilise the full benefit of the franking credits because they have members in both accumulation and pension phase will benefit over a SMSF in pension phase). The other argument to retain the existing system revolves around the fact that welfare recipients receive substantial government assistance but self-funded retirees do not (class warfare if you like).
We do not intend to pick sides in this debate but we do believe that if implemented, the Labor Party should come up with some way to compensate those who have legitimately structured their affairs over many years to work within the existing policy parameters.
Part B: Impact on investment portfolios
The impact on investment portfolios will largely depend on your asset allocation. This is because the asset classes with the highest amount of franking credits are Australian shares (excluding real estate investment trusts) and hybrid securities. A summary of different risk profiles and possible asset allocations follows:
Over the next 10 years, we estimate the average annual return from these asset classes to be as follows:
You will note from the above table that the average income from Australian shares is expected to fall from 5.20%pa to 4.00%pa while the average income from hybrids will fall from 5.00%pa to around 3.50%pa.
Based on these potential outcomes, we estimate the potential return for different investor risk profiles to be as follows:
Quantifying the potential loss from the abolition of franking credits
Depending on your risk profile, we estimate that the average client will be between 0.36%pa to 0.63%pa worse off. Based on a $1million sum invested, this would equate to a decrement in investment earnings of between $3,600pa to $6,300pa.
Potential impact on asset allocation
It is important to remember that franking credits will continue to be useful to individuals and super funds that have marginal rates higher than zero as those franking credits can still be used to offset tax payable. Under those circumstances no strategic asset allocation changes are likely to be required. However, for those individuals or super funds in pension phase where the marginal tax rate is zero, some changes to their strategic asset allocation could be considered as follows:
We are likely to recommend a slight decrease in exposure to Australian equities. The loss of franking credits will reduce the total return expected from equities over the next 10 years from about 10.20% to 9.00% per annum. Nevertheless, the total return remains attractive as against other asset classes. Within the asset class itself we do expect an increase in demand for higher yielding shares (e.g. certain infrastructure stocks) that have little to no franking.
We are likely to recommend a slight increase in exposure to international equities. International equities have traditionally provided less attractive income returns than Australian equities. This has been compensated by higher potential growth prospects as international companies traditionally reinvest a higher proportion of profit back into their underlying businesses. We would expect international equities to benefit from increased demand from Australian investors now that the income differential has narrowed.
Australian Real Estate Investment Trusts (AREITs)
AREITs are likely to benefit from the franking credit changes. Distributions from AREITs typically contain little to no franking, enhancing their income return against other asset classes. Nevertheless, we are unlikely to recommend clients increase exposure to this asset class as we believe asset values are already relatively expensive.
This asset class is likely to be adversely impacted by the proposed abolition of franking credits. The vast majority of listed hybrid securities pay franked dividends. We are likely to recommend clients reduce their hybrid exposure.
We are likely to recommend an increase in exposure to fixed interest, particularly investment grade corporates. We believe there is a reasonable probability that investors will rotate out of hybrids and into higher yielding fixed interest securities. This is likely to create additional demand for investment and non-investment grade fixed interest. We continue to recommend some caution in high yield non-investment grade fixed interest as we believe the risks often outweigh the potential returns. Investments need to be considered on a case by case basis.
Cash and Term Deposits
We are unlikely to recommend any change in our exposure to this asset class. This continues to represent the low risk component of client portfolios. This asset class provides downside protection in falling markets, as well as the liquidity to take advantage of any market corrections.
Copyright © 2018. The information provided is not personal advice. It does not take into account the investment objectives, financial situations or needs of any particular investor and should not be relied upon as advice. While the information is provided in good faith and believed to be accurate and reliable at the date of preparation, we will not be held liable for any losses arising from reliance thereon. We recommend investors consult their personal financial adviser to discuss suitability and application to their individual circumstances. Advisors at Pitcher Partners Sydney Wealth Management are authorised representatives of Pitcher Partners Sydney Wealth Management Pty Ltd, AFS & Credit Licence number 336950.