Friday, 19 August 2016

When it comes to investing, tax is an area that most people acknowledge is important but generally find challenging to get their heads around. One topic that seems to receive a lot of media attention is franking credits. They’ve been around since the introduction of dividend imputation in 1987, but even after all this time they’re still not well understood. So what are they? In essence they’re a mechanism through which the double taxation of corporate profits can be eliminated for most Australian taxpayers. Basically in the case of an Australian resident shareholder, if an Aussie company pays tax then that shareholder doesn’t also have to pay tax the company has already paid on the income the company distributes.

More technically whenever shareholder distributions (e.g. dividends) are made, a company may have the opportunity to attach a (franking) credit. These credits allow shareholders to claim the amount of tax that has already been paid by the company, when lodging their own tax returns. Corporations have discretion around how these credits are distributed, but when passed on they generally have the benefit of reducing an investor’s tax bill in relation to the dividend received.

This has implications for investments made in a concessionally taxed environment like super. With taxes on earnings in the accumulation and income phases currently set below the corporate tax rate it’s not uncommon for investors to receive a tax credit or refund. Efforts by Central Banks to stimulate global economic growth through lower interest rates have left all investors searching for strategies to enhance the future yield and return prospects of their portfolios. Many investors have increased allocations to companies which deliver high fully franked dividends (e.g. Australian Banks) to try to improve prospects, but often there appears more focus on the marginal return implications than the associated sector and security concentration risks introduced that can dominate the return outcomes.

As a consequence, the amount of franking credits distributed by a company is widely reported and any amendments to their dividend policy are heavily scrutinised. If shareholders place undue emphasis on franking credits, it would be unreasonable to expect companies not to do the same. A climate which rewards organisations that distribute progressively greater proportions of their profits to satisfy investor preferences has the potential to jeopardise long-term decision making. When faced with the choice of how best to re-deploy profits, a dividend increase should not necessarily be the first response. Initiatives like research and development into original customer products or services; the adoption of new technology to streamline business operations and client communication; or even a retirement of existing debt to shore up the corporate balance sheet are all examples of what might be considered a prudent use of these funds. They offer a far more sustainable pathway to enhanced shareholder returns and a secure long-term corporate future.

These sentiments may possibly resonate more easily with members in the accumulation phase who are still trying to grow their wealth, but they remain just as relevant for those no longer making contributions. Sustaining a pool of financial capital to be drawn as an income over a multi-decade investment horizon will most likely require some level of exposure to long-term asset growth.

It’s important to clarify that we’re not against franking credits. On the contrary, we regard dividend imputation as critical to the equitable treatment of different income sources across the tax system.

Our only query is with the prominence it attracts in the public domain, for both investors and corporations.


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