Scott Kelly, Portfolio Manager for the DNR Capital Australian Equities Income Portfolio & Fund provides his insights on the franking reform proposed changes and the potential impacts on income-seeking investors.
So in short, the Labor government’s seeking to make changes to Australia’s franking regime. So in terms of a brief timeline, of course we will remember Bill Shorten’s ultimately floored franking policy, which failed at the 2019 election, where Anthony Albanese appeared to have learned from his predecessor. And he pledged not to change Franking credits prior to the election in May this year. However, in September, treasury, treasury drafted a policy to stop companies from paying fully franked dividends when it was being funded by a capital raising. And, that policy is still under review. And, then in October’s federal budget, the government specifically targeted the tax treatment of off market share buybacks and selective share cancellations. And draft legislation was released last week that effectively aligns the tax treatment of off-market share buybacks with on-market share buybacks.
Well, one of the distinguishing features of Australian equities is the Franking credits regime. A Franking credit is, is generated when Australian resident companies pay income tax and distribute after tax profits through dividends. And depending on their tax situation, shareholders might get a reduction in their income taxes or a tax refund as a result of receiving the Franking credit. As such, Australia has long been a market characterised by high dividend payout ratios, which is largely driven by this Franking policy. Historically, off market buybacks have been used by Australian companies to distribute Franking credits to low tax rate shareholders. The Commonwealth Bank first used this scheme in 1997 and since then around 50 billion of cash and around 17 billion of imputation tax credits have been distributed to shareholders.
Well, there were initial fears that Labor’s franking reform was going to be grandfathered as, as far back as 2016. However, importantly, these changes do not look like they’ll be applied retrospectively. Labor’s policies are, are designed to, to significantly reduce the appeal of undertaking an off market buyback or raising capital to fund the payment of dividends. And in short, this place is limits on the methods that companies have to pass Franking credits through to investors. Treasury estimates the changes will increase receipts by over half a billion over the next four years. And in our view those who will be impacted the most by these changes are self-funded retirees and retail investors. Those investors with low and marginal tax rates will be affected the most by these changes for companies under the proposed schemes there’s increased risk that Franking credits will become permanently trapped within companies. and there are of course, broader implications for the economy upon which Australia’s franking regime has supported many, many years and decades of investment and growth.
Certainly, the proposed changes reduce the effectiveness of Australia’s franking regime and transparency has been very poor today. And I think there are legitimate concerns that the proposed changes could be just the beginning of broader changes. Under Labor. Labor believes its proposal simply closes a loophole to align corporate tax treatment of our market and off market share buybacks and, and importantly, look, they’re pledging that the Franking credit system is, is here to stay. So if you take Labor at their word low tax paying investors will continue to be able to benefit from the Frankie regime which will continue to enhance after tax returns through fully frank dividends and fully franked special dividends. We expect Franking rich companies to review dividend payout ratios possibly increase them and potentially also pay special dividends more regularly. At DNR Capital, our investment strategy considers after tax income, and after tax returns as part of our investment process, and stock selection. So, we still expect there to be plenty of opportunities for investors to target companies delivering a sustainable and growing tax effective income over time.
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