Scott Kelly, Portfolio Manager for the DNR Capital Australian Equities Income Strategy, provided his insights on the latest franking reforms and what this means for income seeking investors.


Well, in February of this year, the Labor government introduced a Treasury Laws Amendment Bill, which is targeting changes to Australia’s franking system. Then in March, the Senate referred this bill to the Economics Legislation Committee for their inquiry and report. And then in June, the committee recommended that schedules one to four of the bill be passed unamended. However, schedule five, which is the proposal to target franked distributions funded by capital raisings, well, that this needed to be clarified.

The bill proposes two key changes, which were estimated to save the budget $600 million over the next four years. The first change relates to the tax treatment of off-market share buybacks, and it’s estimated that this proposal will raise the majority of the 600 million savings. Legislation effectively aligns the tax treatment of off-market share buybacks with on-market share buybacks. And there’s been very little industry pushback to the proposed reform and it’s likely to proceed in its current form.

The second proposed change is more problematic, and it is the schedule five that the Economics Legislation Committee suggested that clarification was required. And it basically relates to franked dividends being funded by capital raisings. And the history here is that in the past, a few large companies raised capital from shareholders through fully underwritten capital raisings, and then paid out all that money raised as a franked dividend. And Labor basically wants to clamp down on this. So Labor’s proposal states that a company will not be able to pay out franked dividends that are directly or indirectly funded by capital raising. And whilst at face value that may not seem unreasonable, a number of concerns about unintended consequences have been noted by industry.

The first problem is that the proposed test to determine whether companies can pay out fully franked dividends observes an established practice of paying dividends over time, and this potentially puts startups at a disadvantage given they tend not to pay out dividends in the first few years of operations. Secondly, the proposal appears to capture a dividend reinvestment plan, which is also a form of capital raising, and this potentially could result in shareholders losing franking credits over time. And finally, companies will still be able to fund dividends by taking on debt. This potentially puts small companies at a disadvantage given their limited access to capital markets relative to larger companies.

But importantly, the Senate inquiry has recommended that government clarify this schedule, ensure it targets the intended behavior, and address the industry feedback that’s been provided to the committee. And Assistant Treasurer Stephen Jones has said that the government will consider the committee’s recommendation to clarify the capital raising measure.

Well, overall, we continue to believe the transparency from the Labor government has been very poor, and I think there are legitimate concerns that the proposed changes could just be the beginning of broader changes under Labor. Labor believes its proposal simply close loopholes, and they’re pledged that the franking credit system is here to stay. So if you take Labor at their word, low tax paying investors will still be able to benefit from the franking regime, which will continue to enhance after-tax returns through fully franked dividends and special dividends.

Well, certainly the proposed changes reduce the effectiveness of Australia’s franking regime. In our view, those who will be most affected by the changes are self-funded retirees and retail investors, those investors with low and marginal tax rates. For companies, under the new proposals, there’s the increased risk that franking credits will become permanently trapped within the companies. And there are also broader implications for the economy upon which Australia’s franking regime has supported investment and growth over time. We expect that franking rich companies will review and possibly increase dividend payout ratios and potentially also look to pay out 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. And we still expect that there will be plenty of opportunities for investors to target companies delivering sustainable, growing tax effective income over time.



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