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One of the more unlikely outcomes of the recent federal election, apart from the surprise return of the Coalition government, is that many Australians who had never heard of franking credits are now aware of them.
Labor’s proposal to end cash refunds of franking credits was met with a groundswell of opposition, mostly from retirees who depend on franking credits for part of their income. Now that franking credits are back on the table, it’s likely that many more investors will be curious about how to take advantage of them.
Australian shares that offer fully franked dividends are especially popular with retirees and anyone seeking income from their investments. In the lead up to the election investors were being warned by some commentators to diversify their sources of income away from shares and investment products offering franked dividends to other sources of yield such as Australian Real Estate Investment Trusts (A-REITs).
Note: A-REITs are professionally managed trusts that invest in a portfolio of properties. Almost all income collected from rents and realised capital gains are passed through to investors in the form of distributions (often referred to as dividends). Investors are then taxed on these dividends at their marginal rate. As no tax is paid within the trust, the dividends they pay are not franked.
Now, with the election uncertainty out of the way, confidence has returned to market sectors offering dividend franking such as the banks. At the time of writing (June 3) the ASX bank index is up over 7% since the election. By comparison, the ASX200 A-REIT Index has traded sideways since the election, after rising around 14% in the four-and-a-half months leading up to the election.
The search for high-yielding investments is only likely to intensify as interest rates fall.
As expected, at its June meeting the Reserve Bank cut the cash rate by 25 basis points to a new low of 1.25% and is widely tipped to cut further this year. As a result, term deposit interest rates are headed down towards 1.5%, Australian 10-year government bond yields are at an historic low of 1.49% is at historic lows and global bond yields are at 30-year lows.
By comparison, the dividend yield on Australian shares is currently around 4.1% (5.8% when grossed up to include franking credits). Shares, unlike bonds or term deposits, also have the potential for capital growth over the long run.
Note: The dividend yield on a share is the last 12 months’ dividends divided by the current share price. The grossed-up dividend yield takes into account franking credits.
A short history of franking
For those whose grasp of franking is still a little shaky, a quick revision.
Many Australian companies pay franked dividends where tax paid at the company level is ‘imputed’ or taken into account when profits are distributed to shareholders in the form of dividends.
Under our system of dividend imputation, companies pass on a tax credit to shareholders for tax already paid at the company level. Shareholders can then use these imputation credits or franking credits to offset tax liabilities on other income, including salary.
Dividend imputation was introduced by the Hawke/Keating Government in July 1987 to end the double taxation of company profits. Before then, companies paid tax on their earnings and shareholders were taxed on the dividends paid out of profits at their marginal rate.
The system was made more generous in July 2000 when the Howard/Costello Government allowed excess franking credits to be paid as a cash refund. This meant that people who pay no tax can claim a full refund from the ATO. This system remains in place with the Coalition back in government.
How does it work?
Say an Australian company makes pre-tax earnings of $1 a share. It pays tax at the company rate of 30 per cent, or 30c a share, and returns the remaining 70c to shareholders as a fully franked dividend.
When shareholders compete their tax return, they add the 70c dividend to the 30c franking credit and declare $1 of taxable income. They then pay tax on the $1 of taxable income at their marginal rate.
If you are on the top marginal rate of 47 per cent (including Medicare levy), then tax is 45c but after the 30c tax credit you pay tax of just 17c.
Super funds pay a top income tax rate of 15%, and no tax when they pay a retirement pension. If your marginal tax rate is zero, as is the case for many retirees, you receive a 30c cash refund from the Australian Taxation Office.
If you are required to lodge an income tax return you can use it to claim a refund of excess franking credits. And if you are not required to lodge a tax return, you can apply to the ATO for your refund.
The table below shows recent net and gross-up dividend yields on some large Australian companies popular with income investors. These are for illustrative purposes only; they are not investment recommendations.
|Company||Net dividend yield %||Gross dividend yield %|
Source: Marketindex.com.au dividend yield scan 3rd June 2019
You can find up-to-date information on dividend yields and whether the shares are fully or partly franked (or not franked at all) in many places, including the ASX website, Marketindex.com.au and broker websites. The Australian Financial Review investor sharemarket tables each Monday provide the net and gross dividend yield for the top 300 companies.
As you can see from the small selection of shares in the table above, investors who buy shares in a bank receive far more income than investors who put their savings in the bank. For example, NAB share investors currently receive a dividend yield of 6.8% which increases to 9.8% when franking credits are added. NAB is currently offering its banking customers term deposit interest rates of around 2%.
Of course, where investing is concerned it’s never that simple. Before you race off to find out which shares offer the best yields, there are a few things to keep in mind.
In some cases, a high dividend yield results when a company’s share price drops due to poor performance. This is because the dividend yield is calculated by dividing annual dividends by the most recent share price.
Before investing in a company for its attractive dividend yield, you need to do your research. Is the company in a strong financial position, with a positive earnings forecast? Is the current level of dividends sustainable? Stockbroker reports and ASX announcements will help you answer these fundamental questions. The payout ratio, or the proportion of profits paid out as dividends, can be found in the company’s annual report.
If a company is paying out all or most of its profits as dividends, this could indicate it has few growth prospects and nowhere to invest its profits. If the company is paying out more than it earns, warning bells may sound.
It should also be remembered that high returns are a trade-off for high risk. Unlike a bank term deposit where your capital and interest are guaranteed, dividend income is not guaranteed, and neither is the capital you outlay to buy your shares.
When selecting shares, it’s important to focus on the total return from a combination of capital gains (or losses) and dividends. Dividends are paid at the discretion of the company’s directors and can fluctuate or be cut entirely depending on market conditions. Share prices also fluctuate depending on market conditions and the price investors are prepared to pay.
That said, franked dividends from quality Australian shares should continue to provide a reliable source of income for investors.
What about ETFs and managed funds?
In all the discussions about franking credits, people often forget or don’t realise that franking credits also apply to listed products other than Australian shares.
Take ETFs (exchange-traded funds) and traditional unlisted managed funds. Both use a trust structure, which means they must pass on all underlying income and realised capital gains to investors and investors are responsible for any tax. Income is typically paid via quarterly distributions.
If an ETF or managed fund holds investments in Australian shares that pay franked dividends, any franking credits are also passed on to investors with their quarterly distributions. At the end of the financial year the ETF or managed fund will notify investors of the fund’s franking credit level on their annual tax statement.
When investors pay tax on the dividend, they pay the difference between the company tax rate and their marginal tax rate. If your marginal tax rate is less than the corporate rate or you pay no tax, you stand to receive a cash refund of any excess franking credits attached to your ETF or managed fund distributions.
The upshot is that the death of Labor’s franking credit proposal will also benefit investors in ETFs or managed funds with underlying investments in Australian shares that pay franked dividends.
Cloud removed from LICs
LICs (listed investment companies) have long been popular with yield-seeking investors due to their high exposure to Australian shares.
Because of their company structure, LICs pay tax on income they receive from their underlying investments and pay dividends (franked or unfranked) to their investors. As a company, directors elect whether to pay dividends and can smooth the volatility of the income stream to investors from one year to the next.
In the period between the announcement of Labor’s franking credit policy in March 2018 and the election in May 2019, LICs with Australian share portfolios were devalued by the market. Many commentators speculated that retirees would be encouraged to diversify away from a heavy reliance on franked dividends to other sources of yield. As a result, the share price of many LICs dropped from a premium to their net asset value (NAV) to a discount to NAV.
Investors who held on stand to gain as the market adjusts to the Coalition victory, while new investors can proceed with more confidence. It’s worth noting, however, that Australian shares have traditionally been a high-yield investment and LICs offer exposure in a professionally managed, diversified and easily traded package. This would still be the case even without the tax advantages of franking credits.
Investors return to hybrids
Another investment sector to bounce back into favour after the Coalition’s surprise election victory was Australian hybrids.
Note: Hybrid securities are sophisticated investments with elements of both debt and equity that can generally be traded on the ASX. Banks and other companies issue hybrids to borrow money from investors. They typically pay interest at a fixed or floating rate until a date in the future, but the amount and timing of interest payments is not guaranteed as it is with a government bond. They can be converted to shares or your investment can be terminated by the issuer at any time.
Hybrids are high-yielding investments that also offer franking credits. Many were heavily sold in the run-up to the election by investors worried about the loss of franking credit cash refunds. This was despite research by Morningstar that only 10-20% of investors would be affected by the policy.
As a result of the selling, interest rate spreads between hybrids and short-term interest rates widened. Now the election is over, investors are moving back into high-yielding investments that offer franking credits, including hybrids. Interest rate spreads have narrowed but not to where they were before Labor announced its policy in March 2018.
Market commentators believe hybrid yields could prove even more attractive now that the Reserve Bank has started cutting rates.
Lessons from the election
As Warren Buffett once wrote, in the short term the market is a voting machine but in the long term it’s a weighing machine. In other words, in the short-term share prices reflect the short-term fears or optimism of buyers and sellers but in the long term prices reflect the underlying value of the investment.
This view is especially pertinent in the aftermath of the May 2019 federal election.
In the lead-up to the election, shares and other investments that offered franking credits such as managed funds, ETFs, LICs and hyrids took a hit. People who sold otherwise sound investments crystallised their losses and will have to pay more if they want to get back into the market.
One of the lessons from the election is the importance of thinking long-term and setting your asset allocation accordingly.
All investment entails risk, and political risk is just one of the risks investors need to be aware of and manage.
High-yielding Australian shares will always have a role to play in a diversified investment portfolio, with or without cash refunds of franking credits. Even so, it is wise for retirees who rely on income from their investments to diversify their sources of income with a focus on after-tax yields, with or without franking.