Dividends. What’s all the fuss?
In the last few days Opposition Labor Leader Bill Shorten has proposed a radical transformation of dividend imputation. Putting aside his mistaken belief that his voters are “Aussie Battlers”- when in fact they are hard-working small business owners and contractors, many of whom receive franked dividends from their business endeavors – it’s worth looking at what all the fuss is about…
Prior to 1987, when a company paid tax on its profits of 49 per cent (as it was in 1986) any AFTER TAX profits that were distributed again to shareholders in the form of dividends, were also taxed in their hands. In other words, the profits were taxed twice, once in the company’s hands and then again in the shareholder/owners’ hands.
Double taxation is neither fair nor reasonable and in 1987 the double taxing of dividends was abolished by Hawke and Keating with the introduction of dividend imputation. We understand Finland, Italy, Mexico and New Zealand also have a form of dividend imputation.
Through the use of tax credits called “franking credits” the ATO was notified that a company had already paid tax on the income it distributed as dividends. The shareholder then did not have to pay tax on the dividend income unless their tax rate was higher. If their tax rate was higher they paid a top-up, amounting to the difference between the company tax rate and their personal rate…
And if their tax rate was lower than the company tax rate they paid nothing extra, but they DID NOT receive a refund of any difference either.
That was until July 2000 when the rules were changed by Howard & Costello and shareholders received a cheque from the ATO for the difference between their lower rate and the higher company tax rate.
Budget Impact
With a generational avalanche of retired baby boomers now on zero tax rates the cost of this difference amounts to the ATO sending cheques of about $5 billion to shareholders annually.
(Of course, lowering the corporate tax rate, would also lower the amount of the refunds.)
Capital Allocation Weirdness
The cash refund from dividend imputation means franking credits have no value to a company but enormous value to shareholders on lower tax rates.
As a result, we see lots of suboptimal capital allocation decisions.
A company able to generate very high rates of return on incremental capital should keep the money rather than pay dividends (and then be forced to replace the payments with dilutive equity issues or risk-increasing debt). We have written about this constantly here at the blog and it forms the foundation of our valuation approach. Companies are today forced by shareholders to distribute their franking credits, which have no value to the company, by paying dividends. In other words, a dollar paid is worth more than a dollar retained but look….
Look at the ASX 200 – it is exactly where it was a decade ago, Why? Because the dividend payout ratio is about 80 per cent meaning companies are only keeping 20 per cent for growth including employing more people. Shareholders are worse off under this system in the long run.
One Solution
Unlike Shorten’s suggestion, which is regressive and UUAustralia See our video here) one solution might be to introduce progressive tax rates to all post retirement incomes grossed up for franking credits. These tax rates can be much more lenient than pre-retirement and some fairness can still be introduced.
By that I mean that if someone is only managing to pay the bills, put food on the table and go on a domestic holiday once or twice a year then no tax should be paid by them and they might even be permitted to keep their franking credits…
But if someone or some entity is earning 10 million dollars in tax free income or more annually, including cheques from the Australian Taxation Office, that is something that should be examined.
Another possible solution was my friend Hamish Douglass’s optional system where companies can choose to pay 15 per cent tax but have to give up tax credits on their dividends.
Ultimately this country needs to earn more from its exports, everything else is just tinkering…see below links.
Mr Turnbull, it’s time we stopped selling off the farm
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
RIC DOBOSZ
:
Great comments by all, thank you ..personally it will impact on me big time ,,In today’s world no matter who is in power ,,, you need to be a active investor in Retirement.. ie.. SMSF, this is not what retires want ,,The days of buy and forget are over ,, I for one have already started my revision to asset change,,yes early but Remember this is going to be Labour policy so if they don’t get in next time There is always time after that,, remember health is more important than Wealth …
Max Zan
:
Investors in a non taxable situation holding high yielding stocks will be the ones worse off by this proposed change.
Lets say you hold a high yielder such as Westpac and are in a non taxable situation – if the change goes ahead you will lose about 22% of the Income currently received (based on assumptions below ) The situation is worse if no capital gain is achieved.
– Current Share price $29.50
– Current Dividend per share $1.88
– 2017 Payout Ratio approx 79%
– Current Dividend Yield 6.4% (54%)
– Franking credit Value 2.7% (22%)
– Potential Capital Growth (SGR) 2.8% (24%)
– Total Potential Return 11.9 % (100%)
If the change is implemented, the high yielders may no longer be popular as focus turns to low yielding High Growth stocks – The focus will turn to overseas shares as the Australian market is mature and has a limited number of growth stocks.
It’s a sneaky change but the present system is way too generous and unsustainable – Investors will have to adapt and plan around it.
Iain Cameron
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Great article Roger and Hamish Douglass’ idea of companies paying 15 per cent tax but then not having tax credits on their dividends is worth further consideration.
It would be interesting to know what effect this would have on Shorten’s claimed $59 billion in savings. Labor’s calculation was based on imputation credit refunds paid by the ATO a few years before Scott Morrison changed the law and pension funds are now limited to hold a maximum amount of $1.6 million.
Roger Montgomery
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Thanks Iain,
yes the limit to contributions does also limit the potential value of the ATO cheques.
Tom Newton
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$5.9 billion per year in savings? I don’t think so. People will easily prevent their tax credit from being “lost”. One simple solution would be (for those funds outside super), to sell shares with a capital gain tax liability, use the tax credit, pay no CGT, then buy the shares back again. Another would be to sell shares and buy bonds or real estate, again creating a tax liability that is offset by the franking credit.
The whole concept will never fly. It is so disappointing that our politicians are so stupid.
Chris
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The problem Tom, is that the ATO would likely consider that a ‘wash’ sale, i.e. a means of deliberately evading tax because you sell them, crystallise a loss or profit and then repurchase them immediately….although it is interesting that they never tell you when exactly you could or would reasonably be expected to purchase them again and for it not to be considered a wash sale.
It’s all very much at their consideration and you only find out after the fact or if you obtain a private ruling…can you say “transparency” ?!
andrew ronan
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Hi Roger, Australia has one of the highest sovereign risk ratings in the world already and when you have people like Bill Shorten in with a very good chance of getting elected to power and making that situation far worse than it is already, I think we are better off taking dividends and investing them elsewhere , Australia is closed for business and has been for ages,
we are very good at exporting entire industries let alone jobs. Also I don’t think their are to many small business people who vote Labour, unless they have a red, green, orange, tape fettish and they enjoy pain and taxes and being sued by their employees, customers, and general public,
oh yes I nearly forgot, the most expensive electricity prices in the world. Roger we have to sell the farm and import another 270000 refugees and immigrants next year so we can keep our rent seeking flat building ponzi economy from falling over. What we need is a home grown Donald Trump at the wheel and not a Shortistan or a Halal Mal.
Paul
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I’m not sure shareholders are worse off?
Look at the ASX200, it has doubled in the past 9 years, and companies have paid out 80% of profits in franked dividends.
A spectacular return for investors by any measure.
Roger Montgomery
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If you pick ‘9’ years – you have picked the very bottom of the GFC in 2009. Sentiment at the very bottom of the GFC did not compel many to even add to their existing holdings, those holdings purchased earlier when sentiment was more optimistic.
Chris
:
Roger, it’s not just about baby boomers, it’s about everyone and anyone (including Gen X, Y and Millennials) who has a superannuation account in either accumulation or pension phase.
If a company pays tax at 30% and the rate inside superannuation is 15%, that’s a 15% free kick on the money that is also going into those accounts from the refund of franking credits during accumulation phase. Obviously, pension phase is at a 0% tax rate, so those people will be hit too, but it affects everyone.
Roger Montgomery
:
Hey Chris,
You are right. It’s the baby boomers however who took full advantage of Costello’s largesse and ploughed money into super with few caps. Since then the subsequent generations (and now Baby boomers too) have had significant caps put on their contributions.