At the risk of adding to the fervour around the debate over the possible removal of franking credit refunds should Labor win Government, I see the policy in a more practical light.
Labor is clearly concerned that the current arrangements will become substantially more costly to the budget over time as the population ages and super balances grow. The party is seeking avenues to raise revenue and in this case is doing so by aiming to ensure that profit generated in the economy doesn’t pass through the system without contributing to tax revenue. As such, franking credits are an understandable target, albeit one whose current planned implementation will clearly lead to some blatantly unfair outcomes for different investors.
There are plenty of advocacy groups and commentators focusing on the direct consequences of the policy, which I will summarise later. What’s received less attention, however, is the broader investment implications for asset and product allocation if the changes are implemented as currently planned.
Indeed, everyone needs to focus on the broader market and portfolio impact of this policy as these could affect all investors through the valuation impacts on different assets and strategies, not just those directly denied excess franking credits. Of course, precisely quantifying the impact of these changes is next to impossible but we can make some sensible guesses at the direction of the moves.
In this regard, below is what I see as the major impacts.
- Stocks paying high franked dividends such as banks, telecommunications and large miners could become less attractive and less highly rated from a valuation perspective.
- Those hybrid securities relying on their grossed-up yield from franking credits may be de-rated (some of this may have already occurred on the initial policy announcement).
- Some companies may be more inclined to pay out unfranked or partially franked dividends.
- Sources of non-franked income may become more attractive – e.g. interest income, rental income, trust distributions, encouraging increased asset allocation exposures to property, infrastructure and fixed interest.
- Industry super funds will benefit further from fund flows (helped along by the Hayne royal commission) as some individuals move away from SMSFs. Clearly, for retirees with a SMSF and receiving an aged pension (commenced after March 28, 2018) the case for keeping the SMSF going is reduced.
- Investment vehicles/assets that pay little income may become more attractive e.g. global shares.
- Listed Investment companies (LICs) are particularly vulnerable, especially those that target a high level of local franked dividends or that generate a high dividend from active trading (especially if currently trading at a premium to NTA). Many LICs rely on returning to investors most of their total return (dividends and realised gains) via the payment of franked dividends. Current premiums on some vehicles could shrink or disappear and discounts on the sector generally would expand. LICs’ vulnerability is because they are heavily owned by retirees and individual investors who may be the most impacted by the franking credit change. Interestingly, we have already seen several LICs pay out special or higher dividends in the recent reporting period, partly in anticipation of the policy.
- To the extent there is continued issuance of listed closed-end funds these are more likely to be listed investment trusts (LITs) with debt related LITs currently the flavour of the month.
Currently, two LIC funds in the Watermark stable of funds are in the process of converting from LICs to trusts (albeit to unlisted trusts), although this move has been primarily driven by pressure to eliminate the discount to NTA on small listed vehicles rather than tax issues. Still, it shows the conversion from company to trust can be done, and if the Labor proposals go through as currently proposed I would not be surprised to see some other existing LICs convert to LITs over time.
Of course, the excess franking credit changes cannot be looked at in isolation.
Indeed, some of the logical responses of investors to the policy may be less effective because of other changes Labor is proposing. For example, strategies that are focused more on capital gains (such as global shares) may be impacted by plans to cut the capital gains tax discount to 25 per cent for assets held over 12 months, albeit with grandfathering on existing positions prior to policy commencement. I believe this proposed change has not received the attention it deserves, given most of the focus has been on the policies around excess franking credits and the removal of negative gearing.
Family trusts will be less flexible if the plan to tax beneficiaries at a minimum tax rate of 30 per cent on distributions is introduced. The elimination of negative gearing for property (other than new properties) and on other assets – again with existing holdings grandfathered – is less likely to be directly relevant to those who currently benefit from excess franking credits.
Much will depend on the timing of introduction and the relevant grandfathering arrangements, but the impact and administrative burden of these other policy changes could be significant.
Ultimately, a removal of excess franking credits could benefit some financial planners by prompting client engagement and strengthening the argument for robust, well diversified portfolios that are less dependent on Australian shares. Of course, this should be tempered by the need for caution in allowing tax issues to be a large driver of asset allocation.
Clearly, those advisers best placed to engage with clients in this way will be those who are already considering the implications, risks and opportunities of these potential policies rather than those focused on whining about the proposed changes. It may not make sense to act yet but it does make sense to have clear plans in place.
Clearly, even to those not against the principle of cracking down on access to franking credit refunds, Labor’s current plan is a mess of blatant inequity and administration complexity. Further, these very exemptions and distortions and the ability to avoid the impact by switching from a SMSF to certain industry or retail funds will see changes in investor behaviour that mean the policy will likely raise much less than expected.
Still, it seems Labor is not going to back down and, further, has a high probability to win the upcoming election. With this in mind, concentrating the fight on trying to prevent Labor introducing the policy at all seems rather pointless. Perhaps that effort would be better focused on emphasising to Labor policy makers some of the inequities and administration issues raised, and suggesting how these could be remedied or improved. Some sensible suggestions such as simply capping the level of excess franking credits for all investors at a modest dollar level have been put forward.
Of course, some may have the view that there is no need to think about implications of these policies yet because Labor may either not win the election, back down, heavily water down proposals or will not be able to get them through Parliament.
However, with the election being held within 2 months, the LNP needing a miracle to avoid defeat and possible implementation of the franking credit policy as early as 1 July this year, this seems a head-in-the-sand approach. We have an interesting few months ahead.