Of all the tax strategies available, the State Street Global Advisers Tax Lab suggests the most important is preserving franking credits. Here they provide the big picture.
For those who are allergic to maths, ratios and tax acronyms, here are the key things to know about franking credits:
- Franking credits provide a direct boost to after-tax returns.
- Franking credits are designed to avoid tax being paid twice on company profits. They apply only for Australian shares held by Australian investors.
- You have to hold a company’s shares at the time it pays a dividend to get any franking credits on offer. However, you can lose that franking credit if you don’t hold, or haven’t held, the company for at least 45 days.
- If you earn more franking credits than you have tax payable on the dividend you can offset against tax payable on income from other sources or actually get a tax refund!
- Franking credits are easier to measure than many other after-tax strategies.
- Benchmark franking credit information is available from vendors like S&P and MSCI.
- Franking credits are a direct boost to after-tax returns. (Did I mention that already?)
How Franking Credits Work
We can best explain franking credits using a simple example. A company earns a profit of $100 and the board decides to pay all profits to shareholders. The only shareholder is a superannuation fund.
First, the company has to pay $30 tax on its profits, leaving it with $70 it can pay as a cash dividend. So it declares a $70 dividend that is ‘fully franked’, meaning it comes with a $30 ‘franking credit’.
Next comes some bad news for the superannuation fund. The fund received only $70 in cash, but it has to include the franking credit in ‘taxable income’. So the superannuation fund has a tax bill of $15 on its $100 of supposed ‘income’.
Then comes the good news. The superannuation fund can use the franking credit to pay its tax bill. In fact, if the franking credit is larger than the tax bill, the fund gets a refund from the Australian Taxation Office (ATO). So the fund has a tax bill of $15 and a credit of $30, resulting in a refund of $15.
The end result is that the combined tax paid by the company and the fund on the original $100 profit is determined by the fund’s tax rate, not the company’s. Of course the company has to have paid tax in Australia, and it has to pay dividends for all this to occur, but it is, in this writer’s opinion, a pretty neat system.
What Are They Worth?
Not every dividend paid by an Australian company is ‘fully franked’, but the direct boost to returns is still significant. As of October 2016, the cash dividend yield on the Australian share market was approximately 4.5 per cent per annum (p.a.).
Franking credits added about 1.4 per cent p.a. to this yield, giving a ‘grossed up’ yield of 5.9 per cent p.a. All up, the after-tax difference between having and not having franking credits was around 1.2 per cent p.a. for a passive Australian equities portfolio. So to begin the lessons:
- If your manager is deciding whether to purchase a company, they should be including the potential value of the franking credit in their considerations.
- Losing Your Franking Credits
- This is something you really want to avoid, so it is important you know the ‘45-day rule’. For a superannuation fund to claim a franking credit, it must hold the shares for at least 45 days around when the dividend is paid. It can be before, after or both — but it has to be at least 45 days. This rule exists to stop investors from buying shares for the sole purpose of pocketing the tax credit.
- If your managers have been doing lots of buying and selling of the shares, the ATO will use the last-in, first-out method to determine if your fund can keep the credit.
- What does this mean for after-tax management?
- If your manager is selling a share, they should be particularly careful if it is close to a dividend payment. That doesn’t mean they shouldn’t sell, just that they should factor in any loss of franking credits.
- In a multi-manager portfolio, no individual manager can completely control the franking credits in their portfolio. It is theoretically possible for manager A to trade in a way that negates the franking credits earned on manager B’s portfolio.
Chasing Franking Credits
Losing franking credits is one thing, but actively chasing them is another. There are a few complications.
- If franking credits provide a clear benefit, you might expect companies that usually pay franked dividends to trade at premium prices. However, only some buyers and sellers value franking credits; some (like foreign investors) don’t. Analysing the impact of franking credits on share prices is not simple.
- Aggressively chasing franking credits can introduce significant risks into your portfolio. You are likely to see big swings between individual names and market sectors, and these will persist for at least 45 days.
- Aggressively chasing franking credits tends to increase portfolio turnover. This may have negative capital gains tax consequences.
State Street Global Advisors