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Dividend Imputation Credits – Potential Impacts of Proposed ALP Policy

The Australian Labor Party (ALP) has announced that if it was to win the upcoming Federal Election, it would eliminate the cash refund of excess imputation credits for all recipients with the exception of individuals receiving Centrelink pensions, charities and not-for-profit institutions, and SMSFs that have at least one Centrelink pension or allowance recipient before March 2018.    

 

20th March 2019 / 12 mins read
Andrew Cassar
Senior Consultant
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Summary

The Australian Labor Party (ALP) has announced that if it was to win the upcoming Federal Election, it would eliminate the cash refund of excess imputation credits for all recipients with the exception of individuals receiving Centrelink pensions, charities and not-for-profit institutions, and SMSFs that have at least one Centrelink pension or allowance recipient before March 2018. 

Superannuation funds make up a small proportion of recipients of franking credits , with most credits received utilised to offset tax on other income sources, including member contributions.  Tax exempt entities (i.e. charities and not-for-profit institutions) make up a small component of the recipients of franking credits but they receive the majority of the benefit in the form of a cash return from the Australian Taxation Office (ATO).

Dividend policy across corporate Australia has generally been relatively consistent over the last 10 years. The past decade has seen many Australian companies focus on improving shareholder return by growing dividends and initiating buybacks and special dividends with the added incentive of franking credits. Drawing on the perspective of Australian equity investment managers, the ALP’s proposed policy regarding imputation credits is not expected to alter the behaviour of corporate Australia with regards to dividend policy in future.    

The short term (FY 2019) pre- and post-tax return of the Australian share market is likely to be boosted by the temporary increase in the payment of franked dividends (special and ordinary) and completion of off-market share buybacks utilising franked dividends. However, the long-term potential return of the Australian equity market is unlikely to be materially impacted as a result of the current version of the Labor policy on franking credits.     

Introduction

The dividend imputation system was introduced in 1987 to ensure that the profits of companies operating in Australia are not subject to ‘double taxation’ – firstly in the hands of the company, and then in the hands of the individual Australian shareholder.
 
Under the original system, imputation credits could be used to reduce an individual’s tax liability. Much like other tax credits within the Australian taxation system, if the recipient did not have a tax liability, or the tax liability was smaller than the imputation credits, the imputation credits went unused.
 
In 2001, the dividend imputation system was amended to allow any excess imputation credits i.e. those in excess of any tax liability, to be paid as a cash refund. This meant that those recipients with a tax rate lower than the company tax rate, generally 30%, would receive a cash refund of the amount by which the imputation credit exceeded their tax liability.

Australian Labor Party - Policy Proposal 

The Australian Labor Party (ALP) has announced that if it was to win the upcoming Federal Election, that it would effectively restore the original imputation system, under which any excess imputation credits would no longer be paid as a cash refund. 

The ALP proposal will not change the system of dividend imputation, but rather remove the ability to claim excess imputation credits in cash from the Australian Taxation Office (ATO). The proposal will come into effect from 1 July 2019 if the ALP wins the Federal Election and enacting legislation being approved by Parliament. 

  • Who will be affected?

The ALP policy proposal will not impact the following groups, who would still be able to claim excess imputation credits in the form of a cash payment from the ATO: 
•    Charities and not-for-profit institutions;  
•    Recipients of Centrelink pensions (full and part) and allowance recipients (300k eligible individuals);
•    Self-managed superannuation funds (SMSFs) that have at least one Centrelink pension or allowance recipient before 28 March 2018 (13k eligible SMSFs).

  • Franking Credit Recipients & Utilisation  

According to the Treasury, franking credits that are attached to dividends have grown considerably between 2006 ($31.1bn) to 2014/15 ($47.5bn). As illustrated in Figure 1, approximately 50% of the franking credits are received by individuals, super funds, SMSFs and tax-exempt entities i.e. charities and not-for-profit entities including the Future Fund. The remaining amount are received by companies and non-residents, which generally do not pay additional tax or receive refunds on the dividends. 

Graph 1Figure 2 above shows that since franking credit refunds were introduced in 2001, these have largely been received by individuals, although an outcome of more recent policy changes to retirement incomes combined with a greater use of SMSFs as a savings vehicle has resulted in a large increase in the level of refunds claimed by SMSFs. 

The utilisation of franking credits as either a tax offset or refunded in cash varies across the various beneficiaries, as shown in Figure 3.  By far, individuals and SMSFs receive the greatest amount of franking credit in the form of a refund, whilst super funds generally utilise franking credits to offset tax on other income sources, including member contributions.      
 

Graph 2


According to the ALP, the budgetary benefit of removing the benefit of imputation credits is an annual saving of $10.7bn over 2019/20 and 2020/21, and $55.7bn over ten years.  

Corporate Dividend Policy 

Dividend policy across corporate Australia has generally been relatively consistent over the last 10 years. The past decade has seen many Australian companies focus on improving shareholder return by growing dividends and initiating buybacks and special dividends with the added incentive of franking credits. Drawing on the perspective of Australian equity investment managers, the ALP’s proposed policy regarding imputation credits is not expected to alter the behaviour of corporate Australia with regards to dividend policy in future.    

For reference, the dividend payout ratio of the S&P/ASX 200 Index has averaged 66% over the past decade, whilst dividends per share at an Index level has grown by an average of 33% with an average dividend yield of 4.2%.  

Figure 4 below illustrates the consistent growth in total dividends paid by companies in the S&P/ASX 200 Index and the growing portion of franking credits over the past 5-10 years. 

Graph 3

Australian equity investment managers with which JANA has discussed the ALP policy do not expect corporate behaviour regarding balance sheet management and dividend distributions to materially change if the policy became law. 

  • Franking Credit Balances - S&P/ASX 200 Index Companies

As at January 2019, approximately $38bn of franking credits sit on the balance sheets of S&P/ASX 200 companies, of which 90% sit on the balance sheets of 50 companies. The table below highlights the top 10 companies based on the balance of franking credits available.  

Graph 4


A number of Australian listed companies have initiated significant capital management initiates over the past year. They include off market buybacks by BHP, Rio Tinto, and Caltex, while Wesfarmers, Qube, South32, Adelaide Brighton, Brickwork Investments and Woodside have paid a special fully franked dividend.  There may be other reasons for the capital management (e.g. asset sales in the cases of BHP and Rio) but changes to future franking eligibility were likely considerations by most if not all of these companies.   

Expectations amongst Australian equity investment managers are that some companies are waiting for certainty in the change of policy (the election result or the bill passing Parliament) before initiating capital management initiatives. 

Over the long term, Australian equity managers in general do not anticipate a change in corporate behaviour if the proposed policy was to become law. Companies will continue to pay franked dividends and the large majority of investors should continue to derive value from franking credits attached to these dividends.

Australian Equity Return Expectations

The short term (FY 2019) pre- and post-tax return of the Australian share market is likely to be boosted by the temporary increase in the payment of franked dividends (special and ordinary) and completion of off-market share buybacks utilising franked dividends.

However, the long-term potential return of the Australian equity market is unlikely to be materially impacted as a result of the current version of the Labor policy on franking credits. For institutional asset owners, the impact will not be relevant as franking credits can still be utilised to offset tax on other investment income and the tax benefits of franking credits are allocated to individual members usually flows through "crediting rates" or "unit pricing". 
  
The return expectations for a segment of the retail shareholder base will be reduced to the extent of the loss of franking credit rebates, including many SMSF.  However, according to Balanced Equity Management (BEM), this relates to less than 5% of share ownership of the top 100 companies listed on the ASX.  In the short term, there may be some selling evident by these investors if they adjust their asset allocation away from Australian equities. This could see temporary pressure on the performance of high fully or mostly franked dividend yielding shares which are well held by this shareholder group (including bank shares).

From a global perspective, and relative to countries without a dividend franking policy, after-tax return expectations for domestic shares will remain attractive for most domestic taxpayers (as cashflows equivalent to the corporate tax rate in most offshore jurisdictions are lost).  Additionally, there is already a high proportion of listed companies with no or limited franking benefits (including REITs, infrastructure stocks, and those with significant offshore earnings (such as CSL, Cochlear and Brambles). 

Conclusion 

Individuals and SMSFs receive the greatest amount of franking credit in the form of a refund although this group of investors equates to less than 5% of share ownership of the top 100 companies listed on the ASX. Superannuation funds generally utilise franking credits to offset tax on other income sources, including member contributions.

Drawing on the perspective of Australian equity investment managers, the ALP’s proposed policy regarding imputation credits is not expected to alter the behaviour of corporate Australia with regards to dividend policy in future. Finally, the proposed policy change is likely to have a modest impact to the Australian equity market over the short-term with no material impact over the long-term.