Navigate a changing game for franked dividends

Why on earth are franking credits back in the headlines? Are they threatened once more?

Actually, for most investors most of the time, franking credits on share dividends remain highly desirable. But it’s because they are so important to investors that any tinkering with any dimension of the franking system is going to set off alarm bells.

In the past fortnight the government has somehow managed to tinker twice!

Let’s look at those two changes relevant to franked dividends and put them in perspective.

1. The move to cut back on special dividends.

The Treasury announced it wanted to “harmonise” the tax system in the last budget by stamping out some arrangements that companies had started using around franked dividends.

The idea was to stop off-market buybacks that streamed franked dividends to investors, and to stop companies raising money while also paying out franked dividends at the same time. In common with the new ­attempt to stamp out super-wealthy investors exploiting the super system, the concept appeared reasonable, but the execution of the policy looks terrible.

On closer examination, there was a risk that some stocks could have franked dividend plans banned. In fact, the legislation is so poorly drawn that it was kicked into touch this week by means of a Senate inquiry into the issue.

The plan was meant to raise $600m. Opponents of the bill suggest it will cost a lot more than that in lost opportunities for business.

Who knows? The only thing we know for sure is that what might have been a sideplay has become a headline issue.

2. The neutralisation of franked dividends for the top end of the super system.

Under the terms of a new plan to place a 30 per cent tax on earnings in super above, there is a franked dividend dimension.

How it works for this new tax band in super is that there will be no change to franked dividends, but there is a change to the impact of franked dividends for high super amounts.

Once the new changes are put through, franked dividend benefits will be neutralised for big amounts (earnings above $3m) because the tax rate on this segment of super and the corporate tax rate will be identical, at 30 per cent.

Does this matter much? The government’s first estimate was that 86,000 people would be affected, but since the $3m cap is not indexed, about one in 10 people could be hit this way in 30 years time. This is hypothetical, but it also means if someone wants to argue that the franked dividend system is being undermined, they can mount an argument.

Nothing stays the same

The conclusion is surely that nothing stays the same for long in the tax system. Franked dividends are a powerful facility for any investor, but they are not set in stone. Any government at any time can change the rules.

As an investor, you have to weigh up these issues and the degree to which they may affect your portfolio. As Don Hamson, CEO of Plato Investments, puts it: “There are changes, but in many ways franked dividends are better than ever in relative terms.”

For most investors, franked dividends have been the backbone of their retirement income plans, and this won’t change.

As Tim Mackay of Quantum Financial said on this week’s Money Cafe podcast (Everything you need to know about the super changes): “Most retired investors will still be getting their cheques from franked dividends … the benefits flowing through from franking credits will still be the same.”

How franking works is complex, but think of it this way. In terms of money in your pocket that you get from fully franked dividends, the lower your tax rate the more lucrative they are.

That’s why retirees and charities are the most energetic supporters of the franking system.

For non-taxpaying retired investors, a franked dividend of $1 is worth $1.43. For a retired investor who pays tax (above $1.7m it is 15 per cent on earnings), it works out at $1.21. Under the proposed plan to tax amounts above $3m, it would work out at $1 for $1 – that’s why the franking effect would be neutralised for the wealthiest retirees.

Occasionally, the stream of franked dividends is improved by the arrival of a special dividend (now under the spotlight in the Senate), but the outcome is the same – you get a so-called impu­tation credit that boosts your ­income.

As Paul Aliprandi at Wilsons Private Wealth suggests: “Knowing the changes that are taking place, many SMSF trustees have entered an arms race, equipping themselves with as many fully franked dividends and distributions as they can find. Meanwhile, strong demand for franked income products from all issuers is being underwritten by imminent supply-side constraints, being the government’s drive to stop the release of trapped franking credits through off-market buybacks and capital raisings.”

Even in the top 30 per cent bracket, franked dividends are at least “realised gains”, which may be more attractive for some than “growth”-focused investments such as property or private equity.

Top franked stocks

So if you were to “equip yourself with as many fully franked dividends as you can find”, where might you start?

I asked Wilsons to produce the top 10 franked dividend stocks on a forward consensus basis. The average dividend yield across the market is around 4.5 per cent. You might have thought the top 10 would be dominated by the big four banks with their 6 per cent-plus dividends, but the reality is that they are so highly priced as stocks their dividend yields are rarely the very best.

The three banks that make the top 10 cut are Westpac, ANZ, and Bendigo and Adelaide Bank. Westpac has a yield of 6.8 per cent expected for the year ahead, creating a post-franking dividend yield that would be more than 8 per cent. ANZ also offers 6.8 per cent.

Bendigo and Adelaide which is a very small player in the wider market but its dividend returns match bigger players. Its consensus yield is 6.5 per cent.

Outside of banks we are talking largely about resources – Whitehaven Coal, which hit the jackpot as an unpopular stock that made a fortune from the new energy crisis, offers a forward dividend yield of 12 per cent.

Similarly AGL, the power group in the headlines almost as often as franked dividends, has an 8.3 per cent yield. Woodside, with its exposure of gas, has a 7.1 per cent yield and Minerals Resources offers 6.5 per cent.

Rounding out the list is Stockland, the property group, at 6.9 per cent and Nine Entertainment at 6.4 per cent.

Separately, there are also big changes looming for capital gains tax in super, especially at the top end. At its most extreme, Hamson points out that long-term capital gains could be taxed more highly in super than in the hands of the highest marginal tax investor.

That’s something that will push assets outside the super system. This issue is only starting to ­bubble.

But if the government’s modest measure on special dividends has already triggered a Senate inquiry, we have a lot of horse trading to go before the bigger changes to super get through parliament.