SCOTT FRANCIS – 21 AUGUST 2013

Summary: The Coalition’s parental leave plan will involve a 1.5% levy on the highest-earning Australian companies, and this will not be franked. What that means is that shareholders in affected companies will lose the same proportion of their dividend franking credits.

Key take-out: Those still looking for dividends could look at ‘tilting’ their portfolio toward high-yielding shares that pay higher dividends, and therefore higher levels of franking credits.

A surprise move by the Coalition to fund its controversial parental leave policy substantially through a levy on Australian companies and their shareholders is set to become a key feature of the election.

Opposition spokesman on finance, Matthias Cormann, confirmed this week that a new 1.5% levy on Australian corporate profits for those companies making more than $5 million per annum in gross profits would not be franked ... that is, it would not count as a tax credit when dividends are paid. It might seem like an arcane piece of financial information, but it’s not … and Australian small shareholders are going to pay.

Why? First, our top companies will now have to cough up $1.6 billion per annum to the government (that’s an official estimate from the Independent Parliamentary Budget Office). Second, the levy hits retail shareholders hardest, especially retirees, who depend on franking, and third, the levy isolates and penalises Australian resident shareholders who are the only beneficiaries of franked dividends, leaving foreign investors untouched by the change.

Moreover, the decision ignores two-decades of consistently supportive policy towards franked dividends.

In the two decades since Paul Keating introduced franking credits, there has been little change to that part of the tax landscape.

A 45-holding day rule was introduced to stop people exploiting the tax benefits of franking credits by just holding them for a day, and rules allowed for the refund of excess franking credits as a tax refund – something appreciated by many investors.

The benefits of franking credits

As a quick look at the benefits of franking credits to a retiree, consider an investor with $1 million invested in fully franked Australian shares paying an income of 5%. That is a cash income of $50,000. As well as this, they will receive a further $21,400 of franking credits. This is a significant sum of money, and no doubt a great help in funding retirement.

I think that we are very lucky to have a sharemarket providing an average yield of around 4% with franking credits of another 1.3% – we can enjoy the income from shares and let the capital growth take care of itself over time.

At the moment, when a company pays tax, they are able to pass that tax payment onto shareholders in the form of ‘franking credits’. For example, a company that earns $100 a share pays 30% tax, or $30 per share. That leaves them $70 in dividends to pay to investors. As well as the $70 cash dividend, they can also pass on the $30 tax paid as a franking credit. This stops the investor having to pay tax at both the company level, and then again at an individual level – effectively stopping the ‘double taxation’ of dividends.

Franked dividends are very popular, for as well as receiving the dividends from the companies that they own, shareholders also receive a tax benefit in the form of a ‘franking’ or ‘imputation’ credit. The benefit for most retirees is that they don’t actually have to pay tax in retirement, so the franking credit becomes a tax refund and is as good as extra income.

The actual impact of the levy (with and without company tax rate cuts) – and how investors pay

If a 1.5% levy was included on top of the company tax rate, and the 1.5% levy could not be used for franking credits, the impact in the previous example would be that:

1. $100 of income was earned.
2. $68.50 was left after 30% company tax ($30) and 1.5% ($1.50) levy for maternity leave.
3. An investor would receive $68.50 (down from $70) as the cash dividend, and still only the $30 in franking credits.

Their benefit will fall by 1.5%. Not a huge amount, but still significant in an environment where companies are struggling to grow their dividends, and investors are looking for every dollar that they can get.

The Coalition has also talked about cutting the company tax rate to 28.5%. If they did that, the cash flows from a $100 of company earnings would look like this:

• $100 of income earned.
• $70 left after company tax (28.5% or $28.50) and the 1.5% levy ($1.50).
• Franking credits of $28.50 (down from $30).

Either way the cost is 1.5% of the total value of dividends, borne by shareholders.

What can investors do?

The question is – if the levy becomes a reality … and the Coalition are firm favourites to win the federal election on September 7, what can investors do?

Those still looking for dividends could look at ‘tilting’ their portfolio toward high-yielding shares that pay higher dividends, and therefore higher levels of franking credits. That said, there are risks in this strategy, with many high-yielding companies (banks and Telstra for example) already having undergone periods of strong price growth. Another strategy might be

Investors might become more aggressive with any plays that provide access to franking credits.

Suncorp recently announced its dividends –a 50 cent dividend that was fully franked and a special dividend. On a share price of around $12.50, this is a yield of 4% fully franked just on this one dividend alone.

Investors might consider buying the shares before they go ex-dividend next Monday, to capture the 50 cent dividend plus 21 cents of franking credits. Of course, this is a very high-risk play. Most investors have to hold the shares for 45 days to benefit from the franking credits, and the price of the shares could potentially fall more than 71 cents (the value of the dividend) during that time.

One last question to ponder – what might happen if the 1.5% levy is introduced by the Coalition government, and is not able to generate franking credits?

We won’t know the answer to that for a few months … but on the other hand we do know.

Perhaps those beyond the age of having children and benefitting from maternity leave might feel somewhat aggrieved that they are helping subsidise this with their sharemarket income.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.