Australia’s franking regime in doubt as the government targets franked distributions funded by capital raising

Scott kelly

SMSFs and retails investors with low and marginal tax rates to be most impacted

The government’s Treasury Laws Amendment Bill related to franked dividends being funded by capital raisings proposes two key changes estimated to save the budget $600 million over the next four years. The first change relates to the tax treatment of off-market share buybacks.

The second proposed change is the schedule five that the Economics Legislation Committee suggested that clarification was required. This relates to franked dividends being funded by capital raisings.

This Legislation effectively aligns the tax treatment of off-market share buybacks with on-market share buybacks, says Scott Kelly, Portfolio Manager for the DNR Capital Australian Equities Income Strategy.

“There’s been very little industry pushback to the proposed reform and it’s likely to proceed in its current form.

“Historically large companies have often raised capital from shareholders through fully underwritten capital raisings and then paid out all that money raised as a franked dividend.

“But the government wants to clamp down on this move so that a company will not be able to pay out franked dividends that are directly or indirectly funded by capital raising. And whilst, at face value that may not seem unreasonable, a number of concerns about unintended consequences have been noted by industry.

“The first problem is that the proposed test to determine whether companies can pay out fully franked dividends observes an established practice of paying dividends over time and this potentially puts startups at a disadvantage given they tend not to pay out dividends in the first few years of operations.

“Secondly, the proposal appears to capture a dividend reinvestment plan, which is also a form of capital raising and this potentially could result in shareholders losing franking credits over time.

“And finally, companies will still be able to fund dividends by taking on debt. This potentially puts small companies at a disadvantage given their limited access to capital markets relative to larger companies.

Kelly says “Overall we believe there are legitimate concerns that the proposed changes could just be the beginning of other broader changes. We believe that the proposed changes will reduce the effectiveness of Australia’s franking regime.

“In our view, those who will be most affected by the changes are self-funded retirees and retail investors, and those investors with low and marginal tax rates.

“For companies, under the new proposals, there’s the increased risk that franking credits will become permanently trapped within the companies.

“And there are also broader implications for the economy upon which Australia’s franking regime has supported investment and growth over time. We expect that franking rich companies will review and possibly increase dividend payout ratios and potentially also look to pay out special dividends more regularly.

“At DNR Capital, our investment strategy considers after-tax income and after-tax returns as part of our investment process and stock selection. And we still expect that there will be plenty of opportunities for investors to target companies delivering sustainable, growing tax effective income over time.”