Impact of proposed changes to franking credits

Funds Management

by Clive Tompkins

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MLC Australian Shares Portfolio Manager John Woods talks with Sinead Rafferty, Portfolio Specialist at NAB Asset Management about the Federal Election, Labour's proposed changes to franking credits and what the changes will mean for companies with high dividend payouts and franking.

Sinead Rafferty:
Hi I’m Sinead Rafferty, Portfolio Specialist at NAB Asset Management. And today I’m joined by our Australian Shares Portfolio Manager, John Woods. Welcome, John.

John Woods: Hi.

Sinead Rafferty: With the Federal Election looming, Labor have made some announcements in relation to proposed changes to franking credits. Can you tell us, what are franking credits and what those announcements were?

John Woods: Franking credits basically allow investors in Australian shares, to offset the tax that’s already been paid by the company, against the return they earned from dividends. And one of the announcements that’s been made is Australia’s one of the few countries, in the OECD that allows investors to offset more than the tax that they’ve paid through dividends, using franking. So they actually end up getting a refund. Labor’s announced that they’re likely to end that if they’re elected.

Sinead Rafferty: The Australian market’s already facing several headwinds. We know about the fall in the housing market, high household debt, retail sales are suffering. Is this likely to make Australian shares maybe less attractive?

John Woods: All else equal, franking is a pretty strong tailwind, particularly for Australian based investors and mostly for those, who have very low tax rates. And if franking for some of those investors is removed, I’d expect that can’t be interpreted as a positive for Australian shares.

Sinead Rafferty: Are some sectors more likely to be impacted than others. For example, are the valuations for banks, mining and maybe telecoms going to be less attractive than they were?

John Woods: It does come down to the sector. And basically, franking is most important to Australian companies that earn their profits, here in Australia and have large dividends. So that tends to be companies like the banks, very domestically focused, telecoms very domestically focused and have large payout ratios. For mining, it’s a little bit nuance. So some of the more mature miners going to start returning capital back to shareholders. They earn franking here and that was part of the reason to have a dualistic structure for BHP Group (ASX:BHP). But for the smaller miners that actually fund their growth through their earnings, they don’t have very high dividends and thus, franking’s less important for them.

Sinead Rafferty: Do you think we’re more likely to see an increased number of buybacks and special dividends, as maybe some companies seek to distribute those franking credits, prior to any potential changes?

John Woods: I think we’re already starting to see that. So we’ve had Rio Tinto Limited (ASX:RIO) announce completed buyback, BHP complete one. Caltex Australia Limited (ASX:CTX) is underway, Woolworths Group Limited (ASX:WOW) has just announced one. But it’s important to note that even if the buyback isn’t completed by a changing government, franking credits will still have value. And distributing those franking credits through a buyback is a very effective way for the corporate to target, those investors who benefit from them the most.

So the proposed change will impact a small amount of investors and they may not participate, in the buyback in the future. But there’ll be other investors who can participate and they’re likely to pay more for those franking credits. And that allows the company to buyback more shares and that benefits all shareholders.

Sinead Rafferty: The payout ratio for Australian companies is much higher than the global norm. Do you think that potentially could change, if any changes come through?

John Woods: There’s no doubt that countries around the world, where there is an incentive for the corporate to target, after tax outcomes tend to have higher payout ratios. So in the US we tend to see much lower payout ratios in Australia. And in the US though, they still benefit from a capital gains discount. So what we’ve seen US corporates do is have more significant buybacks. And potentially over time, Australian shareholders will have their say. And they might encourage companies to return more capital by buybacks, than dividends in the future.

Sinead Rafferty: What about the potential impact for the MLC portfolios, particularly Inflation Plus, which is already underway to Australian shares. Do you think there’re any opportunities there that we could take advantage of?

John Woods: For Inflation Plus, we always seek to invest in the highest risk adjusted returns. And we take tax implications into account. With Australian shares particularly, as an asset allocation team, we control our asset allocation for Australian shares, all the way down to their security level. So it’s almost certain that all things won’t be equal, if this policy is enacted. And we might see investors, who are no longer able to claim those excess-franking credits, exiting those positions rapidly. And if that causes a disruption to the valuation, it’ll be an opportunity for us to acquire more of those shares in our portfolio.

Sinead Rafferty: Thanks for your time John.

John Woods: Thank you.

Sinead Rafferty: And thank you for joining us.