Thanks to Labor’s intended changes on franking credits, there’s a growing number of companies looking at issuing special dividends — and no shortage of shareholders urging them on.
You may have noticed that several companies are moving [$], or being urged to move, to issue special dividends ahead of the next federal election.
They’re doing so because Labor is proposing to change the way franking credits work, or to be more particular, remove the dividend imputation on franking credits.
To understand what that means and why companies and their shareholders are looking around for special dividends before the election — you need to start at the beginning.
First of all, what are ‘franking credits’?
Generally speaking, people aren’t huge fans of paying tax twice.
When a company issues a dividend, it’s from a pool of money left over once the government gets its fill in the form of company taxes.
So, effectively, the pool of money from which a dividend has been issued has already been taxed.
When a dividend is distributed to shareholders, that dividend is counted as income for the shareholder. Therefore, they need to pay income tax on it.
That same money has now been taxed twice — and as stated above, people don’t generally like to be taxed twice.
So, the government brought in ‘franking credits’ as a way for this situation to be avoided.
When the government gets a pool of profit it takes company tax from, it then effectively marks that pool of money with ‘franking credits’ as a way to identify that money.
When a dividend is then drawn from that money, it comes with a franking credit attached — so it’s able to show the government that it’s already been taxed.
The government sees the credit, and doesn’t count that income as part of the shareholders’ income.
Make sense? Great. Because it’s about to get a bit more complicated.
What’s this ‘dividend imputation’ thing?
In 2001, the Howard government moved to institute a new rule to allow shareholders with a tax rate below the current company tax rate to not only not have their dividends not counted as part of their income — but get a cash refund for the credits they hold.
It was meant to make the whole dividend thing simpler for the Australian Tax Office and shareholders, not to mention make Australian shares a lot more attractive to invest in.
But it’s opened up a can of worms — particularly for those drawing down superannuation in retirement age.
Some people drawing down superannuation, either from a fund or their own self-managed superannuation fund, get tax concessions which lower the rate of tax they pay on their income.
They do this in a variety of ways, and you can read about them all here if you want to really do a deep-dive — but some are able to pay a grand total of zero tax on income from superannuation.
So, people who get taxed less than the prevailing tax rate can get a tax refund on their credits (once their tax obligations had been taken care of).
It’s this arrangement that Labor is seeking to get rid of, angering a lot of people who have managed their tax affairs around the current franking credit system.
Labor’s argument is that the Australian taxpayer should not be giving taxpayer money to a class of people who either don’t pay tax, or pay little in tax.
Suffice to say, it’s opened up a big ol’ can of worms — and with poll after poll indicating that Labor could very well get in at the next election, investors are getting nervous.
What companies and their shareholders are doing about it
This hand-wringing is why you’re starting to see companies issue special dividends to their shareholders, as a way to give them franking credits before the proposed legislation makes it to the floor of parliament.
Companies such as Australian Foundation Investment Company (ASX:AFI) and Brickworks (ASX:BKW) have issued snap dividends to their shareholders.
They’re betting that Labor will get in, and in any case, are giving shareholders the opportunity to cash in on the current franking credit system while it remains in place.
But companies aren’t obligated to issue a dividend with franking credits attached or issue a dividend at all — they can save them up for later use.
Wait, how does that work?
When a company’s profits are taxed by the Australian government, they are given franking credits for the rest.
But what if a company chooses to use the profit for something else — such as re-investment into research and development?
Those franking credits don’t disappear.
They’re held in an account by the company, and can be applied to any dividend the company may choose to issue in the future.
For example, it’s estimated that BHP Billiton (ASX:BHP) has a franking credit balance of $15.1 billion sitting in the back-pocket.
That means it could issue a $15.1 billion fully-franked dividend today if it chose to do so.
It probably won’t, but a shareholder can dream.
In any case, if a company has a surplus of franking credits in the account, you can expect to see shareholders make noise about a dividend.
That in itself could throw off a company’s cash management strategy, as it may not always be the best move to give money back to shareholders.
If a company is in a fast-moving industry such as tech, it may make more strategic sense to invest in further product development.
In the longer-run, that will create more value than giving shareholders an immediate gratification.
But as the odds of a labour victory in the upcoming election shorten, expect to see more shareholders wonder if they should be getting a better return from their boards.
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