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How would changes to dividend imputation impact LICs?

ETF Watch - Mar 17, 2018

Anyone with a passing interest in investing would have come across the Australian Labor Party’s recent announcement to overhaul Australia’s dividend imputation system if elected at the next Federal Election. We steer clear of politics here at ETF Watch, so will avoid philosophical debates on the merits of the proposal. Like most Government decisions of this nature there’s winners (the Federal Budget) and losers (low tax payers who receive dividend income). We’ll let the myriad of commentators with an opinion on the matter argue the pros and cons of such a policy.

In this post we’ll specifically take a look at Listed Investment Companies (LICs) and how such a policy would impact investors in these. One of the appeals of investors to LICs is that they often come with a stable fully franked dividend, meaning those investors who do not pay tax on income (SMSF Pensions and low income earners) are able to receive the regular dividends as well as a refund cheque from the ATO once a year when they claim their franking credits. For those who have not followed the Labor policy closely, they are essentially proposing to remove the refund cheque from these investors, with franking credits being able to be used to offset tax on income, but not to earn a tax rebate.

How do franked dividends work in LICs?

Their name gives it away. LICs are a type of company that invests in other (usually listed) companies. As a result, LICs pay tax in Australia just like any other companies, currently at 30% for companies with an annual turnover greater than $2m per annum. They can also choose to pay dividends to investors, and assuming they have been making a profit (or have retained franking credits) will pass the franking credit to the investor with the dividend payment. The investor can then use that franking credit to offset any tax payable, or if they are on a low tax rate, can receive a refund on the franking credit.

Why do investors love franked dividends in LICs?

In recent years LICs have built a reputation as providing investors with consistent, high yielding fully franked dividends. For an investor who relies on this to fund their lifestyle (eg a self directed investor), this allows them to forecast their income fairly accurately, and rely on dividend payments to fund their lifestyle. This wasn’t always the case though. Before 2010, LICs were not able to retain earnings, meaning they must have paid out what they earned each year. The result of this was lumpy, inconsistent returns, depending on the performance of the LIC that year. Whilst the returns would likely still be fully franked, the inconsistency in dividends made LICs not as attractive as they are today.

What’s the impact of Labor’s proposed changes on LIC dividend yield?

The simplest way to look at the before and after changes is with an example. In this example we’re going to assume the taxpayer is on the 0% tax bracket (ie a SMSF in pension phase or a low income earner). This is the group of investors which has the most to lose. The investor holds $10,000 in ABC LIC, which has a dividend yield of 5%, fully franked. The LIC choses to retain some of its profits, which represent 8% of the portfolio value.

  Current State After Proposed Changes
Value of Shares $10,000 $10,000
Company Profit $800 $800
Company Tax paid (30%) $240 $240
Net Profit After tax $540 $540
Dividend (franked) $500 $500
Franking Credit $214 $214
Taxable income $714 $714
Tax payable $0 $0
Tax Refund paid $214 $0
Total income received $714 $500
Total Income yield 7.14% 5%

Whilst the above example is simplistic, it shows how much the impact of franking credits can have on yield, with an increase of 2% annual yield in this case. This is the extreme case, with investors who pay tax potentially not affected by the change, as they have taxable income to offset the franking credits against.

Do LITs become a preferred alternate to LICs?

The sister to the Listed Investment Company (LIC) is the Listed Investment Trust (LIT). Whilst very few LITs exist on the ASX, they are becoming increasingly popular. LITs and LICs share many of the same characteristics, such as a close ended structure and the ability to trade at a discount or premium to their underlying Net Asset Value (NAV). The real difference is their tax structure. A LIT is a type of Trust, and Trusts don’t pay tax but must pass on all earnings they receive to their shareholders who then pay tax at their own marginal tax rate.

In the table below, we take a look at the difference in tax treatment of income for a LIC and LIT share holder assuming Labor’s proposed changes become reality. As we need to better understand the sources of income for this example, we’re going to assume that the entire income yield comprises of 60% fully franked dividends from the underlying companies invested in and 40% realised capital gains. We will also assume the 5% income yield is 100% of the company earnings.

  Listed Investment Company Listed Investment Trust
Value of Shares $10,000 $10,000
Franked Dividend Earnings $300 $300
Realised Capital Gains $200 $200
Company Tax Paid (30%) $150 $0
Franking credits received $90 $90
Net Profit After tax $440 N/A
Dividend $440 $500
Franking Credit $150 $90
Taxable income $590 $590
Tax payable $0 $0
Tax Refund paid $0 $0
Total income received $440 $500
Total Income yield 4.40% 5%

In the above example, the factor impacting the LIC investor is the proportion of the LIC earnings that are not fully franked dividends (ie the capital gains), as the LIC must pay  tax at the company tax rate for this, compared to the LIT who’s shareholder pays the tax, in this case $0. This means a higher impact to LICs with high portfolio turnover, or whose dividends they receive have less franking credits attached, such as an internationally focused LIC. As per the previous example, as the investor moves up the tax scale, the impact  becomes non-existent.

Will LITs become the preferred structure under a Labor Government?

It’s difficult to predict  what will happen if Labor win the next election and manage to get these changes through. The biggest disadvantage that LITs pose is their inability to provide consistency in their yield, with their annual distributions tied to the performance of the fund in the year the distribution is paid. Will low tax investors favour slightly higher yield over income consistency? That’s anyone’s guess.

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