How to use franking credits to reduce your tax bill

Investors should consider the after-tax performance of their assets in relation to franking credits, writes Aaron Minney.

There is an increasing demand from investors to consider the after-tax performance of their assets.

The Financial Times Stock Exchange and the Association of Superannuation Funds of Australia joined forces last year to launch the first after-tax benchmarks for the Australian equity market, which has already had client take-up.

In this tax-aware environment, franking credits are very attractive since they can reduce your tax bill and raise the after-tax return on your investment.

However, recent research undertaken by Colonial First State Global Asset Management has some interesting results with regard to the tax effectiveness of loading up a portfolio with franking credits.

Franking credits are valuable to shareholders. They represent the tax that a company has already paid on their dividends, and reduce the tax bill for shareholders — and in some cases even generate a refund.

Individual investors need to consider this value when looking at a stock investment. The market does. It places a value on any franking credit that is paid — similarly to the way the market values dividends.

Indeed, the two are linked. Before a dividend is received, the stock is said to go ‘ex-div’ — meaning new buyers are no longer entitled to the coming dividend payment and any associated franking credit.

The market valuation of the dividend can be seen in the drop in the share price between the time when the stock is entitled (‘cum-div’) to when it trades ex-div.

This fall is most of, but usually not the full, dividend entitlement (and any attached franking credit).

The impact of tax is a key reason for why the market adjustment is never complete. Dividends are taxed as income, whereas there is a discount available on the tax of any capital gains on the share price.

Without access to the tax discount, taxpaying shareholders demand a discount on the dividend in order to receive an equivalent after-tax return.

At question is whether the drop in the share price takes into account the franking credit of the dividend or not. At face value, this is not clear, because the discount is applied to the gross dividend (the combination of the cash dividend and the franking credit, both of which are added to the shareholder’s taxable income).

The latest research indicates that the franking credit has been taken into account by the market.

There are different experiences across different stocks. The extent to which the franking credit has been factored into the stock price varies dramatically.

For large liquid stocks with high levels of franking credits, there is a large portion of the franking credit that is captured in market prices.

For small companies, or those with only a small amount of franking credit, the market is less aggressive in factoring the franking credit into the stock price.

For the three years to June 2009, the market adjustment for an ASX 100 stock with a high franking credit (eg, banks and insurers) was around 85 per cent of the gross dividend (cash dividend plus the franking credit).

The adjustment was only 36 per cent of the gross dividend when there was only a small amount of franking available, which happens with companies with a lot of offshore earnings (such as the large miners).

The after-tax return is impacted by these discounts, as well as the benefit of the franking credit.

Indeed, some individual taxpayers are worse off after tax when they receive a fully franked dividend where the market extracts the 85 per cent of the value, because the benefit they miss from the discounted capital gain would have been greater.

On the other hand, when you are effectively only paying a little over a third of the value of the dividend it is easy to see how, even after paying tax on the gain, you will be better off.

The research does not completely explain why this is the case.

However, when you consider the actions of some participants in the market, it is easier to understand.

Some investors who are aware of the value of franking credits have targeted stocks with franking credits in order to capture the after-tax benefit.

In effect, they have been prepared to pay for the after-tax benefit even though it is costly under most (pre-tax) performance measures to do so.

There are even unitised products available to retail investors that do this to some extent.

There are enough of these investors that there has been a bidding war resulting in the value of the franking credit being captured in market prices.

Indeed, in some cases they seem to be above market prices. When investing this way it is not possible to invest in every stock, so these franking credit chasers have concentrated on stocks that have high levels of franking credits, thinking that they will get a bigger benefit.

In fact, and because of their actions, the benefit that has been available is generally in stocks that have not been chased — that is, the stocks with small amounts of franking.

There are three key take-home points from this research for investors:

• Be aware. The market makes you pay for any franking credit you potentially receive, so make sure that you value the credit and do not waste it;
• Don’t chase. Investors should not chase stocks with high franking in order to improve their after-tax returns. The benefit is now marginal, and it limits the scope of the investors to hold other stocks where the franking credit may be lower but the after-tax return benefits greater;
• Understand the asset. As with any investment decision, there needs to be a careful consideration of the underlying reason for holding an asset. You should only buy an investment when you understand — and desire — its fundamental characteristics.

Aaron Minney is head of investment research and development at Colonial First State Global Asset Management.