Goals-Based Investing

How Labor’s proposal to change the dividend imputation system may impact retirees

By Jeff Rogers
Previous Chief Investment Officer, ipac (retired) Sydney, Australia

If the Labor Party’s proposal to reform the application of the dividend imputation system is legislated, it is likely to meaningfully reduce the after-tax return on Australian shares for a significant group of retirees. 

Here we address some of the implications of the policy proposal for retirees and the attainment of their financial goals.

Who is most impacted by these proposals?

The greatest impact will be on two groups of people whose investment income faces a zero (or very low average) rate of tax. 

The first group consists of current retirees whose preference is to hold their superannuation savings in a self-managed super fund (although there are some exemptions). 

The second group comprises households with direct investments in Australian shares who don’t qualify for the aged pension or other government assistance. While some members of this group may have other non-taxable sources of income, many in the group are older self-funded retirees whose savings are outside the superannuation system.

Why are the proposals so contentious?

There is an implication that those who are impacted have been “cleverly rorting” the system by taking advantage of loopholes in the current rules. That isn’t right. And those people who thought they were doing the right thing by deferring consumption to invest in domestic companies to sustain a self-funded retirement may be annoyed by that proposition. 

In addition, changing the rules around investment of retirement savings will weaken confidence in the retirement system and reduce the attractiveness of discretionary savings, the so-called third pillar of the system. 

Introducing these significant changes in rules has a disproportionate impact on retirees or those soon to leave the workforce. This group of people are solely reliant on their financial capital, so their primary response would need to be an adjustment to spending.

Why are high-income shares so attractive?

High-income Australian shares can be very attractive in the context of achieving retirement income goals. 

Traditionally, portfolio construction focusses on the trade-off between return and risk (measured as volatility relative to cash) on the capital under management. 

However, it is an entirely different matter when it comes to designing a strategy to provide confidence around meeting a retirement income goal, and where risk is characterised by a shortfall of income. 

A retiree, or someone heading into retirement, needs an investment strategy designed to fund cash flows. Using fixed income securities or an annuity (perhaps with residual value to provide a bequest) would be expensive. A traditional equity strategy is less expensive on average but exposes the retiree to considerable timing risk as capital will be required to be converted to cash on a regular basis and a cash flow shortfall might arise if markets are weak for a protracted period.   

That exposure to timing risk can be meaningfully mitigated by investment in companies with strong balance sheets and whose management returns free cash flow to shareholders through dividends (with franking credits attached). If the income from this equity portfolio can satisfy essential spending goals in retirement, then a retiree is largely insulated from timing risk as they aren’t forced sellers of shares. 

While young accumulators with distant retirement goals should probably focus on (global) companies with strong potential for long-term compound growth, things are different for retirees. For many retirees, an appropriate Australian equity income strategy can provide considerable confidence that they are on track to meet their retirement income goals.

Remind me how the dividend imputation system operates.

The dividend imputation system aims to ensure that the profits of Australian companies are only taxed once for Australian investors. To implement this system, imputation credits, equal in value to any company tax paid on the company’s profits, are attached to the dividends. These credits can be used to reduce any tax liability of the Australian investor. Calculation of that tax liability will of course include the investor’s share of company profit from which those dividends are derived. 

So Australian company tax is essentially a withholding tax. The actual amount of tax that an Australian investor ends up paying depends on their overall circumstances. This prevents the double taxation of dividends that would otherwise occur, first by the company and second by the shareholder.

What happens when the credits are larger than Australian tax liability?

Under the current system, if credits are larger than the tax liability then the investor receives a cash refund on the unused portion of franking credits. This adjusts for the fact that the companies in which they invested have effectively withheld too much tax on behalf of the Government. 

This system has been in place since 2000. Before that, from the inception of imputation system in 1987, there were no cash refunds for unused credits. The unusual feature of the system as it operated prior to 2000 was, in respect of the unused portion of the imputation credits, that the investor was effectively paying tax on the associated corporate profits at the company tax rate. These investors were therefore often paying more tax on those profits than offshore shareholders.

Will the proposed policy stop cash refunds of franking credits?

Well sort of, though not exactly. While the Labor party describes the payment of the cash refunds as a loophole which it intends to close, they still propose to allow several groups of investors to receive cash refunds. Exemptions include the Future Fund, together with charitable and religious organisations. 

Recently the Labor party has promised to exempt all individuals who are recipients of a Government pension or allowance as well as those self-managed superfunds which, before 28th March 2018, had a member on a Government pension or allowance.

Who would be impacted by the proposed policy?

While it is hard to be certain until legislation is drafted, there are two types of investor who are likely to be most impacted by the proposal. 

First, individual shareholders with a small portfolio of Australian shares and limited sources of other taxable income, but who don’t qualify for the exemption mentioned above, will be impacted. In contrast, individuals with large portfolios of Australian shares will be unaffected. 

Second, super funds with limited amounts of concessional contributions, with a high exposure to Australian shares, with losses or limited sources of other taxable income, or with a large proportion of members in pension mode will tend to be impacted. So a vast number of SMSFs are likely to be affected while industry super funds with a young member base are not going to be impacted. It is probably be the case that most other large super funds, including retail platforms, would be unaffected at present. However, as the superannuation system continues to mature, some of these large funds could find themselves increasingly impacted.

Are investors likely to change their approach?

It’s expected there will be behavioural change. Some SMSF and individuals may revise their investment strategies, selling their Australian shares and buying property trusts or infrastructure securities whose income (largely) isn’t withheld. In other cases, members of SMSFs may shift their portfolio of Australian shares to a large super fund which has sufficient taxable income to avoid any wastage of franking credits. And some individuals with personal holdings in Australian shares may be able to contribute those shares to a large super fund with the same favourable outcome. 

Finally, the recently announced revision that exempts individuals who are recipients of a Government pension will encourage people to re-arrange their affairs so that they become eligible (and maintain eligibility) for a part-pension earlier than might otherwise have been the case. This action enables these households to become fully entitled to the franking credits attached to dividends from their Australian shares.

How likely is it that we will see the proposal legislated?

For the proposal to be enacted, Labor will need to win the next election, then get the legislation drafted and passed through the Senate. So, while it is appropriate to consider the implications of the proposal it appears too early to act on it.

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Important notes

While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455)  (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.

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