If the Labor Party’s proposal to change the dividend imputation system is legislated, it will likely reduce the after-tax return on Australian shares for a significant group of retirees. Jeff Rogers, ipac CEO, explains the potential impacts.
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 SMSF retirees and the attainment of their financial goals.
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.
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.
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).
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.
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.
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.
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 SMSFs 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, SMSFs 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. Meanwhile, industry super funds with a young member base are not going to be impacted.
Are investors likely to change their approach?
It’s expected there will be behavioural change. Some SMSF investors may sell 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.
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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