Labor’s franking credit changes raise bigger questions

To be sure, Labor’s proposed changes are more modest than its far bigger proposed crackdown on $11.4 billion of refundable franking credits that contributed to its 2019 election loss.

But the latest changes will still impact the capital markets and how companies fund and distribute dividends.

Labor’s first measure related to off-market share buybacks should be relatively uncontroversial.

Share buybacks give shareholders the option to sell their shares back to the company. This reduces the quantity of shares on issue among remaining shareholders who split the profits and receive higher earnings per share.

But oddly in Australia, shareholders have sometimes sold their shares “off market” to the company at a discount to the sharemarket price.

The companies have compensated the investors for the price shortfall by streaming franking credits as a large portion of a dividend and capital return.

The strategy has allowed investors such as low-taxed superannuation funds and self-funded retirees to receive extra cash refunds via franking credits and pay less capital gains tax on the return of capital.

The strategy is, in effect, a capital return, dressed up as a franked dividend, enabled by a share buyback.

But Labor’s second change to franking credits connected to capital raisings is more dubious.

Because shareholders have to opt in to a share buyback, the only shareholders who typically take advantage are investors such as superannuation funds who have a lower tax rate than the 30 per cent company tax rate.

Other taxpayers are effectively subsidising the streaming of franked dividends to select shareholders. Streaming of franking credits to certain shareholders has long been prohibited.

Companies including BHP, Rio Tinto, Commonwealth Bank of Australia, Westpac, Woolworths, JB Hi-Fi, Metcash and Caltex have legally used the off-market share buyback strategy.

University of Melbourne emeritus professor of finance Kevin Davis has estimated the tax minimisation strategy may have cost the budget as much as $2 billion in 2018 and about $500 million a year thereafter.

Treasury’s more conservative estimate is that the proposed change will save the budget about $200 million a year.

The change will sensibly align the tax treatment of off-market share buybacks with on-market share buybacks.

But Labor’s second change to franking credits connected to capital raisings is more dubious.

The measure was first proposed by Scott Morrison when he was treasurer in 2016, after the Australian Taxation Office raised concerns following a Tabcorp capital raising and special dividend in 2015. It was never legislated by the Coalition.

The change will potentially penalise shareholders of companies reinvesting their profits in expansion and not immediately paying out all profits as dividends.

For example, take Company A and Company B.

Both companies make a $100 million in profit and both companies pay the maximum corporate tax rate of 30 per cent, equal to $30 million.

Company A immediately distributes all the profits to shareholders, who also share in $30 million of franking credits to avoid double taxation.

Company B reinvests most of the profit in new plant, equipment, software and facilities to grow its business. It does not immediately pay a dividend to shareholders.

Some years later Company B has matured and wants to reward shareholders. But after its earlier investment spree, it does not have sufficient cash to pay a franked dividend and needs to raise equity to fund the distribution. It still has $30 million of franking credits on its balance sheet.

The key difference between Company A and Company B is the timing of when they paid a dividend to distribute the franking credits to shareholders to prevent double taxation. Money is fungible, after all.

Yet, under Labor’s change, the franking credits will be disallowed for shareholders in Company B if the purpose of the capital raising was to distribute the franking credits.

The law change will force companies reinvesting profits and growing quickly to waste franking credits. In effect, it will increase the cost of capital for high-investing companies.

The change will disincentivise the reinvestment of profits. It will encourage the immediate payout of franked dividends, at a time when business investment is needed to increase the economy’s productivity.

Moreover, the change will encourage companies to take on more debt to pay franked dividends.

Debt capital raisings will be allowed to fund the distribution of franking credits, but equity capital raisings will not.

The change may also impact dividend reinvestment plans by companies.

Treasury estimates the second measure will save a very minor $10 million a year, though tax experts and shareholders warn it could be more.

Finance academics Davis and Christine Brown - who support the first measure - strongly oppose the second change. They argue there is “nothing inherently wrong” with raising cash to pay out unused franking credits which are due to shareholders because company tax paid is a prepayment of investor level tax.

Moreover, the compliance red tape companies will face whenever they raise capital and pay dividends will add to the regulatory burden on the economy. Lawyers and consultants will be the winners.

More broadly, Labor’s latest intervention on franking credits raises a legitimate question about the long-term future of dividend imputation.

A tax review by former Treasury secretary Ken Henry, and the Productivity Commission, both called into question the economic value of dividend imputation in a more globalised investment world.

Only domestic shareholders, not foreign investors, benefit from franking credits.

On the positive side, tax advisers say dividend imputation encourages good tax compliance by local companies because domestic shareholders value franked dividends for company tax paid.

But offshore investors are arguably the marginal investor that business and policymakers should be trying to attract to deploy their capital in Australia.

To stimulate business investment, Henry and the commission suggested replacing the dividend imputation system with a new form of corporate taxation such as a business cash flow tax or allowance for corporate equity.

The benefit would be giving an immediate tax write-off for new investments and effectively taxing marginal investments making a normal rate of return at or near zero.

Such a bold reform would encourage new investment and attract more foreign investors to boost the economy’s capital deepening and productivity.