At yesterday’s meeting the RBA decided to keep official cash rates at the historic low of 1.50%p.a., and with the ‘little battler’ (our Australian dollar) still being resilient and trading between $0.75-$0.76 (vs. the USD), low cash rates look destined to continue for some time. As a result, the saver continues to be punished and the borrower rewarded, and for many self-funded retirees with their savings invested in term deposits, savings accounts or looking for the security of a capital stable or fixed income investment, this is not an ideal outcome.
As a result of the prevailing cash rates, investors are increasingly looking towards growth assets such as equities as a way to obtain more attractive levels of income. This is not ground breaking or a particularly new phenomenon, it’s been happening for a number of years now, however, with rates remaining low, the ‘flight to yield’ is only likely to increase. One aspect of investing in local equities, as most of you will be aware, is franking credits. Given we’ve just come out of the 30 June end of financial year period and many of us are eager to get those tax returns in to our accountants to see what we can get back from our friends at the ATO, I thought it was an ideal opportunity to briefly re-visit what franking is and why it is useful for investors who are holding Australian equities in their portfolios.
Franking came about due to tax reforms introduced under the Hawke-Keating government in 1987. Essentially, it was designed to prevent investors being taxed twice on investment income from company dividends. Until that point, when a company paid out a dividend from after-tax income (i.e income which it had already paid company tax on), then the investor who received this dividend ended up paying tax again at their own marginal rate. Franking basically allows the investor to receive a tax rebate on the company tax already paid. Prior to this reform, investors were in effect taxed twice. Post reform, investors receiving the dividend are effectively taxed the difference between the company tax rate of ~30% (which is already paid) and their own marginal rate. Makes sense once you say it out loud…
Most importantly, franking credits become more useful the lower your tax rate is. The lower your personal tax rate, the more powerful the franking credit as effectively you’re getting a cash refund on the franking credits you have received that you haven’t had to use to offset against the tax you may be paying on the dividends. Let’s think about this with regard to an SMSF that has moved into pension phase or even for a not-for-profit entity where your tax rate is zero: in this situation the value of a fully franked dividend is actually worth more than a dollar – based on current tax rates, your $1 is actually worth $1.43, whilst for an SMSF paying the 15% tax rate, the value of the fully franked dividend is $1.21. This concept isn’t new and I’m sure many of you have read endless other articles or heard fund managers and financial media commentators speak about franking, however it’s always important to consider it when you’re reviewing your investment returns.
For a practical example of franking credits, let’s look at the BetaShares Australian Dividend Harvester Fund (managed fund) (ASX: HVST). Because we’re talking about franking credits, I’ve used data from the 2015-16 financial year for illustrative purposes. For an analysis of the latest performance see my colleague Adam’s recent post here.
Performance comparison: HVST v S&P/ ASX 50: 1 year to June 2016
Source: BetaShares, Bloomberg. Past performance is not an indicator of future performance.
As we will describe below, the impact of franking credits had a significant impact on the Fund’s total returns. In terms of HVST’s pure price return over the financial year, HVST was -7.30% whilst at the same time the S&P/ASX 50 Index’s price return was similar, down -7.40%. The Fund’s income return for the financial year was 11.6% vs 4.8% compared to the S&P/ASX 50. Adding the two figures together, HVST delivered a total return over the period of +4.3% vs -2.6% for the S&P/ASX 50.
Now let’s look at what franking credits can do: over the 2015-16 year HVST paid out franking credits of 3.5% vs. 1.7% for the S&P/ASX 50. So adding 3.5% onto the total return figure above of 4.3%, for those taxpayers on zero tax rate, HVST’s “gross” total return over the year was 7.8% vs -0.9% of the S&P/ASX 50. The franking added a full 3.5% to the fund’s gross returns or an additional 1.8% for the year vs. the S&P/ASX 50.
So, as I’ve tried to demonstrate, franking credits are valuable additions to your portfolio – don’t ignore them! The actual amount of franking credits you have received will be displayed on the annual tax statement that you receive from your fund manager (we do our tax statements around the third week of July each year). Once you have these statements, make sure you pass them on to your accountant to include in the relevant year’s tax return in order to make sure you receive the benefits of your franking credits. If you are not required to complete a tax return, you can still access your franking credit rebates via the ATO and there is information on their website as to how to do that, otherwise call them and they can help.
So to sum it all up, frankly it could be dear if you don’t give a damn! Franking credits are important to keep in mind when thinking about your investments, and, in particular, when it comes to tax time.
Note: The above information should not be construed or relied on as tax advice and you should obtain professional, independent tax advice before taking any course of action.