Labor’s plan to limit the refundability of dividend franking credits could affect Australian securities worth $500 billion — almost a quarter of the Australian Securities Exchange — and it could lead some investors to take greater risks to replace lost income, according to Morgan Stanley.
Investors affected by the plan, mainly self-funded retirees focused on maximising after-tax income, may sell Rio Tinto, Wesfarmers and South32 in particular in favour of higher-yielding securities like hybrids, said Morgan Stanley’s head of wealth management research, Nathan Lim.
Based on Labor’s figure that it will claw back at least $5.6bn a year, and assuming a 3.95 per cent dividend yield for the S&P/ASX 300, franked at 57.5 per cent, Mr Lim said the value of shares and hybrid securities needed to generate such an amount of cash refund is well over $500bn.
“We are unable to verify the robustness of the ALP’s estimate, but on the surface we believe it is sufficient to say this policy change could affect a significant amount of capital.”
It comes after the Liberal Party leadership spill last month lifted the prospect of a Labor win.
“Of all Labor’s policies, the plan to limit dividend franking credits has generated significant investor attention,” Mr Lim said.
“To be clear, we do not forecast political outcomes, although we have observed that the incumbent Liberal-National Coalition has consistently trailed the ALP in the polls since the last election.”
The ALP has estimated that the current “flaw” in the franking system will cost the government up to $8bn a year, which is in their opinion unaffordable.
Initially set up to stop company profits from being taxed twice by the government — at the company level and again after shareholders receive their dividends — dividend imputation sees shareholders receive a credit as recognition that the company had already paid tax on the profits.
Labor says an issue arises when a shareholder pays no tax and the credit goes from reducing personal tax to a situation where the shareholder receives cash back from the government.
It has proposed that franking credits be ineligible for refundable tax offsets beyond reducing tax obligations to zero, but given a social benefit, charities, not-for-profit institutions and pension recipients will be exempt, reducing the estimated clawback to between $5.6bn and $5.8bn annually by 2021.
While acknowledging Labor’s proposal — that franking credits be ineligible for a refundable tax offset beyond reducing a tax obligation to zero — will reduce “distortions” in the risk/return relationship between particular groups of shares that have seen some investors receiving “outsized benefits” for the level of risk they incur, Mr Lim said some investors would be confronted with a difficult choice: do nothing and accept lower income, or take more risk to generate more income.
For Australian resident investors who aren’t taxpayers and therefore receive cash back from the government as a refund under the current system, the fully-franked yield from shares in the major banks and Telstra will be “very difficult to replace” if Labor’s policy is implemented.
“If you hold bank shares and are likely to be affected by the proposed changes, even at higher risk levels, there is little that can be purchased to replace your lost cash benefits from franking.”
Mr Lim said investors facing this dilemma weren’t likely to sell their bank shares as the incremental risk to get the additional return was likely to be too uncomfortable.
“If you hold hybrids, REITs and bank shares can potentially replace your lost income but at the cost of taking on higher risk,” Mr Lim said. “We are uncertain how many investors would make this adjustment though, given many investors treat hybrids as part of their defensive positioning.”
A petition started by Wilson Asset Management in May to maintain the dividend imputation system has received more than 13,500 signatures. In a poll of 3000 Australians, WAM found 27.9 per cent plan to spend their financial assets to qualify for the age pension asset test.
“Extrapolating this to the Australian public, Labor’s $55.7bn savings estimate is overstated by $16bn without accounting for the additional pension costs,” the fund manager said.
It also found that 68.5 per cent of respondents earn $90,000 or less annually and 52.9 per cent would be forced to reduce their family’s living standard and quality of life in order to accommodate for the dividend imputation changes.