By John Kehoe

Investors and tax advisers say the Albanese government is gradually chipping away at the distribution of franking credits to low-taxed superannuation funds and self-funded retirees.

The budget revealed that a loophole used by some of Australia’s largest companies, including BHP and banks, will be shut down for off-market share buybacks to stop the “streaming” of franked dividends to shareholders under a measure estimated to raise $550 million over three years.

But Treasury’s revenue estimate is deliberately conservative. University of Melbourne emeritus professor of finance Kevin Davis has estimated the alleged “tax rort” was possibly costing the budget as much as $2 billion in 2018 alone and about $500 million annually thereafter.

Professor Davis proposed the change to Treasury and said the final legislation was likely to ban using franked dividends as part of an off-market share buyback, to bring it into line with overseas.

Sandon Capital founder and chief investment officer Gabriel Radzyminski said the crackdown would stop companies undertaking off-market share buybacks and using fully franked dividends as a component.

“It’s been a huge feature for self-funded retirees to participate in off-market buybacks and companies have lost another tool to manage their capital to monetise franking credits,” Mr Radzyminski said.

“This risk is this is the thin end of the wedge and the signal that slowly but surely they’re going to further attack franking in the future.”

Wilson Asset Management chairman Geoff Wilson accused Labor of “breaking an election promise” not to change the franking system, after it ditched its more wide-ranging 2019 election policy of ending the refund of excess franking credits.

“If you break down who this impacts, unfortunately it is mum and dad investors, super funds and their beneficiaries, SMSFs [self-managed super funds] and lower income investors that get hurt by this change,” Mr Wilson said.

“Off-market buybacks have been an effective tool for listed companies to return capital to their shareholders and this legislation will prohibit any dividend component from being included in the buyback value, and therefore placing further restrictions on companies distributing franking credits to their shareholders.”

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

The surprise budget announcement will stop a tax-effective return of capital to shareholders under a strategy that has been pushed by institutional shareholders, including big superannuation funds, to maximise cashing in on franking credits and limiting their capital gains tax.

Off-market share buybacks give shareholders the option to sell their shares back to the company, often in Australia 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 to shareholders.

The strategy has allowed investors such as low-taxed super funds to receive extra franked dividends 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.

The only shareholders who typically take advantage of a buyback are investors who have a personal tax rate less than the company tax rate, such as super funds and self-managed retirees who can benefit the most from franking credits.

Australia is virtually the only country in the world where shareholders offer to sell their shares at a discount due to the existence of the dividend imputation system.

Low-tax and zero-tax shareholders such as superannuation funds, retirees and charities then receive franked dividends in return, as part of a mix of capital returns and franked dividends.

Institute of Public Accountants general manager for tax policy Tony Greco said the strategy had allowed the uneven distribution, or streaming, of franking credits.

“The uneven distribution of franking credits in a tax-advantaged way costs Treasury money, so we support this change at a time of ongoing structural budget deficits,” Mr Greco said.

In future, when an investor sells their shares to the company, it will be a capital gain transaction – consistent with on-market share buybacks.

About 32 listed companies have completed 47 off-market buyback transactions since 2006-07, according to Treasury.

Corporate tax lawyer Tony Watson said stopping off-market share buybacks “could be the first step to abandoning imputation”.

“It is a loophole that a company is able to buy back its shares by using franking credits rather than real money,” Mr Watson said.

“My guess is they could eventually get rid of dividend imputation and this could be just a step along the way.”

“They went to the 2019 election to scrap refunds, which I thought was a good idea.”

The latest change took effect from 7.30pm on budget night.

The budget measure follows a related measure to prevent companies using capital raisings to fund the payment of excess franking credits to shareholders.

Mr Wilson said: “Labor’s legislation on capital raising and franking distributions is designed to stop companies paying out franked dividends to shareholders where it is directly or indirectly linked to capital raising and this change announced in the budget now restricts companies from paying franked dividends to shareholders when they are returning capital,”

“Labor is on the same path they were on in 2019, only this time they are trying to disguise their attack on franking credits by limiting companies’ ability to manage their capital on behalf of shareholders, versus going after the shareholders directly.”

The United States, which doesn’t have a franking system, recently announced it would impose a tax on share buybacks to discourage the practice and encourage investment by companies.

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