Aussie shareholders love their dividends. Probably too much so, which can be dangerous in today’s low yield environment. Investors can often be lulled by high-yielding stocks with dividends that aren’t sustainable or are subject to enormous business risk. It can be an unpleasant discovery that shares in real companies don’t function at all like a cash deposit, and an extra 2% yield is small recompense if shares fall 30%.
Banks are a notorious example of businesses where investors tend to inappropriately fixate on dividend yield. They should be looking at the balance sheet, and thinking about business issues such as credit growth, bad debts and required capital ratios. They should also be thinking about disruptive threats to the traditional banking model.
So I had a quiet chuckle the other day when I read in the newspaper that ANZ was prepaying tax in order to maintain enough franking credits to fully frank its dividend (an allegation the company subsequently denied). It seemed a bit ridiculous, given the company has recently raised $3bn of new capital from shareholders in order to strengthen its capital base, that it was going to such extraordinary lengths to maintain a $5bn per year dividend. Why give with one hand and take with the other? Why not simply reduce the dividend to fund the extra capital?
Having spent a bit of time thinking, however, the joke is on me. What ANZ is doing makes perfect sense for shareholders.
ANZ could have funded the extra capital by cutting the dividend by around $1.04 per share. If they had done so, shareholders would have missed out on $0.44 of attached franking credits. The impact of this on shareholders depends on their marginal tax rate. To a shareholder that pays no income tax, $0.44 in value has been lost, assuming the franking credits aren’t later distributed, because they would have been fully rebated the franking credits. To a 15% tax payer, $0.22 in value is destroyed. For a 30% tax payer, there is no difference. And a 45% tax payer will actually benefit from the reduced dividend by avoiding $0.22 per share in additional income tax.
But the franked dividend has implications beyond this year’s income tax return. If ANZ cut the dividend by $1.04, every ANZ share effectively carries $1.04 in extra value through retained earnings. Each share has $1.04 more cash than if the dividend wasn’t cut. That $1.04 is eventually going to be taxable as capital gains, depending on when each shareholder trades their shares. Compared with the result had the dividends been paid out, corporate shareholders would theoretically pay an additional $0.31 in capital gains tax.
Here’s the benefit to various ANZ shareholders from not cutting the dividend by $1.04 (assuming 50% discount applicable to individual capital gains tax):
Income tax benefit | Eventual capital gains benefit | |
0% tax individual | + $0.44 | – |
15% tax superannuation | + $0.22 | + $0.104 |
30% tax corporate | nil | + $0.31 |
45% tax individual | – $0.22 | + $0.234 |
The exact value of the extra capital gains tax is debatable, because it depends on when the shares are eventually sold, and how the withheld cash is used in the meantime, but it’s sure worth something. And with that factored in, across various shareholder tax scenarios, it overwhelmingly makes sense for Australian companies to distribute as much as possible in franked dividends. If a company needs funding to grow, shareholders are much better off funding it by issuing new shares, rather than retaining earnings within each share. The simple way of thinking about this is that franking credits associated with retained earnings are usually lost forever.
The value maximising strategy is to pay out 100% of earnings as fully franked dividends and issue new shares to fund a business’s growth.
Of course, that doesn’t mean that investors should be fooled by high dividends. A company that is paying dividends while raising capital is not as valuable as one that is paying the same dividend without needing to raise capital. The dividend is still a furphy, just a very tax effective one.
Ideally (from a tax perspective) dividends should just be used as a franking credit clearing mechanism. Preferably as large, one-off payments to allow those who don’t suffer a tax penalty receiving dividends (eg pension mode super funds) to buy shares from those who do (eg individuals).
Not sure about the idea of prepaying tax to generate franking credits though. You’d want to be pretty confident it was just a short-term timing issue, not that you simply don’t have enough franking credits long-term to keep franking your dividend.
Finally, the other thing that impacts this analysis is any value placed on the franking credits by others. Selling to a pension mode super fund may generate more capital gains than just the cash value of the dividend (especially if the dividend is lumpier).
Nice to hear from you again Richard hope you are well! All true, the best strategy of all is to preferentially hand franked dividends to low tax investors. And ANZ prepaying tax, if that’s what they actually did, only makes sense if you are confident you will be generating sufficient franking credits long-term.
Nice article thanks. I always like to play the game where you study the fate of one dollar. Weather that be from an individual’s point of view deciding on the best structure to invest in, or businesses allocating capital.
As stated it makes a huge difference depending on what tax bracket the holder is in.
The large one off dividend run in the style of ARBs special dividends would be my choice. It’s obvious they want to retain the capital, they activate the DRP for that dividend only.
They also allow it to be either a DRP or bonus share payment. Although I believe that option is only available to some old companies. I’d appreciate some clarification on that and who can use the BSP as it appears to be a grey area.
Thank you Matt. Very enjoyable reading.
Franking credit explains why Aussie public companies have relatively higher dividend yield than those in other developed countries.
Thanks for the very interesting article Matt.
Could you please clarify the statement: “The simple way of thinking about this is that franking credits associated with retained earnings are usually lost forever.” I can see your analysis hinges on that assumption, but why is this so? I thought unused franking credits could be carried forward and used in future years?
Is it that a company with most of it’s earnings in Australia will never have enough untaxed earnings to which it can attach those franking credits in future years? Perhaps the assumption of the franking credits being lost doesn’t hold for a company with significant overseas earnings?
Cheers
Great question Franco,
You are correct that unused franking credits can be carried forward and used in future years. In practice however this doesn’t happen very often.
The reason is that companies need a lot of cash to distribute a big pile of franking credits, $7 cash for every $3 in franking credits distributed to be precise. When a company elects to retain earnings, it is usually investing that cash to grow the business.
That investment should itself eventually earn more cash of course, but it’s also likely to generate more franking credits. So you kind of never ‘catch up’ on the retained franking credits.
Matt, I think your analysis re franking credits is erroneous . Why I say this is because a franking credit of 30 cents is of same value to any person / smsf / corporation etc. All get a benefit of 30 cents . The only difference is some get is as 30c cash , some as 30c offset from their tax A/C and others a mix of cash and offset. Numerous advisors also claim as you do of the different value but I am pretty sure I am correct. In my case in pension SMSF mode I get 30c cash back but my family company gets 30c rebate off it’s tax liability and hence is also 30c better off. Possibly I am wrong , if so please explain where.
Thanks Rod, this is a really interesting point.
Probably the best way to explain is that, just as you say, $0.30 of distributed franking credits are worth $0.30 to all investors, on all tax rates, as a credit to their tax return each year.
But more broadly income itself, on a post-tax basis, is worth different amounts to investors on different tax rates. For example $1 of income is worth $1 to an investor on a zero tax rate, but only worth $0.55 to an investor on a 45% tax rate.
By choosing to retain earnings, a company basically forces all investors, on all tax rates, to value earnings at 70% of their pre-tax value (and also embeds an unrealised capital gain). If that income is instead distributed, low-tax investors can realise more value for it, say 85% of pre-tax value for a 15% tax-payer. It’s that difference between the corporate tax-rate and investor tax-rate that is critical.
It’s confusing!
But the heart of the matter appears to be a contrivance to offer a fully franked dividend.
So the business headline is ‘company tricks old age pensioners/retirees to pay high price for their shares’.
Thank you for provoking my Type II brain process! I still don’t get it, after re-reading a couple of times. I might be very very slow
“…Across various shareholder tax scenarios, it overwhelmingly makes sense for Australian companies to distribute as much as possible in franked dividends. ”
But, as Buffett harps on about, $1 of earnings retained in the right company should be worth much more than a $1 paid out because it can be reinvested and compounded continuously (hopefully at least for a long time) without a cent being paid in tax until some “infinite” point in time the future. Have I missed something, or is the franking credit overlay on this: “pay out or not pay out” question, simply a distraction from the real question: What is the long term ability of the business to compound retained earning?
Your article has made me question my fundamental capital allocation beliefs, but the penny has not dropped! I would much appreciate you spelling the conclusion out again in this context? I suspect other readers would too.
Hi Domenic,
Don’t worry, you don’t need to re-calibrate your capital allocation beliefs. Matt’s point is not that all companies should pay all of their cash out to shareholders – there are many businesses that can get much better investment returns by retaining capital. His point is that, even if you want to retain cash for future growth, you get a better tax result by paying the franking credits out. This is unlikely to ever happen in reality, but the most efficient approach is to pay the maximum amount out as fully franked dividends and then issue new shares to raise the funds (through a dividend reinvestment plan, for example) required for growth.
Don’t stress too much about it though, Matt was simply making a theoretical point about getting franking credits out of a corporate structure.