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Franking changes to impact SMSFs and retail investors

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By Keith Ford
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4 minute read

According to a portfolio manager at a boutique investment management firm, the government’s proposed changes to franking credits could have unintended consequences.

In March, the federal government introduced the Treasury Laws Amendment (2023 Measures No. 1) Bill 2023 into Parliament, with franking credits derived from off-market share buybacks and capital raisings the target of the reforms.

Provisions include aligning the tax treatment of off-market share buybacks undertaken by listed companies with arrangements for on-market share buybacks. At present, part of the purchase price of an off-market share buyback can be reported as a dividend.

The reforms would also prevent certain distributions funded by capital raisings from being frankable, in a bid to ensure arrangements cannot be put in place to release franking credits that would “otherwise remain unused where they do not significantly change the financial position of the entity”.

According to Scott Kelly, portfolio manager for the DNR Capital Australian Equities Income Strategy, this legislation effectively aligns the tax treatment of off-market share buybacks with on-market share buybacks.

“There’s been very little industry pushback to the proposed reform and it’s likely to proceed in its current form,” Mr Kelly said.

"Historically, large companies have often raised capital from shareholders through fully underwritten capital raisings and then paid out all that money raised as a franked dividend.

“But the government wants to clamp down on this move so that a company will not be able to pay out franked dividends that are directly or indirectly funded by capital raising. And whilst at face value that may not seem unreasonable, a number of concerns about unintended consequences have been noted by industry.”

He said that the proposed test that would determine whether companies can pay out fully franked dividends would put start-ups at a disadvantage, as they “tend not to pay out dividends in the first few years of operations”.

“Secondly, the proposal appears to capture a dividend reinvestment plan, which is also a form of capital raising and this potentially could result in shareholders losing franking credits over time,” Mr Kelly said.

“And finally, companies will still be able to fund dividends by taking on debt. This potentially puts small companies at a disadvantage given their limited access to capital markets relative to larger companies.”

He added that there are also concerns over whether this initial change would just be the tip of the iceberg and lead to more broader changes.

“We believe that the proposed changes will reduce the effectiveness of Australia’s franking regime,” Mr Kelly said.

“In our view, those who will be most affected by the changes are self-funded retirees and retail investors, and those investors with low and marginal tax rates.

“For companies, under the new proposals, there’s the increased risk that franking credits will become permanently trapped within the companies.

“And there are also broader implications for the economy upon which Australia’s franking regime has supported investment and growth over time. We expect that franking rich companies will review and possibly increase dividend payout ratios and potentially also look to pay out special dividends more regularly.”

Following the Senate economics legislation committee’s June recommendation that the federal government review the legislative amendments that target franked distributions funded by capital raisings, the SMSF Association said it feared that the reforms would affect legitimate commercial activity and competitively disadvantage profitable and growing companies.

“This is a positive outcome, recognising what we argued in our submission – that the proposed amendments needed to be much more targeted,” SMSF Association chief executive Peter Burgess said at the time.

“The Senate committee’s decision now gives the government the opportunity to clarify the amendments to ensure they appropriately target the identified behaviour and not create a situation where legitimate business behaviour is unfairly penalised.

“As we argued in our submission, there are many legitimate situations where the dividend paid by a company would not pass the proposed established practice test and as a result, would be ineligible for franking.”