![The latest Telstra buyback was snapped up by investors because of its franking credits.](/content/dam/images/g/k/a/v/k/b/image.related.afrArticleLead.620x350.gs2hkk.png/1476689549677.jpg)
If one ever needed to gauge the pulling power of tax benefits for investors, the response to the most recent Telstra share buyback was a great case study.
The final deal was priced at a 14 per cent discount to the market and yet was so attractive to the company's hoard of shareholders that it achieved an 84 per cent scale back, implying that demand for the buyback far exceeded capacity.
Ignoring the investment merits of Telstra, the telecoms behemoth, for a moment – as shareholders evidently did in droves – one has to question why the deal was so popular. The answer is the same as for most of the 20 largest companies in Australia – franking credits.
The long game
It's elementary that a portfolio of assets needs to consist of more than a set of one-dimensional tax offsets focused on tax credits. However, targeting part of a self-managed superannuation portfolio to fully franked dividends can add substantially to performance over time. Here are three ways franking credits can be useful.
- Contributions tax. For a 55-year-old contributing $35,000 in concessional contributions this year, $5250 of these contributions will be paid out as contributions tax. However, if the SMSF held a portfolio of blue chip shares directly or through an exchange traded fund such as the Vanguard Australian High Yield vehicle, this tax bill would be substantially offset. Assuming the $5250 tax bill could be fully offset with franking credits and it was invested over 10 years with a 7 per cent annual return, it would double in value. If the cycle was repeated for each year of contributions through to the age of 65, the individual would bank an extra $19,000 in their super. This is before other income or capital growth are included.
- Fund earnings. If a fund realises capital gains, or other dividend income during the year, franking credits can serve to offset this income. Although this income is only taxed at 15 per cent – assuming a hold period of less than a year – franking credits operate presently at a corporate tax rate of 30 per cent for large companies. An investment in another high yielding ETF such as the BetaShares Dividend Harvester fund has generated up to 3.5 per cent in franking credits in the past year. Again, these franking credits offset taxes within the fund successfully.
- Pension phase. When your fund crosses the Rubicon into pension phase, franking credits take on an additional dimension where tax is fully offset, leading to those credits being refunded to your fund. Fully franked dividends from shares then become another income source, which means, in the case of shares such as Commonwealth Bank of Australia, 2 per cent a year on top of what is already a healthy dividend stream.
But no free lunch
Despite the clear attraction of franking credits as part of a portfolio, there are a number of aspects to consider.
- Aussie shares. In reality, this opportunity relates almost solely to Australian shares, and within that group, largely to ASX 20 stocks. Despite the clear income attraction of the ASX 20, the price of these assets has been underwhelming in the past 12 months, having underperformed the broader S&P;/ASX 200 by about 2.5 per cent. Put simply, a myopic focus on stocks that deliver decent franking credits will leave your portfolio exposed.
- Cash flow. Obtain franking credits requires the fund to lodge a tax return. Frequently this occurs well after the end of the financial year, meaning it could be 18 months after your fund was entitled to the credits that they are claimed and received as cash in the fund. However, this is a cash flow issue only in the first year, if you continue to hold these assets long term.
- Hold period. Importantly, to be entitled to franking credits, the fund must hold the assets for 45 days or 90 days for preference shares.
Asset allocation data from the Tax Office reminds us that blue chip Australian shares remain a stalwart of SMSF portfolios, and it's easy to see why. If you could generate an extra 1 per cent annual return in your fund from tax credits – depending on your weighting towards Australian shares – that would equate to a 10 per cent total return over 10 years. When you do the maths, it makes franking credits a worthy constituent of a portfolio.
Tony Davison is General Manager and Senior Financial Advisor at Henderson Maxwell. www.hendersonmaxwell.com.au