Franking credits keep wheels turning

The sharemarket has settled into a consolidation phase at between 5400 and 5600 index points, mirroring changes in overseas markets. While analysts are confident the current reporting period will not produce unexpected changes to their forecasts, international political instability makes further upward movement in prices unlikely.
 
Compared with overseas markets - several of which are near record highs, largely because of historically low interest rates - the Australian market is supported by two important factors: the relatively high dividends available from quality companies, and Australia's taxation arrangements. All the major overseas markets operate with company tax arrangements that tax dividends twice - once in the hands of shareholders and again when shareholders receive dividends. Thus, even though their company tax rates may be lower than Australia's 30 percent, these shareholders pay more tax on their dividends.
 
These double taxation arrangements distort investment decisions in several ways. First, they encourage investments in trusts and other unincorporated entities. Second, they encourage companies to reinvest income, rather than distribute dividends to shareholders, on the basis that reinvested income will generate capital gains tax less heavily taxed in the hands of shareholders.
 
In the US, the distortions are large because overseas profits are taxed only when repatriated. This is why American companies have built up huge cash reserves overseas, which are being used to buy overseas assets in low-tax jurisdictions. Australia has been spared these distortions following the far-sighted decision in 1987 to remove the double taxation of dividends by introducing the imputation credit system.
 
Our income-tax system does not influence decisions whether to invest in a company or a trust structure, or discourage companies from paying dividends to shareholders. Compared with overseas tax arrangements, this is a major encouragement to residents who are eligible for imputation or franking credits to invest in shares.
 
Importantly also, international comparisons of price-earnings ratios do not accurately reflect the real value of Australian shares to local investors. For example, a local company with a P/E ratio of 14, paying an average tax rate of 30 percent, generates pre-tax earnings for investors of 10.1 percent of the share price, rather than the 7.1 percent of earnings suggested by the P/E ratio.
 
These tax arrangements, together with the fact that our market is still 20 percent below previous peak levels, provide a strong underpinning of our sharemarket that is not available from overseas investment. Owning shares becomes more attractive if the tax rate payable by investors is lower. An ageing population and continuing strong growth in superannuation assets will continue to increase demand for shares as long as the economy performs well. This will be true only if future governments continue to recognise the importance of retaining the imputation credit system.

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Daryl Dixon

Executive Chairman

Daryl Dixon is one of Australia’s foremost investment experts and a well known writer and consultant. He has provided trusted advice to thousands of personal clients over more than 25 years and is an acknowledged expert in the areas of tax, superannuation (including public sector superannuation), social security and investments.

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