Franking credits with less downside risk

Did you know that not all investors are eligible to claim the franking credits? There are a number of strategies investors may look to utilise to limit their exposure to a fall in the share price of their chosen stock, while remaining eligible to receive the franking credits.

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The dividend imputation or franking credit system was introduced to Australia in 1987 to eliminate the double-taxation of company profits. The new system allowed companies to attach “franking credits” – a tax credit representing the Australian tax already paid by the company – to dividends paid to their investors.

Franking credits were instantly popular with investors. The franking credits meant top marginal tax payers only need pay top up tax on dividends received – the difference between their marginal tax rate and the company tax rate, currently 30%. For investors with a marginal tax rate below 30%, the franking credits may be used to reduce their tax payable on other income. Some of these investors may even receive a refund from the ATO.

But did you know that not all investors are eligible to claim the franking credits? For example, offshore investors are not eligible. What about the rest of us?

For most of us, the holding period rule is simple. To claim the franking credits we need to hold the stock for 45 days excluding the dates of purchase and sale.

To prevent investors receiving franking credits without being exposed to the performance of the share price (a practice known as “dividend stripping”) the requirement to hold the stock “at risk” was introduced. “At risk” means the investor must have more than 30% exposure to a change in the share price.

There are a number of strategies investors may look to utilise to limit their exposure to a fall in the share price of their chosen stock while remaining eligible to receive the franking credits.

Where an investor has a positive outlook on the future share price

An investor with a positive outlook on a stock could consider buying the shares prior to the ex-dividend date. To protect the capital value of their share investment they may simultaneously buy European Put Options. European options may only be exercised on the Expiry Date. To illustrate, let’s assume the investor buys CBA shares at $83.18 on 14 February 2017. CBA is forecast to pay a $2.02 fully franked dividend. To be eligible to receive this dividend the investor needs to purchase the CBA shares prior to the ex-dividend date (forecast 21 February). To claim the franking credits ($0.866 per share) the investor must hold the stock at risk for a period of 45 days excluding the dates of purchase and sale. With a view to satisfying their holding period requirements, the investor purchases CBA Put Options with an Exercise Price of $83.18 and an Expiry Date of Monday 3 April 2017 (48 days). The Put Options cost $3.10.

The below table illustrates the pre-tax outcomes the investor would experience given various CBA share prices on the Expiry Date of the Put Options:

1 Return = “Pre-tax Profit/Loss” divided by the purchase price of the CBA shares ($83.18)

2 Annualised Return = Return divided by (48 days / 365 days). Please note, an annualised return assumes the investor is able to continuously reinvest funds at a consistent rate of return. To do this in practice, using the above strategy, the investor would need to make multiple investments in multiple stocks given the timing of dividends over the course of a year and continuously generate that consistent rate of return on each reinvestment of funds.

Where an investor has a neutral or slightly negative outlook on the future share price

Alternatively an investor with a neutral or slightly negative outlook could consider buying the shares prior to the ex-dividend date and selling European call options with an Expiry Date of 3 April 2017 (48 days).

To illustrate, let’s assume the investor buys CBA shares at $83.18 on 14 February 2017. CBA is forecast to pay a $2.02 fully franked dividend. To be eligible to receive this dividend the investor needs to purchase the CBA shares prior to the ex-dividend date (forecast 21 February). To claim the franking credits ($0.866 per share) the investor must hold the stock at risk for a period of 45 days excluding the dates of purchase and sale. With the view of satisfying their holding period requirements, the investor sells CBA European Call Options with an Exercise Price of $79.57 and an Expiry Date of Monday 3 April 2017 (48 days). Selling the Call Options generates Option Premium payable to the investor of $2.16.

The below table illustrates the pre-tax outcomes the investor would experience given various CBA share prices on the Expiry Date of the Call Options:

1 Return = “Pre-tax Profit/Loss” divided by the purchase price of the CBA shares ($83.18)

2 Annualised Return = Return divided by (48 days / 365 days). Please note, an annualised return assumes the investor is able to continuously reinvest funds at a consistent rate of return. To do this in practice, using the above strategy, the investor would need to make multiple investments in multiple stocks given the timing of dividends over the course of a year and continuously generate that consistent rate of return on each reinvestment of funds.

To find out how NAB can assist, contact your NAB Private Banker.

 

Disclaimer

This document has been prepared by National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (“NAB”) and is not intended to be relied on. Any advice contained in this document has been prepared without taking into account your objectives, financial situation or needs. Before acting on any information in this document, NAB recommends that you consider whether it is appropriate for your circumstances.  NAB recommends you consider the Equity Options and Approved Options with Loans Product Disclosure Statement  dated 10 June 2010 and the Supplementary Product Disclosure Statement dated 2 June 2014 (together, the PDS) which is available from NAB and which describes features and risks of the product, and seek independent professional advice before making any decisions regarding any product.  NAB is the product issuer. This document is prepared for the consideration of experienced wholesale investors only and NAB does not represent that any securities or services discussed are suitable for you or anyone. Any general tax information is intended as a guide only and is based on our general understanding of taxation laws. It is not intended to be a substitute for specialised taxation advice or an assessment of your liabilities, obligations or claim entitlements that arise, or could arise, under taxation law, and we recommend you consult with a registered tax agent.