Investors in hybrid securities issues, such as CommBank’s PERLS XI Capital Notes or the new issue announced by Westpac on Monday, Westpac Capital Notes 6, should consider carefully the impact of Bill Shorten’s proposed changes to franking credits. While there has been widespread  discussion about the potential impact on widely held bank shares and high dividend payers like Telstra, the hybrid securities market hasn’t rated much of a mention.

A fully franked distribution is critical to the return from a hybrid security, because the actual cash distribution component is adjusted down for this benefit. Westpac’s new hybrid, which looks likely to be priced at a margin of 3.7% over the 90-day bank bill rate, is set to pay a cash distribution for its first 90 days at a rate of just 4% pa. This is calculated by adding the margin of 3.7% to the current 90-day bank bill rate of 2% and then multiplying the sum by 0.7 (an adjustment factor derived from the company tax rate).

This distribution will be fully franked, so for self-funded retires drawing a pension from their SMSF, the  return is currently 5.7% pa when the franking credits are refunded. Take away the refunding, the 4% looks interesting but not particularly compelling. Better than a term deposit earning 2.5%, although much higher risk, but a lot less than the dividends on bank ordinary shares, which in some cases are yielding over 7%. Also, less than the distribution yield on some relatively lower volatility securities such as property trusts, Transurban and Sydney Airport.

This is one of the reasons that I advised caution on the CBA PERLS XI issue (see http://www.switzer.com.au/the-experts/paul-rickard/is-commbanks-new-hybrid-a-real-pearler/).

Of course, only some types of investors will be impacted by the change and as it is almost impossible to estimate just how many there are, the toll on the ASX-listed hybrid securities market is but a guess. My guess is that as a retail oriented market ideally suited to income investors, particularly SMSFs, the impact could be considerable. I am also assuming that the ALP  wins Government and that when presented as legislation to the Senate, it passes through the Senate crossbench without amendment. Still big assumptions.

That said, let’s make the assumptions and see who could be impacted.

Who is impacted?

Bill Shorten’s plan is to abolish the refunding in cash of excess franking credits. Only recipients of a government benefit (including a part aged pension) will be exempted.

Franking credits will still be applied as a tax offset and available to reduce tax, but they won’t be refundable. This means only some taxpayers are impacted.

Let’s take a couple of examples to show who is impacted. We will start with Mary, an individual paying tax at the highest rate of 47% (includes 2% Medicare Levy). Assume that the distribution on the hybrid  security is $70, and the attached (non-cash) franking credits are $30. Both the distribution in cash ($70) and the franking credits ($30) are taxable, so Mary’s taxable income is $100. At a rate of 47%, this means tax of $47 is payable. Next, the franking credits are applied for a second time, this time as a tax offset of $30. So, Mary’s net tax bill is reduced to $17.

Once Mary has paid tax, she is left with $53 in cash (the distribution of $70 less net tax of $17). As the franking credits have been used as a tax offset, there is no cash refund from the ATO.

Under Shorten, Mary is not impacted.

Next Jane, who’s paying tax at 34.5%. Assume the same distribution of $70, attached franking credits of $30, taxable income of $100. At a rate of 34.5%, she pays $34.50 in tax. Against this, she applies her franking credits as a tax offset of $30, leaving net tax to pay of $4.50. After paying this, she is left with $65.50 in cash. Again, as the franking credits have been used as a tax offset, there is no cash refund. Under Shorten, she is not impacted.

Let’s go to the other end of the tax scale and take Bob & Sally’s SMSF, which is fully in pension mode and has that fantastic tax rate of 0%. Assume the same cash distribution of $70, attached franking credits of $30 and taxable income of $100. At a rate of 0%, Bob & Sally’s SMSF pays $0.00 in tax. But the franking credits are still available to be used as a tax offset, and as there is no tax to pay, they are refunded in full by the ATO. Bob & Sally’s SMSF total return is $100, the $70 cash distribution and the $30 cash refund.

Under Shorten, the cash refund goes. The return to the SMSF drops from $100 to $70.

Other 0% taxpayers, such as a non-working spouse whose taxable income is less than $18,2000, would be similarly impacted.

Finally, the tricky example –  Fred & Grace’s SMSF in accumulation mode paying tax at 15%. Whether it will be impacted or not will depend on the fund’s asset mix.

Let’s assume  the same distribution of $70, franking credits of $30 and taxable income $100, and make a further assumption that all assets of the SMSF are fully franked shares or hybrid securities. Tax of $15 is assessed against the hybrid security (tax rate 15%), and against this, a tax offset of $30 is available. After application of the tax offset, no tax is payable, and there is an excess offset of $15 that could be refunded in cash. Potentially,  a return of $85 (the $70 cash distribution and $15 tax refund). 

As Fred & Grace’s SMSF is fully invested in franked shares, there won’t be any net tax to pay, so  excess tax offsets are refundable in cash by the ATO. Under Shorten’s plan where refunds will cease,  the return on the hybrid security will fall from $85 to $70.

If on the other hand, Fred & Grace’s SMSF had assets that don’t pay franked distributions, such as international shares, term deposits, property or cash, then they may not be in receipt of a cash refund. This is because the excess tax offsets from the hybrid security are being applied to reduce the tax payable on the income from those other assets. This won’t change under Bill Shorten’s proposal.

So, impacted are SMSFs in pension phase and other 0% rate taxpayers. Some SMSFs in accumulation phase will be impacted, while others won’t. High rate individual taxpayers won’t be impacted, nor will foreign investors and most Australian institutional investors.

But my sense is that SMSFs in both pension phase and accumulation phase are big investors in hybrid securities, and under Shorten, they won’t look particularly attractive investments.

If you are impacted, what can you do about it?

The answer is not a lot. Although the ALP softened its original position to provide an exemption for persons who are in receipt of a government benefit and an SMSF where at least one member was receiving a government benefit, in the case of an SMSF, it is not prospective (the SMSF had to be in this position prior to 28 March 2018). So, if your SMSF is already in pension mode, you can’t take any action.

One potential strategy for those approaching pension age is to invest outside super to maximise the tax-free income threshold of $18,200), while ensuring that you qualify for the age pension. To get under the assets test limit and qualify for a part pension, you may have to invest in the family home or spend (not gift) some of your funds. Seek the appropriate advice before contemplating this strategy – it could have some downsides.