6 investments that just became more attractive under Labor's tax changes

When we recently modelled six hypothetical investors under Labor's new capital gains tax regime, one result stood out.

Income-focused investors like Dividend Dave generally fared better than growth-focused investors such as Growth Grace or Start-up Sam. In some scenarios, indexation eliminated capital gains tax altogether, while fully franked dividends continued to deliver tax-effective income.

So should investors rethink their portfolios and abandon growth in favour of income?

Not according to Viola Private Wealth's Daniel Kelly and Affluence Funds Management CEO Daryl Wilson.

Don't let the tax tail wag the investment dog

While both agree Labor's reforms have changed the relative attractiveness of different investments, they also argue the objective hasn't changed: maximise after-tax total returns — not simply minimise tax.

"In our view, overweighting income solely because of the tax changes could be a mistake," says Wilson.

"Comparing expected after-tax, risk-adjusted returns across a range of investments is our preferred approach. Looking only at the headline income yield or the tax rate on one component of the return may end up costing you money."

Kelly agrees, stressing that income investments are only relatively more attractive.

"We have not abandoned growth investments, alternatives or long-duration assets just because we lose the 50% CGT discount. Higher-returning asset classes generally remained higher-returning after tax," he says, pointing to the modelling below.

In other words, the tax reforms narrow the advantage previously enjoyed by growth assets — they don't suddenly make income investments superior.

Does Geoff Wilson have a point?

That brings us to one of the more interesting debates sparked by the reforms.

Wilson Asset Management founder Geoff Wilson recently argued investors may now be better off owning an investment delivering 3% capital growth and a 7% fully franked dividend yield than one producing the reverse.

Kelly says there is merit to that argument - but only to a point.

"It creates a stronger case than previously, but it does not automatically make the income investment superior," he says.

He illustrates the point with a simplified example.

• An investor on the top 47% marginal tax rate receiving a 10% return entirely as unfranked income would keep about 5.3% after tax.
• By comparison, a 10% capital gain, assuming 3% inflation and tax on only the 7% real gain, leaves roughly 6.7% after tax, while also retaining the benefit of tax deferral until the investment is sold.

"From a CIO perspective, I would therefore not choose the income asset simply because more of the return is distributed," Kelly says.

"I would compare the probability of achieving the return, downside risk, liquidity, duration, reinvestment opportunities and the sustainability of the cash flow. The new rules narrow the tax advantage ... but they do not eliminate the need to assess the quality of the underlying return."

Daryl Wilson also cautions investors against focusing on one component of return in isolation.

A 10% income return and a 10% capital gain may generate the same pre-tax return, but their after-tax value depends on the investor's tax rate, inflation, franking credits, available capital losses and when the investment is sold.

"Franking credits are useful, but they also result in grossed-up dividends which increase taxable income, while capital losses can reduce taxable capital gains but cannot be deducted against ordinary income," Wilson says.

"A low-income taxpayer may find franked dividends especially attractive up to a point. Those on higher incomes will probably still find the deferral and inflation protection elements of capital gains preferable."

The wrapper matters too

Wilson agrees private credit has become relatively more attractive, but argues investors should also think about how they own investments.

"There has been a general trend, which many investors may not have noticed, for LICs to pay a greater share of returns via income. This provides a clear point of difference over most ETFs," he says.

He notes the growing number of fixed-income listed investment trusts paying regular monthly income, the emergence of more equity-income LICs and a broader trend of listed investment companies increasing both the size and consistency of dividends.

Australian Foundation Investment Company's (ASX: AFI) recent decision to pay a higher final dividend and a special dividend - which was followed by an 8% rise in its share price - is one example he believes may encourage other LICs to follow suit.

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Three opportunities Wilson likes

Wilson believes Labor's reforms could breathe new life into parts of the market that have gradually shifted towards paying a greater share of returns through income. In particular, he sees opportunity in LICs and REITs, many of which combine attractive yields with discounted valuations.

1. Bailador Technology (ASX: BTI)

Wilson's first pick is Bailador Technology, a listed investment company focused on private technology businesses. It currently trades at around a 40% discount to net tangible assets, despite a strong long-term investment record, while offering investors a 7.4% cash dividend yield plus franking credits.

He believes the market continues to undervalue the quality of the portfolio.

"Semi-regular investment sales and other third-party events continue to support portfolio valuations, yet BTI currently trades at around a 40% discount to net asset value," Wilson says.

"Paul Wilson, David Kirk and the team have delivered well above-average results over quite a few years. The portfolio has been much less affected than many others by the recent pull-back in private equity valuations and the 'SaaSpocalypse'."

2. GDI Property (ASX: GDI)

Wilson also likes GDI Property, an A-REIT with a portfolio of office assets concentrated in Perth, one of Australia's strongest commercial property markets in recent years.

The trust currently offers an 8% cash distribution yield, but what makes it particularly interesting under the new tax regime is that a significant portion of those distributions has been tax deferred.

Rather than paying tax immediately, investors reduce their cost base, effectively deferring part of the tax until the investment is eventually sold.

"This can provide a very tax-effective outcome and is one reason why we might see REITs, including GDI, come more into favour over the next year or so," Wilson says.

3. BCI Minerals (ASX: BCI)

Wilson's final idea is quite different.

Unlike the first two investments, BCI Minerals isn't an income play today. Instead, he sees it as an example of a quality capital-growth investment that could eventually evolve into an income-producing business. It’s also core holding of one of his preferred LICs, Ryder Capital (ASX: RYD).

BCI is developing the Mardie Salt Project in Western Australia, one of the world's largest salt developments. While the market has remained patient through years of development, Wilson believes the investment case improves significantly once production begins.

"Right now, the market probably doesn't understand the very attractive potential returns that this project can generate for shareholders over the long term," he says.

If all goes to plan, Wilson believes BCI could reward investors in two stages: capital growth as the market re-rates the project during commissioning, followed by a growing stream of dividends once production and cash flows mature.

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Three areas Kelly believes have become relatively more attractive

While Wilson's ideas focus on individual stocks, Kelly prefers to think at the asset-class level.

Despite indexation improving the relative appeal of Australian equities, Kelly isn't abandoning global markets. He believes their superior return potential more than offsets the less favourable tax treatment.

“We still see the overall total return as being significantly more attractive in offshore markets - and certainly more than enough to overcome the tax treatment - so we remain relatively underweight the ASX," Kelly says.

But he points to three asset classes whose returns are largely delivered through income, making them relatively more attractive now that the tax advantage previously enjoyed by capital-growth assets has narrowed.

1. Private credit (listed or unlisted): Contractual yields typically range between 7% and 9%. “Its tax treatment has not improved under the new rules, but the tax advantage previously enjoyed by capital-growth assets has narrowed.”

2. Fixed interest: Investment-grade bonds can now generate around 5% to 7% while also providing diversification and liquidity. “Higher starting yields mean investors can now earn a more meaningful return from investment-grade bonds without taking the same level of equity or private-market risk.”

3. Unlisted infrastructure debt: Some funds target cash distributions of 8% to 10% with relatively low default rates. “The indexation model improves its relative appeal because a larger proportion of the return is delivered through income, but it does come with illiquidity and project risks.”

Paying less tax doesn't always make you richer

As tempting as it may be for Growth Grace to reinvent herself as Dividend Dave, paying less tax doesn't automatically leave you with more money.

The objective isn't to minimise tax. It's to maximise after-tax total returns. As Wilson puts it:

"A mediocre investment does not become attractive merely because less tax is payable."

Kelly reaches much the same conclusion.

"Although income investments are now relatively more favourable from a tax perspective, it is not suddenly the case that they are expected to outperform growth investments. The key word is relative."

It's a point Warren Buffett has been making for decades. The greatest fortunes aren't built by maximising income or minimising tax, but by allowing capital to compound over long periods.

Reflecting on Berkshire Hathaway's record of delivering ~20% since 1964, Buffett wrote last year:

"In a very minor way, Berkshire shareholders have participated in the American miracle by foregoing dividends, thereby electing to reinvest rather than consume.

Originally, this reinvestment was tiny, almost meaningless, but over time, it mushroomed, reflecting the mixture of a sustained culture of savings, combined with the magic of long-term compounding."