How CGT changes “level the playing field” for income investing

The easy answer for investors looking to avoid the capital gains tax changes announced in the budget would be to pivot their holdings towards income and away from growth.

Even before the official announcement of the changes, modelling was underway to understand how an inflation-adjusted treatment of capital gains would shape investment.

“By contrast the relative attractiveness of stocks where returns are more driven by their steady income streams become more interesting under the scenario where the 50% CGT discount is replaced by indexation,” UBS said.

“For investors, capital gains from growth equities will now be taxed at their full marginal rate (subject to inflation indexation and a 30% floor), rather than at an effective rate of roughly 23.5% for a 47% taxpayer,” Teh explains.

“In contrast, franked dividend income was already taxed at marginal rates. The structural tax advantage of deferring gains inside a growth portfolio has been significantly reduced.

“The effect is most pronounced for investors outside the superannuation system. For individual investors the attractiveness of high-yield, fully franked equities rises on a relative after-tax basis, with the benefit scaling with the marginal tax rate.”

The impact can be seen in the chart below, which compares two strategies earning the same 10% pre-tax return - a dividend strategy as 5% franked yield plus 5% growth and a growth strategy as 10% pure capital growth.

However, with an inflation-adjusted CGT system, the growth strategy’s after-tax returns drop by more than $2,400. In contrast, the dividend strategy barely changes.

Australia is already dividend heavy

While Teh notes that the current system “heavily favoured” growth investing, the dividend imputation system that was introduced in 1987 had already created a more attractive environment for Australian income investors than in other markets.

“The net result has meant that Australian equities typically pay a dividend yield which is double that of global stocks.”

“At the margin, the shift in tax incentives may tilt capital management decisions toward special dividends over share buybacks,” Teh explains.

“So, while the overall quantum of dividends is unlikely to surge, the composition of how excess capital is returned could gradually shift in income’s favour.”

“A few mitigating factors are worth noting. First, the changes are largely prospective. Gains accrued prior to 1 July 2027 retain the 50% discount, while post-2027 gains are indexed from the asset’s market value at that date rather than the original purchase price,” Teh says.

Secondly, the CGT changes don’t affect super funds, so the budget changes won’t “materially alter the calculus for superannuation capital allocation” for either accumulation or pension phase members.

“The rotation will be more visible at the individual retail investor level. For those holding growth equities in their own name outside of super, the after-tax comparison between capital growth and franked income has materially shifted,” Teh adds.

“The CGT changes amount to a straightforward tax grab on capital growth. The logical response is to shelter more capital within superannuation. However, there is a limit to this shelter as those with balances above $3 million will find the new legislated Division 296 tax ensures the government captures a share of that, too.”

Disincentives to growth

Given the franking credit system already provides an incentive for companies to distribute earnings rather than reinvest them in the business, Teh says there is a chance that even more money flowing into income equities could negatively impact long-term returns.

“This matters because Australia already suffers from chronically weak business investment and productivity growth relative to global peers. A tax system that further rewards distribution over reinvestment risks entrenching that structural weakness.”

What are the top yielding stocks?

• Bank of Queensland (BOQ): The bank has a market cap of $4.2 billion and delivered a 10-year average dividend yield of 6.2%.
• Stockland (SGP): The property group with a $9.7 billion market cap had an average dividend yield of 6.1%.
• Vicinity Centres (VCX): The REIT has a market cap of $11.3 billion and an average yield of 5.9%.
• ANZ Group (ANZ): The largest company on the list with a market cap of $111.3 billion, the Big Four bank had an average dividend yield of 5.8%.
• Aurizon (AZJ): The rail freight operator has a market cap of $6.8 billion and a dividend yield of 5.8%.