What companies should do after the CGT changes

Many Australian listed companies routinely disclose their ‘capital allocation framework’ on an attractive PowerPoint slide compiled by Doctorates of Clipart. They are statements of the obvious – companies can use their earnings to pay down debt, invest for the future, pay dividends or buy back shares. The Federal Government’s recent changes to capital gains tax (CGT) have upended ‘the obvious’ and we believe these frameworks must change.

This should not be surprising, as previous government policy changes resulted in big shifts in capital allocation policies. Witness the divergence in dividend payouts between Australia and the US after Australia’s dividend imputation system was introduced in July 1987, shown in the RBA chart below. Further divergence is now warranted, especially after 1 July 2027 when the CGT changes come into effect in Australia.

(VIEW LINK) RBA; Refinitive Datastream" class="">

The recent changes to CGT mean companies should adjust how they fund their businesses. This is a rare instance where all shareholders, no matter their marginal tax rate or whether they are public or private, will benefit from companies moving to pay out all of their earnings via (as franked as possible) dividends and using dividend reinvestment programmes (or other capital raising initiatives) to fund growth ambitions they have.

A worked example

To illustrate this, assume two identical companies, A and B, each valued at $100 today. Each company earns $10 this year. Company A chooses to pay out all these earnings via a fully franked dividend and Company B chooses to retain all its earnings to invest in a growth initiative. At the end of this year, ignoring any indexation or changes to the earnings prospects or earnings multiples of company A or B, Company A will still be valued at $100 (it paid out all of its earnings) and Company B will be valued at $110 (it retained all $10 of its earnings). Assume now that a shareholder sells their shares in both companies at the end of the first year.

No matter your tax rate, shareholders of Company A are better off after tax. This is probably easiest to illustrate for a 47% tax rate investor (but the difference is even greater the lower your tax rate). The investor in Company A pays $100 for their investment, gets $10 of franked dividends and sells their investment for $100. No capital gain is incurred. The investor’s return is a fully franked dividend of $10 and tax of $2.43 is payable ($10 / 0.7 x 47% - $10 / 0.7 x 30%) for a net return of $7.57 after tax (the net return is even greater for lower-tax-rate investors).

The investor in Company B makes a capital gain of $10 and earns no dividend. This is taxed at 47% for an after-tax gain of $5.30, 30% worse than the investor in Company A.

What should companies do?

Australian companies should therefore, all else equal, prioritise dividends over any earnings retentions for growth purposes. This is obviously impractical - companies need to be able to retain some earnings to invest, or to maintain or grow their competitive position. And there’s the rub. Even despite this, companies should still pay out all their earnings as dividends and embark on dividend reinvestment plans (DRPs) to fund their growth.

To illustrate this, let’s assume that Company B still needs $10 to invest in a growth initiative. But it is smart enough to realise that its shareholders will be better off from an after-tax perspective if all its earnings are paid out in dividends. An underwritten DRP provides the solution. Here an investor buys the company for $100, receives $10 in franked dividends and then chooses to reinvest their entire dividend back into the company. If we assume that the shareholder sells their investment at the end of the first year after the receipt of the dividend, most of the maths is the same, but the after-tax outcome will mirror that of an investor in Company A. This is because there is no capital gain. The tax cost base of Company B is increased by the reinvestment of the dividend.

Prior to 30 June 2027, given the transitional arrangements to the new regime, Australian companies should not pay out any dividends and instead use these retentions to buy back as many of their shares as possible. At worst this would be an after-tax neutral scenario, but it would certainly maximise the potential for maximum franked dividends per share post 30 June 2027 and shift more capital gains into the discounted regime which applies today.

Other than the negative unintended consequences that Treasury’s CGT changes will bring about (and which we wrote about here) you do have to wonder if Treasury’s piggy bank will be fuller or emptier following these CGT changes.

Today, companies retain a handsome portion of their earnings and the system’s franking balances keep accumulating. Effectively, shareholders are paying tax on a portion of the earnings they haven’t yet received (via the 30% corporate tax rate), or to mirror the recent words of a Treasury official, shareholders are providing a zero-interest loan to Treasury on those franking credits. If companies do as we hope they will, and as the incentives suggest they should, all of these franking credits and the tax benefits associated with them will be passed on to shareholders in full. It is quite possible the Treasury fiscal take actually goes backwards.

In fact, the only winners here will likely be the investment bankers who run the DRPs or raise capital for companies. Way to go Treasury!

Appendix: workings

Table 1: Company A pays a dividend and Company B retains its earnings

Table 2: Both companies pay a dividend and Company B has DRP

Disclaimer: The information in this article is of a general nature only. It is not personal financial product, tax, legal, or investment advice. It has been prepared without taking into account your individual objectives, financial situation or needs.