Are We About to See a Flood of Dividends?

One of the big unknowns about the federal government’s capital gains tax changes is how companies will respond to a greater demand for dividends.

While the new capital gains tax approach doesn't really come into force until July 1 next year, already investors are voting with their feet and changing their portfolios to reduce the chance of larger capital gains in favour of earning tax advantaged dividends, as I explained here.

There has even been plenty of speculation about Alkane Resources (ASX: ALK) announcing the first dividend in the company’s 60 years as being at least partly inspired by the growing investor thirst for dividends.

Nobody really knows for sure except the board and management of the gold and antimony company that decided to pay out the fully franked dividend of $0.02 per share, but if a small company has the profits to pay a fully franked dividend—and also offers a dividend reinvestment scheme—it's highly likely that this will attract new investors.

It will be interesting to see if Alkane becomes the start of a new trend as small and mid-size companies try to pull any levers they can to increase investor interest.

Investors Voting with their Feet

Australian investors have already been piling into exchange traded funds that focus on dividends, bonds and cash as a response to the looming CGT changes.

According to ETF originator Betashares, money flowing into cash and fixed income ETFs more than doubled in June to $1 billion from $494 million in May.

The arithmetic around reducing potential capital gains and paying more profits out as dividends is quite clear and particularly pertinent because under the CGT changes investors will face a minimum 30% CGT on their gains even if they have a low or even zero marginal income tax rate.

Tax Tail Wagging the Dog?

Running your investments entirely on taxation outcomes is often a folly – just ask anyone who invested in tax advantaged tree farms – but ignoring tax is also foolish, which is why governments use tax changes to drive certain changes.

There can be some unusual unintended consequences and a preference by companies to pay out dividends rather than pumping up their share prices by retaining earnings or keeping some dry powder for expansion could well be one of them.

So, while the taxation tail should not wag the investment dog, we can expect to see some curious examples of investment opportunities specifically tailored for the changing CGT rules.

For a start, with investors crowding into dividend and income ETFs, it will come as no surprise to see more such funds coming to the market to meet investor demand.

It would also be no surprise if progressive companies looked to increase fully or partially franked dividends to increase their attraction to investors, even if it does come at the expense of higher share price levels which attract higher taxes.

Buybacks Discouraged

Such a strategy might discourage share buybacks, which can also boost share prices as the same earnings are spread across fewer shares.

What may also change is the practice for many companies to squirrel away franking credits for a rainy day in case they are needed as part of a special dividend or for some other corporate action.

Under the new CGT rules, any company stockpiling franking credits is effectively paying tax on earnings that their shareholders have not yet received.

In other words, they are providing a zero-interest loan to Treasury on those franking credits.

Time to Pause Dividends?

A company that decided to be really driven by the new tax rules could even stop paying dividends entirely under the current system and perhaps also pump up the share price with a share buy-back.

This would maximise their capital gains under the concessional, old system of paying CGT on just half of the gain.

Then, when the new system came in, they could help their shareholders from being exposed to above inflation capital gains by paying out higher dividends.

I doubt any companies will try that trick but perhaps the real danger of the new CGT system will be to deter investment in small companies that are not yet cash-flow positive.

Traditionally, these sort of early-stage companies such as mineral explorers or early stage drug researchers aim to pay back their investors with outsized capital gains when and if their growth allows them to become cash flow positive and then profitable.

It would be a tragedy if early-stage companies and new floats that are not able to pay dividends are discriminated against by investors simply because they can’t pull the dividend lever for many years.

The overall health of share markets is reduced when the growth of new innovative companies that may become the next generation of market leaders is supressed through tax policies that favour low growth, mature companies that pay fully-franked dividends.