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June 2015

Myth-busting dividend imputationFidelity Worldwide Investmentment submission in response to Re:think tax discussion paper

© 2015 FIL Responsible Entity (Australia) Limited. Fidelity, Fidelity Worldwide Investment and the Fidelity Worldwide Investment logo and F symbol are trademarks of FIL Limited.

The decision to introduce dividend imputation has provided an unforeseen benefit for Australia, perhaps one that is still not fully appreciated by policy makers – it has made Australian companies manage their capital more efficiently. That makes them sounder investments.

Yet this benefit appears to be in jeopardy because the debate about the value of dividend imputation is obscured by myths. This submission by Fidelity seeks to puncture these illusions in the hope that policy makers will possess the information they need when judging the effectiveness of a tax system that has served Australia well since 1987.

NOTE: As well as drawing on published research, Fidelity commissioned Credit Suisse’s HOLT team to review the data to see if experience to date supports our view. We chose Credit Suisse because its HOLT methodology is extremely rigorous and adjusts for most of the distortions that can arise due to differences in regional accounting practices. Fortunately, the HOLT dataset is also long term, geographically extensive and robust. Excludes the metals and mining and information-technology sectors as a simple way to insulate the data from the impacts of the recent commodity and “dot com” booms. We looked at outcomes both before and after franking, using the time periods of 1982-1987 and 1988-2014. On every parameter we examined, the outcomes were as expected. We do not claim that this analysis has the rigour of a proper econometric study – nevertheless, the outcomes are highly suggestive.

Myth-busting dividend imputation – Fidelity Worldwide Investment 2

Myth 1: Franking is an anachronism; Australia should modernise its tax structure.Reality: Franking’s primary benefits – avoiding double taxation, removing the incentive for high levels of corporate debt – remain valid.

Myth 2: Franking is all about the tax refunds.Reality: Franking’s most important influence has been on capital allocation within the economy.

Myth 3: Australia has enjoyed extended economic growth. Franking has played no part in this.Reality: It is likely that franking has contributed to Australia’s lower economic volatility.

Myth 4: If Australian companies have higher payout ratios, it must be at the expense of capex – but we need more investment now, not less.Reality: Relative to US companies, Australian companies pay higher dividends and also invest more; the key difference is that Australian companies run their balance sheets more efficiently.

Myth 5: Franking promotes higher payouts, which reduces reinvestment and lowers future growth.Reality: Higher payouts indicate higher future earnings growth. There is no income-growth trade-off.

Myth 6: Franking turns the Australian stock market into a high-yield, low-price-return market.Reality: Higher dividend-paying share markets deliver higher price returns – even at the aggregate level. There is no income-growth trade-off.

Myth 7: Abolishing franking would boost government revenue.Reality: Franking creates integrity in the corporate tax base. Removing franking would give rise to behavioural changes that could significantly erode the corporate tax base, leaving the national accounts – and retirees – worse off.

Myth 8: Franking disadvantages Australian companies that earn significant overseas revenue.Reality: These companies benefit from the positive side effects of franking; empirical evidence does not suggest a disadvantage.

Myth 9: Franking creates a risky equity-market bias for retirees.Reality: Franking does create a bias toward high-quality, well-managed, cash-generating equities; this will help keep self-funded retirees off the aged pension.

Myth 10: Franking creates a risky home-market bias for retirees.Reality: Franking results in well-managed, high-returning, lower-volatility companies that are justifiably attractive to domestic and international investors.

Myth 11: Franking makes Australian shares less attractive to overseas investors.Reality: Corporate tax levels do not typically feature in investment decisions by foreign investors. Quality of operations and management are more significant, franking supports these.


Myth 1: Franking is an anachronism; Australia should modernise its tax structure.Reality: Franking’s primary benefits – avoiding double taxation, removing the incentive for high levels of corporate debt – remain valid.

Dividend imputation was introduced to avoid the unfairness of taxing company profits twice. That motivation still stands. Without franking, the interest expense deduction would be expected to have more influence in corporate funding. Since the introduction of franking, Australian companies have increased their gearing levels – in line with the secular decline in interest rates in the western world – but to a lesser extent than US companies have.

Pre-franking(1) Post-franking(2)

Corporate debt levels(3)

58%

10 year income return % (2005-2014)

19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%

AUS Adj US Adj AUS Adj US Adj

5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%

Corporate returns(12)

5.9% 5.6%


8.9%8.0%

Corporate returns adjusted(12)

42%34%

AUS ROW AUS ROW

70%

37%

Corporate dividend payouts(9)

4.8%5.4%


5.3% 5.0%

Corporate asset growth(10)

35%42%

Australian‘exporters’

Offshorecomparators

Median HOLT Debt/Equity (2005-2014)

13.3%11.9%


Offshorecomparators

Median CFROI (2005-2014)

4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators

Average income return% (2005-2014)

9.0%

3.4%

Australiancompanies

Offshorecomparators

Average price return% (2005-2014)

55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators

10 year price return % (2005-2014)

190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%

Shareholder returns(15)

0.4%

4.6%


4.5%

6.7%

Percent of companies showing persistance of high returns(14)

3.2%

0.5%


2.5%1.2%

Variance of returns(13)

Dividend Return Price Return


58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




Not creating further incentives for Australian corporates to take on more debt is highly desirable since negative gearing has created an incentive for high levels of borrowing by the household sector:

Australia(4) US(4)

Aggregate credit liabilities Aggregate credit liabilities

0

50

100

150

200

250

300

350

400

0

50

100

150

200

250

300

350

400

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

AUSTRALIA: AGGREGATE CREDIT LIABILITIES

% o

f GD

P

Total FinancialHouseholds GovernmentCorporate

US: AGGREGATE CREDIT LIABILITIES

0

50

100

150

200

250

300

350

400

0

50

100

150

200

250

300

350

400

1988

1991

1994

1997

2000

2003

2006

2009

2012

2015

% o

f GD

P

Total FinancialHouseholds GovernmentCorporate


Myth 2: Franking is all about the tax refunds.Reality: Franking’s most important influence has been on capital allocation within the economy.

Growth and innovation require that funds available for investment are channelled to the most promising opportunities. Franking facilitates this by automatically prompting companies that generate the most cash flow to pay it out, which allows shareholders to reinvest that cash flow into the best opportunities. Without franking, this capital-recycling process would be diminished due to the friction of corporate tax reducing the funds available to be reinvested.

This recycling is necessary in Australia, which is an economy of cash-flow “haves” and cash-flow “have nots”. As the charts below show, Australia has a greater proportion of its market comprised of larger companies. Further, smaller companies in the US tend to generate higher returns than their counterparts in Australia. This means that Australia’s smaller companies are more reliant on attracting the dividends flowing from the largest stocks.

Australia – S&PASX 200 Index by decile(5, 23)

65.1%

13.6% 7.9%

4.4% 3.0% 2.1% 1.5% 1.1% 0.9% 0.6%

10.9%

7.17% 9.3%

13.3% 11.7%

8.1% 9.9%

11.6%

6.0% 8.7%

S&P/ASX 200 Index by Decile

40% 100%

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10

Australia approximate cost of capital CFROI

5.5%

Prop

ortio

n of

Index

Mark

et C

ap (

%)

Med

ian

CFR

OI (

%)

20%

Proportion of index market cap

US – S&P 500 Index by decile(5, 23)

47.2%

16.4%

9.8% 7.1% 5.5% 4.2% 3.5% 2.8% 2.2% 1.4%

13.1% 14.2% 11.9% 11.2% 12.0% 11.2% 12.2%

13.6%

9.7% 7.9%

5.7%

40% 100%

D1 D2 D3 D4 D5 D6 D7 D8 D9 D10

Med

ian

CFR

OI (

%)

Prop

ortio

n of

Index

Mark

et C

ap (

%)

S&P 500 Index by Decile

US approximate cost of capital (RHS) CFROI (RHS)Proportion of index market cap

20%


Myth 3: Australia has enjoyed extended economic growth. Franking has played no part in this.Reality: It is likely that franking has contributed to Australia’s lower economic volatility.

Franking constrains corporate reinvestment. If we assume that companies will fund their best projects first, their second-best projects second, etc., then constrained reinvestment should result in better outcomes. If only the best projects are funded, then those projects are likely to be more robust through the economic cycle. At the margin, this likely brings greater stability to employment, consumer sentiment, etc.

As expected, corporate returns in Australia have improved, and have advanced more than returns in the US:

Pre-franking Post-franking


58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




This holds true even after excluding the anomalous mining and tech sectors:


58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




What’s more, the quality of returns has improved, as the variance of returns has diminished and the persistence of high returns has increased:

Variance of returns(6, 7)

58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




Percent of companies showing persistence of high returns(6, 8)

58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%





Myth 4: If Australian companies have higher payout ratios, it must be at the expense of capex – but we need more investment now, not less.Reality: Relative to US companies, Australian companies pay higher dividends and also invest more; the key difference is that Australian companies run their balance sheets more efficiently.

In this instance, it’s best to look at companies’ overall use of cash. Despite higher payouts (and higher interest expense), Australian companies do not spend less on capex. There is no evidence that higher payouts have led to lower levels of investment.

Australia USCash deployment (% of balance sheet cash)(9) Cash deployment (% of balance sheet cash)(9)

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1995

19

96

1997

19

98

1999

20

00

2001

20

02

2003

20

04

2005

20

06

2007

20

08

2009

20

10

2011

20

12

2013

20

14

% o

f Cash

Bala

nce

Dep

loye

d

Interest Expense R&D Expense Capex Share Repurchase Dividends

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

% o

f Cash

Bala

nce

Dep

loye

d


1995

19

96

1997

19

98

1999

20

00

2001

20

02

2003

20

04

2005

20

06

2007

20

08

2009

20

10

2011

20

12

2013

20

14

The significant difference between the two sets of companies is the “white space” – which is cash that is left undeployed. Australian companies run their balance sheets more efficiently than do US companies. This benefits the Australian economy.


Myth 5: Franking promotes higher payouts, which reduces reinvestment and lowers future growth.Reality: Higher payouts indicate higher future earnings growth – there is no income-growth trade-off.

Conventional wisdom holds that companies retain more earnings when growth opportunities are ample and fruitful. Therefore, the paying out of large amounts of dividends signals a paucity of good growth opportunities. However, academic analysis challenges this view. Arnott and Asness (2003) used 130 years’ worth of data to show that it is high-payout firms that generate the best earnings growth over time.(10)

The work of Zhou and Ruland (2006) supported the Arnott and Asness conclusion.(11) By using data over 50 years, their paper showed that high-dividend-payout companies tend to experience “strong, not weak, future earnings growth”.

Despite Australian companies increasing their payout ratios after the introduction of franking, asset growth rates have increased:



58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




Corporate asset growth(6, 13)

58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%





Myth 6: Franking turns the Australian market into a high-yield, low-price-return market.Reality: Higher dividend-paying share markets deliver higher price returns – even at the aggregate level. There is no income-growth trade-off.

Conventional wisdom assumes that high-dividend stocks offer low growth potential. The perception is that companies that return much of their earnings to shareholders have less to invest than companies that retain their profits. But again this is not supported by the data: over time, high-yielding stock markets have offered the highest total shareholder returns.

Analysis by the London Business School shows that the highest-yielding stock markets returned 13.5% p.a. from 1900 to 2010 versus 5.5% p.a. from the lowest-yielding markets. As the chart below shows, the highest-yielding markets were the top performers over every consecutive quarter-century period last century and over the first decade of the 21st century.

Returns of highest- to lowest-yielding stock markets since 1900 (%)Best returns from high dividend yield markets(14)

5.5 8.0 9.1

10.7 13.5

0

5

10

15

Lowest yield Lower yield Middling yield Higher yield Highest yield

1900–24 1900–2010 1925–49 1950–74 1975–99 2000–2010

Australia’s experience post-franking has shown a continuation of this trend:


Aggregate shareholder returns(15)

58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%





Myth 7: Abolishing franking would boost government revenue.Reality: Franking creates integrity in the corporate tax base. Removing franking would give rise to behavioural changes that could significantly erode the corporate tax base, leaving government finances – and retirees – worse off.

Australia is a first-world nation, with first-world community expectations for the services that its government will provide. As such, we can never compete with smaller or less-developed nations that offer low or even zero company tax rates to attract corporates.

Fortunately, the franking mechanism means that for the majority of companies, the corporate tax take – at whatever level it is set – washes through at the shareholder level. There is a subset of companies – those early stage, capital-consumptive, high-growth businesses that can profitably retain and reinvest every dollar they earn – that do not pay out their franking credits and thus would prefer a lower corporate tax rate. In theory, the risk is that these companies will relocate to a more favourable tax locale. But tax is not the sole variable. We must ensure that other policy settings (R&D tax settings, labour market flexibility, immigration flexibility, low bureaucratic “red tape”, etc.) work together to make the Australian community a great place to start – and grow – a business.

So a lower corporate tax rate could, at the margin, benefit and retain more of these mid-sized growth businesses. However, there is a different and very significant risk that must be taken into account. On a direct peer-group comparison basis, overseas companies exhibit more “lazy cash”. Intuitively, we suspect this is related to their reluctance to repatriate cash earned outside of the US into the US tax system.

Australian “exporters”(9, 16) Offshore comparators(9, 16)

Cash deployment (% of balance sheet cash) Cash deployment (% of balance sheet cash)

Cash Deployment

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

100%

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014


% o

f Cash

Bala

nce

Dep

loye

d

Cash Deployment

2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Interest Expense R&D Expense

Capex Share Repurchase Dividends

0% 10% 20% 30% 40% 50% 60% 70% 80% 90%

100%

% o

f Cash

Bala

nce

Dep

loye

d

However for Australian companies, franking creates a strong incentive for local exporters to retain a large tax liability within Australia, since franking credits are only generated on Australian tax paid. Thus franking limits the scourge of tax minimisation that erodes the corporate tax bases of other first-world nations. This highly beneficial incentive structure should not be given up lightly.


Myth 8: Franking disadvantages Australian companies that earn significant overseas revenue.Reality: These companies benefit from the positive side effects of franking; empirical evidence does not suggest a disadvantage.

Relative to their direct peers listed on other share markets, Australian companies with significant overseas revenue (“exporters”) show lower debt levels yet higher rates of asset growth:(16)

Median HOLT debt/equity (2005-2014)(17) Real asset growth (10-year CAGR)(18)

58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




6.1%

3.3%


Offshorecomparators

Real Asset Growth (10 year CAGR)

But they have delivered higher CFROI and enjoy a lower cost of capital:

Median CFROI (2005-2014)(4) Real WACC (2005-2014)(19)

58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




As a result, they have achieved a higher income return than their international peers – and a higher price return, resulting in a significantly higher total return.

Income Price

Average annual return % (2005-2014)(15)

5.8%

2.4%

Offshorecomparators

Average income return % (2005-2014)

9.2%

3.4%

Australian“exporters”

Offshorecomparators

Average price return % (2005-2014)

5.8% 5.5%


Australian domestically focussed companies

Average annual income return % (2005-2014)

9.2%

1.6%



Average annual price return % (2005-2014)


5.8%

2.4%

Offshorecomparators


9.2%

3.4%


Offshorecomparators


5.8% 5.5%




9.2%

1.6%





They have also outperformed their more domestically-focused Australian peer companies:

Income Price

Average annual return % (2005-2014)(15)

5.8%

2.4%

Offshorecomparators


9.2%

3.4%


Offshorecomparators


5.8% 5.5%




9.2%

1.6%





5.8%

2.4%

Offshorecomparators


9.2%

3.4%


Offshorecomparators


5.8% 5.5%




9.2%

1.6%





It is hard to see signs of disadvantage here.


Myth 9: Franking creates a risky equity-market bias for retirees.Reality: Franking does create a bias toward high-quality, well-managed, cash-generative equities; this will help keep self-funded retirees off the aged pension.

Superannuation funds do show a bias towards domestic equities:

Pension fund asset split(21)

0

5

10

15

20

25

30

35

40

45

50

0

5

10

15

20

25

30

35

40

45

50

1988 1991 1994 1997 2000 2003 2006 2009 2012 2015

% S

hare

Liquid BondsDomestic Equity Other* Foreign Equity

PENSION FUND ASSET SPLIT

* LARGELY RESERVES IN LIFE OFFICES. SPLIT OF FINANCIAL ASSETS

But at the SMSF level, this is directed towards the more stable end of the equity market. Credit Suisse research shows that self-managed super funds own about 16% of the Australian equity market.(22) Credit Suisse discussions with advisers to these funds suggests that these investors want high-dividend yields from large companies they identify with and have a history of dividend growth. They have a Tier-1 group of stocks that includes the big four banks and Telstra. The equity-ownership incentive created by franking does not prompt investment at the speculative end of the market, which lessens the risk of retirees experiencing permanent loss of capital. This exposure to quality, cash-generative growth assets is likely to help retirees maintain their purchasing power throughout an extended retirement, and avoid falling back on the aged pension.


Myth 10: Franking creates a risky home-market bias for retirees.Reality: Franking results in well-managed, high-returning, lower-volatility companies that are justifiably attractive to domestic and international investors.

Franking constrains the reinvestment behaviour of Australian companies. This results in leaner balance sheets, higher returns and lower volatility of returns. They are acutely aware of the importance of maintaining sound balance sheets and of achieving high returns not just fast growth. On the back of this – and deservedly for other reasons – Australian companies have developed a reputation for being well-managed.

As a result of this, Australian companies are favoured by international institutional investors, not just local retirees. This is evidenced by the cost of capital enjoyed by Australian companies, which is in line with that experienced by US companies.


Cost of capital(23)

58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




58%


19.5% 20.6%

AUS US AUS US

29.6% 32.5%


7.9%7.1%


5.7% 5.5%

Cost of capital(16)

4.2% 4.8%

AUS ROW AUS ROW

8.6%

6.2%


5.9% 5.6%


8.9%8.0%


42%34%

AUS ROW AUS ROW

70%

37%


4.8%5.4%


5.3% 5.0%


35%42%


Offshorecomparators


13.3%11.9%


Offshorecomparators


4.5%5.1%


Offshorecomparators

Real WACC (2005-2014)

3.2%

2.4%

Australiancompanies

Offshorecomparators


9.0%

3.4%

Australiancompanies

Offshorecomparators


55%

Australiancompanies

Offshorecomparators

92%

16%

Australiancompanies

Offshorecomparators


190%21%

212%31%

AUS ROW AUS ROW

935%

332%

453%

120%


0.4%

4.6%


4.5%

6.7%


3.2%

0.5%


2.5%1.2%




A low cost of capital benefits all Australian enterprises. It promotes entrepreneurship and capital formation.


Myth 11: Franking makes Australian shares less attractive to overseas investors.Reality: Corporate tax levels do not typically feature in investment decisions by foreign investors. Quality of operations and management are more significant; franking supports these.

Around the world, Fidelity Worldwide Investment has portfolio managers running global and regional portfolios. They use Fidelity’s renowned bottom-up investment process to select stocks. Because Australia is only a small percentage of their benchmark they generally have the discretion to ignore Australian stocks if none are compelling investments.

Their investment processes typically focus on a company’s sustainable competitive advantages and pricing power over its peers, the quality of management, the quality of the balance sheet and the stock’s valuations. Rarely would they look at comparative corporate tax rates before making an investment decision. The factors they do consider are generally improved by franking.

In fact, because of tax certainty due to zero witholding tax on franked dividends, franking is actually a simplifying factor for overseas investors.

Perhaps the only time that tax would come into consideration would be if a new tax, such as the recently proposed mining tax, was imminent or corporate tax levels were to rise to a large extent.

Australia’s dividend imputation system is a non-issue for global equity investors.


Notes and sources

1 Pre-franking 1982-1987

2 Post-franking 1988-2014

3 Corporate debt funding

Calculated as HOLT Debt (book debt plus HOLT capitalised debt items such as lease liabilities) divided by inflation adjusted gross investments.

CS HOLT

4 Aggregate credit liabilities

Credit liabilities excluding equity, as a share of GDP. Sources: Australian data, ABS. US data, BEA and the Federal Reserve, Minack Advisors.

5 CFROI CFROI (Cash Flow Return on Investment) is an estimate of the average real internal rate of return, earned by a firm on the portfolio of projects that constitute its operating assets. A firm’s CFROI can be directly compared against its real cost of capital (the investors’ real discount rate) to establish whether a firm is creating (or destroying) economic wealth. Importantly, CFROI values are also directly comparable across time, industries and countries. Key adjustments in the CFROI calculation include capitalising off balance sheet items (e.g., operating leases, pensions); capitalising research and development, adding back all non-cash items; accounting for inflation; and determining a company asset life (which assists with determining how much cash flow will be earned over a realistic time period).

CS HOLT

6 Corporate adjusted returns

Excludes the metals and mining and information-technology sectors as a simple way to insulate the data from the impacts of the recent commodity and “dot com” booms.

CS HOLT

7 Variance of returns Median CFROI variance over the stated period. CS HOLT

8 Persistence of high positive returns

HOLT’s “eCAP” measure stands for “Empirical Competitive Advantage Period” and is for firms that display unusually persistent CFROI. Competition tends to push CFROI towards the long term average which HOLT has empirically shown is 6.0%, but some firms display above-average CFROI persistence and are awarded eCAP status. With a greater level of stability in CFROI, HOLT projects a “fade” in these eCAP firms at a slower rate than non eCAP firms.

CS HOLT

9 Cash deployment Calculated as each Australian outflow item (e.g., interest expense, capex, dividend) divided by total Australian cash available for reinvestment (cash and investments).

Universe – Australian Top 250 Industrial Firms. Universe – US Top 1500 Industrial Firms.

CS HOLT

10 Robert D. Arnott and Clifford S. Asness “Surprise! Higher dividends = higher earnings growth.” Financial Analysts Journal, Volume 59, Number 1. 2003.

11 Ping Zhou, CFA, and William Ruland. “Dividend payout and future earnings growth.” Financial Analysts Journal. Volume 62. Number 3. 2006.

12 Corporate dividend payouts

Aggregate dividends paid divided by aggregate net income for each country/region.

CS HOLT

13 Corporate asset growth

Calculated as the average annual growth in each country/region, inflation- adjusted gross investments (i.e., HOLT assets that includes inflation adjusted book assets plus capitalised assets such as operating leases and R&D)

CS HOLT

14 Elroy Dimson, Paul Marsh and Mike Staunton, London Business School, 2011.


15 Shareholder returns

Price returns are the index returns when available, prior to index existence market cap weighted returns of initial constituent returns are used. Dividend yields are weighted by market capitalisation and do not include any franking credits. Universes used are the ASX 200 and the MSCI World Ex Australia.

Jefferies

16 Australian companies with significant overseas revenue

Classed as companies with more than 20% of revenue sourced from abroad. The international companies are the two companies most like them listed elsewhere in the world.

17 Median HOLT debt/equity

Company book debt plus HOLT debt and equivalents (operating lease liabilities, pension debt, market value of preferred stock, stock option claim) divided by equity.

CS HOLT

18 Real asset growth Real growth in inflation adjusted gross investment with intangibles. HOLT’s inflation adjusted gross investments includes net working capital, inflation adjusted land and improvements, inflation adjusted gross plant, capitalised operating leases, capitalised research and development, capitalised exploration, construction in progress, other non-current assets adjusted for pensions, and intangibles.

CS HOLT

19 Real WACC HOLT’s market derived discount rate which is a weighted average cost of capital. This cost of capital is a function of market observed equity and debt values and projected cash flows.

CS HOLT


List of foreign companies (from US unless stated otherwise)

List of Australian companies

Ace Amec Foster Wheeler (UK)American AirlinesAT&TBaxter InternationalBemisBerry PlasticsBG (UK)Capita (UK)Cathay Pacific (HK)Coca-Cola EnterprisesCoca-Cola Femsa (MEX)ConcoPhillipsConstellation BrandsDeutsche Telekom (GER)Domino’s Pizza (UK)Domino’s PizzaFactset Research SystemsFreeport-McMoranGlencore (UK)

Grifols (ESP)Harbour Centre Development (HK)Hogg Robinson (UK)Imerys (France) John Wood (UK)Lazard Louisiana-PacificMartin Marietta MaterialsMonster WorldwideSigma-AldrichSimon PropertySonova (CHE)Southern CopperThomas Cook (UK)Thomson-ReutersTravelers CosUnibail-Rodamco (FRA)Urbas Grupo Financiero (ESP)USGWilliam Demant (CNK)

AmcorBHP BillitonCoca-Cola AmatilCochlearComputershareDomino’s Pizza EnterprisesFlight CentreIressJames Hardie Industries

MacquarieQantas AirwaysQBE InsuranceRio TintoSeekSingapore TelecommunicationsTreasury Wine EstatesWoodside PetroleumWorleyParsons

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009 AFSL No. 409340 (“Fidelity Australia). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity Worldwide Investments.Restricted distribution – wholesale investors only.This document has been prepared solely for the purpose of making a submission in response to the tax White Paper and is intended as general information only. This document may include general commentary on market activity, industry or sector trends or other broad based economic or political conditions which should not be construed as investment advice. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The research and analysis used in this material is gathered by Fidelity for its use as an investment Manager and may have already been acted upon for its own purposes. Reference in this document to specific securities should not be constructed as a recommendation to buy or sell those securities but is included for the purposes of illustration only.This document may not be reproduced or transmitted without the prior written permission of Fidelity Australia.Fidelity, Fidelity Worldwide Investment, and the Fidelity Worldwide Investment and the F symbol are all trademarks of FIL Limited. © 2015 FIL Responsible Entity (Australia) Limited. 062015

www.fidelity.com.au

20 Australian domestically focused companies

Companies deriving less than 20% of their revenues from non-Australian sources: the list was not exhaustive, and discretion was used to ensure each sector was represented.

CS HOLT

21 Sources: ABS, Melbourne Institute, Minack Advisors.

22 Credit Suisse. “Rise of the Selfies”. Asia Pacfic/Australia Equity Research. 16 January 2014.

23 Cost of capital HOLT’s market-derived discount rate, which is a weighted average cost of capital. This cost of capital is a function of market observed equity and debt values and projected cash flows.

CS HOLT

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