Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 231

LICs: Traders versus investors for tax purposes

The introduction of the Future of Financial Advice (FOFA) reforms and the increase in SMSFs has seen listed investment companies (LICs) surge in popularity over recent years. Investors can gain exposure to a diverse portfolio of assets through around 100 LICs listed on the ASX. These LICs can be categorised in various ways, including by their asset class, market cap of investee companies, investment style, and whether they are internally or externally managed.

Not commonly discussed is the distinction between LICs that are deemed by the ATO to be ‘investors’ for tax purposes, versus LICs that are ‘traders’. The key differences between these two types of LICs relate to tax, franking, and dividends.

Investors for tax purposes

Many of Australia’s older LICs are investors for tax purposes. These include AFIC (ASX: AFI), which was established in 1928, and Argo Investments (ASX: ARG), founded in 1946. Investors for tax purposes tend to buy investments and hold them for the medium-to-long term. To maintain their status as an investor for tax purposes, these LICs generally turnover 10% or less of their investment portfolios each year. This type of LIC is typically suited to investment managers with a long-term investment horizon and low portfolio turnover.

For accounting purposes, LICs that are investors for tax purposes record movements in the value of their investment portfolios through the balance sheet, rather than the profit and loss statement.

Tax and franked dividends

The franked dividends these LICs pay shareholders are primarily derived from franked dividends received from the companies in the investment portfolio. These dividends are sometimes called ‘flow through’ dividends. When a LIC which is an investor for tax purposes realises (sells) an investment for a capital profit, the LIC can potentially pay a dividend to shareholders that includes a capital gain component. This is called a LIC capital gain dividend. This allows shareholders to claim the capital gains tax (CGT) discount as though they directly owned and sold the shares in the LIC’s underlying investee company. Over and above the benefit of franking flowing through the cash yield paid by the LIC, the capital gain component can be used to further reduce shareholders’ tax liability.

Traders for tax purposes

Many of the ASX's newer LICs are traders for tax purposes. These include the LICs we manage at Wilson Asset Management, such as WAM Capital (ASX: WAM) and WAM Leaders (ASX: WLE). LICs that are traders for tax purposes typically have higher turnover of their portfolios and are often employed by managers with a more active investment style.

LICs that are traders for tax purposes record mark-to-market movements in the value of their investment portfolios through the profit and loss statement, as opposed to the balance sheet.

Tax and franked dividends

Traders for tax purposes can pay dividends out of profits from realised gains, mark-to-market movements in the value of the investment portfolio and dividend income from investee companies. This increases their ability to pay a steadily-increasing stream of fully franked dividends which is particularly appealing to SMSF investors seeking a consistent yield.

Traders for tax purposes rely predominantly on paying corporate tax on realised gains to generate franking credits to attach to dividends paid to shareholders. These LICs derive some additional franking and dividend income from Australian investee companies in their portfolio.

Summary of key differences

 Investors for tax purposesTraders for tax purposes
TurnoverTypically low turnover of investment portfolio (below 10% p.a.)Higher turnover of investment portfolio
Portfolio movementsMovements in the value of their investment portfolios through the balance sheetMark-to-market movements in the value of their investment portfolios through the profit and loss statement
Franking credits Franking credits primarily generated from investee companiesFranking credits primarily generated by paying corporate tax on realised gains
Sources of dividend paymentsPrimarily derived from dividends received from investee companiesDerived from dividends received from investee companies, realised gains, and mark-to-market movements on the investment portfolio
LIC capital gain dividendCan pay a LIC capital gain dividendCannot pay a LIC capital gain dividend

 

Implications for investors

These different types of LICs provide advantages and disadvantages for shareholders and investment managers alike.

Investors should consider their financial objectives and circumstances, including tax implications of owning shares in each type of LIC. While investors for tax purposes and traders for tax purposes are distinct from one another in some regards, both offer the benefits of the LIC investment structure which make them popular with investors. These benefits include the ability to pay a steadily-increasing stream of fully franked dividends, transparency, accountability, and a closed-end pool of capital allowing the investment manager to make rational investment decisions.

[Register for our free weekly newsletter and receive our latest ebook, Cuffelinks Showcase]

 

Chris Stott is the Chief Investment Officer of Wilson Asset Management. This article is for general information only and does not consider the specific circumstances of any individual.

7 Comments
Richard M
December 15, 2017

How does an intending purchaser of LIC shares determine whether the LIC is a trader for tax purposes or an investor?

Graeme
December 17, 2017

Best bet Richard is to contact the manager and ask them. They may, however, only be able to answer what historically has been the case, hence my questions above.

Simon
December 15, 2017

Good point Tom. If and when we get to the point where there aren't enough profits to pay the dividends, those LICs trading at big premiums to NTA will swing to discounts, thereby inflicting a double whammy hit to shareholders - reduced or no dividend, and big capital erosion. Could end up like the way things panned out for Telstra holders who thought the dividend was bulletproof....

Graeme
December 17, 2017

Simon; Like all shares, the 'price' of a listed fund will usually trade at a premium or discount to its 'value', sometimes large. Even the non-trading ones may trade at a discount, albeit a smaller one, if dividends in general are cut, or even just not expected to grow in a recession. One of the charms of listed funds is to be able to take advantage of this. If you're worried about a "double wammy hit", then buy an unlisted fund.

Tom
December 14, 2017

Thanks Chris - good comparison. So if trading LIC's basically manufacture their yield, how sustainable is that in a market downturn?

Graeme
December 14, 2017

Para. 2 indicates that it is the ATO that determines whether a LIC is a trader or investor for tax purposes. Do they decide this every year based on portfolio turnover for the latest financial year?

WAX was an investor up to and including 2013/14 and has been a trader each year since. Does this mean they have had a higher portfolio turnover for each of the last three years than 2013/14 and prior years? Would WAX be deemed to be to an investor for any low turnover year in the future?

Doug
December 14, 2017

Can you explain how mark to market movements generate franked dividends?
Thanks,
Doug

 

Leave a Comment:

     

RELATED ARTICLES

How long can your LICs continue to pay dividends?

Four simple strategies deliver long-term investing comfort

Who's next? Discounts on LICs force managers to pivot

banner

Most viewed in recent weeks

The risk-return tradeoff: What’s the right asset mix for a 5% return?

Conservative investors are forced to choose between protecting capital and accepting lower income while drawing down capital to maintain living standards or taking additional risk. How can you strike a balance?

How long will my retirement savings last?

Many self-funded retirees will outlive their savings as most men and women now aged 65 will survive at least another 20 years. Compare your spending with how much you earn to see how long your money will last.

Buffett's favourite indicator versus all-in equities

Peter Thornhill shows how his personal portfolio has thrived under an 'all-in equities' strategy, but Warren Buffett's favourite valuation indicator says stock markets are priced at their most extreme ever.

In fact, most people have no super when they die

Contrary to the popular belief supported by the 'fact base' of the Retirement Income Review, four in every five Australians aged 60 and over have no super in the period up to four years before their death.

Five timeless lessons from a life in investing

40 years of investing is distilled into five crucial lessons. An overall theme is to embrace uncertainty to make an impact on how much you earn, how much you spend, how much you save and how much risk you take.

Welcome to Firstlinks Edition 403

Most Australians hold their superannuation in a balanced fund, often 60% growth/40% defensive or 70%/30%. Lifecycle funds are also popular, where the amount in defensive assets increases with age. Employees who are not engaged with their super (and that's most people when they start full-time work) simply tick a box for the default fund selected on their behalf by their employer. Are these funds still appropriate?

  • 15 April 2021

Latest Updates

Property

Whoyagonnacall? 10 unspoken risks buying off-the-plan

All new apartment buildings have defects, and inexperienced owners assume someone else will fix them. But developers and builders will not volunteer to spend time and money unless someone fights them. Part 1

Superannuation

Super changes, the Budget and 2021 versus 2022

Josh Frydenberg's third budget contained changes to superannuation and other rules but their effective date is expected to be 1 July 2022. Take care not to confuse them with changes due on 1 July 2021.

Economy

Why don't higher prices translate into inflation? Blame hedonism

Why are prices rising but not the CPI? When we measure inflation, we aren’t measuring raw price changes, we’re measuring the pleasure-adjusted or utility-adjusted price changes, and we use it incorrectly.

Economy

Should investors brace for uncomfortably high inflation?

The global recession came quickly and deeply but it has given way to a strong rebound. What are the lessons for investors, how should a portfolio change and what role will inflation play?

Risk management

Revealed: Madoff so close to embezzling Australian investors

We are publishing this anonymously knowing it comes from an impeccable source. Bernie Madoff’s fund was almost distributed to retail Australian investors a year before the largest-ever hedge fund fraud was exposed.

Exchange traded products

How long can your LICs continue to pay dividends?

Some LICs have recently paid out more in dividends than their net profit as they have the ability to tap their retained profits and reserves. Others reduced dividends to ease the burden on cashflow and balance sheets.

SMSF strategies

How SMSF contribution reserving can use the higher caps

With the increase in the concessional cap to $27,500 on 1 July 2021, a contribution reserving strategy could allow a member to make and claim deductions for personal contributions of up to $52,500 this year.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.