'Captive capital' key to understanding LIC dividends
There are fundamental differences in the way income is drawn from listed investment companies versus managed funds, explains Morningstar's Andrew Miles.
Mentioned: Australian Foundation Investment Co Ltd (AFI)
There are fundamental differences in the way income is drawn from listed investment companies versus managed funds, explains Morningstar's Andrew Miles.
In a recent webinar about Listed Investment Companies hosted by Morningstar, one viewer asked a question about how LICs pass on capital gains as dividends.
To answer the question, you need to compare the different structures of the two investment vehicles.
In a managed fund, investors pool their capital with other investors. The combined capital is invested by a fund manager on their behalf. Investors receive dividends and any realised capital gains from the fund's underlying investments.
In a listed investment company, investors buy shares in a listed company whose business it is to invest in a range of companies and other assets. Because LICs are incorporated companies, the board can choose to distribute dividends out of its after-tax profit to shareholders.
How LICs are formed
When an asset manager wants to create a listed investment company, they turn to the market to raise capital via an initial product offering (IPO).
When the IPO is fully subscribed, they list the company on the ASX and issue shares to the participants. The funds raised from the IPO are then invested in a portfolio of securities which are managed by a professional fund manager.
The value of the underlying investments forms the basis for the net tangible assets (NTA) of the LIC. The funds are considered 'captive' in the sense that the assets are closed-in for the manager to invest and cannot be redeemed.
For investors who didn't participate in the IPO, they can buy and trade shares in the LIC on the ASX off other market participants.
This type of closed-end structure can be advantageous for listed investment companies. Because the assets are closed, the portfolio manager doesn't have to worry about investors pulling money out of the fund.
"In an open-end structure, you can usually redeem your money every day," Miles says.
"This can create difficulties for an investment manager. If they take a very long-term time horizon on their investments, actually being in a closed-end structure can be helpful because they've locked that captive capital in and they don't have to worry about exiting a position at an inopportune time because a handful of investors are looking to redeem."
LICs v LITs v Managed Funds | Summary of key features by investment vehicle type
Source: Morningstar
How dividends are passed on
With their captive capital, the managers running the LIC invest in a range of companies and other assets. For example, the Australian Foundation Investment Company (AFIC) – one of the oldest investment companies on the ASX – invests in large Australian companies like the Commonwealth Bank, Westpac and BHP Billiton.
When these companies receive dividends and realise capital gains from their investments, they pay a company tax rate of 30 per cent, and keep the profits in reserve.
The LIC board then decides how much of those profits are distributed to shareholders in the form of dividends.
A more passive investment philosophy will generally result in franking credits being generated from dividend income. An active philosophy will tend to generate franking credits from realised capital gains, which are taxed at the company tax rate.
This structure is particularly beneficial to investors in pension phase for two reasons, Miles says.
Firstly, if a LIC can generate consistently strong investment returns it can retain a portion of profits each year which can be paid out in future years.
"There are lots of LICs that have done a really good job of taking those profits, paying some out and just trying to ensure a nice, smooth income stream for investors. And so, if people are in retirement, that nice smooth income stream can help them budget and help them support their lifestyle," he says.
Since 2010, regulatory changes mean that LICs can pay a dividend even when they post a loss.
Secondly, the income distributed to shareholders can be franked. This is because the income received via the LIC is subject to tax before it is distributed. Therefore, shareholders may be entitled to a credit for tax the company has paid. For individuals with a marginal tax rate of zero, they can receive the credit in a cash refund.
If you're looking to invest in LICs, look at the company's dividend history and whether it has a track record of paying out a steady stream of fully franked dividends. A LIC's performance will also influence the dividends it can pay out, so a highly rated investment process and management team is essential.
Capital gain component of the dividend
As noted above, the dividend a LICs pays to shareholders can include a capital gain amount. Shareholders can claim an income tax deduction for this component, according to the ATO.
"An individual can deduct 50 per cent of the attributable part advised by the LIC," ATO says.
As per the example provided by the ATO, let's say XY is a shareholder in ABC Ltd, a LIC. For the financial year 2018, XY received a fully franked dividend from ABC of $100 with an eligible capital gain amount of $50.
