Deductibility of interest

Rob, that is a fair point, and the spreadsheet is by no means optimised - in the 2nd option your LVR would keep dropping (assuming the growth continued), so if you decided to keep buying units as your marin allowed it would make even more of a difference. The main reason I didnt include what you suggested is LVR - although the investor's own LVR wouldnt change by doing this, on the margin loan side it would as the personal non-deductible loan obviously isnt in the margin LVR calc.

Also, it was already complex enough!!

 

Hi Coopranos,

At the risk of frustrating you, I have changed & simplified the spreadsheet, both borrowings & debt sources. This is partly because of the risk of it being used as financial advice.

Both scenarios reinvest tax savings monthly - might be realistic if you vary a salary witholding rate ? Also the income fund reinvests the after-tax distribution.

IMPORTANT: I have ignored franking credits from the income fund to be pessimistic. If the distributions are fully franked then the yield is 1.4 times higher !!

In fact, on a 30% marginal tax rate, the franked dividends are tax-free. So if you reinvest in the same fund it will grow as fast as a pure growth fund AND there is no capital gains tax liability.

It does show that the initial capital loss means you start at a serious disadvantage for compound investment growth.

I hope I haven't made any blunders, but I am a bit pressed for time at the moment so there has not been due dilligence - which of course should not be a problem as this is purely a theoretical exercise isn't it ?

Cheers,

Rob

 

Rob
I am struggling to understand what you are trying to get across on your spreadsheet.
To clarify: the purpose of this whole exercise is to get your non-deductible debt to become deductible, and THEN get your actual investment growth happening as efficiently as possible.
The first part (ie the buy and sell exdiv to get the div) is NOT an investment strategy at all, its ONLY purpose is to recycle non-deductible debt. As an investment strategy it would be the stupidest thing you could possibly do.
I think for some reason you have understood that the intention of the buying/selling exdiv is to generate actual investment income, that is obviously not the purpose, it is purely for recycling the non-deductible debt.
After the debt is paid off using this div income, you redraw the previously non-deductible debt and invest it + your existing portfolio amount into a more traditional growth style investment plan.

With this in mind, I cant quite see where you are going with your spreadsheet:
1) you have changed the dividend in the "Month 1 Divs" worksheet to quarterly, which defeats the whole purpose of recycling the debt ASAP.
2) You have removed the franking credits from this div debt recycle period which is detrimental to the idea.
3) After your non-deductible debt balance reaches zero, you have let it keep going which continues to chip away at your investment capital. The whole point is the moment that non-deductible debt reaches zero, you redraw it and stop doing the buy/sell exdiv, because it has achieved its purpose.
4) you are calculating tax liabilities on each receipt of income, which is incorrect and over the long term will be massively detrimental to the calculations (because of compound growth - even though you may have a tax liability at the end of a financial year, you have had that whole year using that amount payable in your compound growth investment).

Again I think the confusion is coming from you misunderstanding that I am proposing an investment strategy buying the day before ex-div, getting the div then selling the next day. That is definitely not the case, if you keep doing that even one time after your non-deductible debt is paid off, you are cutting your own legs off.

The only reason I brought this up is because it was suggested to me by a financial planner that it was a good idea to invest in an income fund (ie navra), use the distributions to pay down non-deductible debt, redraw the debt for investment purposes, then bail on the income fund into growth funds. It struck me that this was an incredibly slow way of doing things, and could be achived much faster by using the dividend idea instead. The sooner you get your capital working for you the better, and while you are paying down your non-deductible debt your capital isnt really working for you (as all your "growth" is stripped to the debt through distributions).
It just so happened that the div strategy was also a lot more tax effective, giving you carried forward capital losses of the amount of the original non-deductible debt, plus franking credits to offset the income.

 

Maybe you should stop trying to combined the strategy with an investment at the end.

Also as i mentioned to before, if you use a portfolio loan, then you would actually not loose any capital (to invest) each time you do it. You would be able to pay the div into your personal part of the LOC and redraw it via the investment portion. Thus now having a nill effect.

Brokage and trade size needs to be considered though, you loose .25% per trade, and if your only doing lot sizes of 20k on a 4% yield, your only clearing $500 a time. It could become a very long process....

Additionally, you will have just as much capital now than you would after the exercise, the only difference is the debt would be deductable which it currently isnt. So its not about making your debt working harder.

A flaw i see is while your doing the buy in and out everyday, this is money which you can not invest anywhere. So if you could invest and get a 20% return in a year, or in a year you gain 16k in dividends (each person). You may be ahead in your objective, and behind in your returns.

Coopranos- an extension to this strategy could be on the last day of the month invest into a income MF, Say you do this in the last week of june, you will still get the 10-15% distribution from the fund (plus all your divs through out the year), and say if you do it via navra who distribute capital gain, it may not be taxable.

 

additionally is there a "free" website which will tell you when all the ex div dates are so you do this properly...

on a dividend with a 4% yield, and 0.12% commisions (from comsec), for the income you recieve, 5.9% of that goes in brokage. So 30k trade, 1200 income, but 70.50 in brokage. Even with converting it to deductible debt, your still probably loosing, as (on a 30% tax bracket) you only save 2.29% pa on your home loan, so it would take you 2.5 years to be even in front... ( i think ive done this correctly)

 

Some great points DaveA, cheers for that.
The only reason I put the investment part at the end was to do a valid comparison with the more traditional approach of waiting for the quarterly distribution.
The debt is definitely not working hard for you except for the extra interest expense deduction you get each year, although the impact of this may be minimal.

brokerage hasnt been included in the calcs, I will redo it shortly.

I think your point about not being able to invest the capital while you are doing this is a good one, especially if you have specific criteria about which dividends you want to use. If you decide only to use stocks that have say 75% LVR with your margin lender and are fully franked, you are quite limited in what you can use, so may have to wait a few weeks between divs (although this would also reduce your margin interest cost). Also there is risk in investing your entire capital into one share for one day, especially if there is a downturn in the US overnight. I guess to be fair though you would cop the same if you were fully invested anyway.
The other point about not getting a return on your capital is that if you were using the traditional approach of paying the debt down with quarterly distributions, your capital is effectively not being used for maybe 2 years, instead of only for a month or so using divs.

The major problem i see with doing this through managed funds is that you cant time it so precisely - you might put your application in for units on 29th September, but they dont process it til 1 October and you lose your distribution, plus cop buy/sell spread.

The other (possibly better?) option would be just to invest in growth funds, when your equity growth is the size of your non-deductible debt, sell the units realise the gain, pay off the loan, redraw and reinvest immediately. May not be as tax effective, but probably easier!

 

I really should be working not doing this but it was too tempting...

Ive done my own sheet up, Brokerage is 0.12% (not reasonable as comsec charge flat rates below 25k trades), always less on the way out as the value is lower. I have made the false assumption and havent charged interest on the original 40k borrowed, only the accumulated capital loss. Ive also only done the example for 15 days (straight of trading) not possible i know, and then the remainder of the year interest calculated.

At the end of the 15 trades, your loan balances are 1,077 higher (due to brokage capitalised) and it produces a (full year) saving of $361. Compared to the initial broking cost of $1077, it takes 3 years for you to become in to even territory. It improves with the higher the yield, but there arnt alot of those around.

Additionally using a portfolio loan doesnt really help you that much, because brokerage is higher, still i think there is something flawed in my calculation there...

Tax isnt taken into account as this strategy works best for someone on a 30% tax bracket. They also need to be fully franked dividends (as this offsets this assumtion)...

Comments are welcome

 

this is very rough, but this is a full year of trying, so it seems the longer you do the better off you are...

 

Dave
Looking forward to having a look through your sheets over the weekend.
The other thing that needs to be considered is not just that it would take 3 years for the brokerage to be recovered through savings in the now deductible interest expense, but also need to consider the fact that now the debt is recycled so much quicker we are able to start actively using our capital in growth funds (rather than that capital lingering for 2 years in a lower return incmoe based fund while we wait for the distributions to pay off the debt).

 

I see this point but still question its usage.

The other thing that should be considered is how much is the capital loss worth? On a 30% rate again, for this strategy you effectively are recieving any capital gains tax free (aside from brokerage costs). If you consider your structures (ie growth fund in a trust, the div strategy in ONE individuals name only) you could stream the distributions so only one patner gets the discounted gains, while the other gets the full advantage of the capital loss... Perfect for all the people who complain about navra tax un-effectiveness distributions...

In this circumstance, if you had 5k of gain (less than 12 months) you could invest into a a div, recieve the cash (with FC, so nil tax) and use the capital offset for the gain - Nil tax. If you just sold you would be giving the tax man 30% rather than nil. And the only thing youd have to do is pay brokerage for it (and take a bit of risk)

The more i think about it, the more this could actually be quite benefical...

 

Coopranos,

The exercise is to compare apples with apples.

1) I started with the assumption that you had no spare cash, and must borrow everything. You need extra cash to meet your tax liability after the initial trading to derive dividend income, that is why it went into credit by about the tax liability amount.

YOU CANNOT DEDUCT INTEREST ON BORROWING TO PAY INCOME TAX s.25-5 ITAA97.

The original private loan was redrawn to invest, the tax liability held in cash since you won't have any cash flow from your growth fund. (you could invest the cash until October but I ran out of time).

2) The growth fund reinvested your interest tax savings, assuming that this excess cash was not needed.

3) The after-tax unfranked income fund quarterly distributions and monthly interest tax savings were used to pay down non-deductible debt first AND both immediately redrawn from the investment account to purchase further income investments.

I have ignored the investment of your temporary tax liability which will generate further income.

I have also ignored franking credits.

How pessimistic can I get and yet still show in your example that the income fund beats the trade & growth method hands down.

You would be better to put money into growth first and partially realise a capital gain, pay tax & then pay down your non-deductible debt. Also, the CGT is a tax on some real gain and not just your money coming back (ignoring inflation).

Nothing kills compound growth better than initially losing some capital. That is what happens with the initial trading.

Cheers,

Rob

 

Rob
Not sure what to tell you, you are obviously missing something...
Why on earth you continue to say that you lose capital using the div trading idea is completely beyond me - your capital simply becomes income, which gets paid onto your debt, which then gets redrawn to become your opening capital again - net effect is NIL (less some brokerage).
I dont know why you are talking about borrowing to pay income taxes, using the div/growth idea there is no income tax - you franking credits take care of that.
The spreadsheet I did clearly shows that the difference between the 2 strategies (using an income fund and using div to recycle then growth) is made up of:
1) The future income tax benefit from the capital loss (this is a PAPER loss only, you havent actually lost any capital, just converted it to income then back into capital)
2) The higher return and more tax effective growth of the growth oritented fund over the income fund.

If there is a problem with the spreadsheet I did, let me know and I will redo the numbers. I have looked at it a few times and except for brokerage as mentioned by DaveA, it looks good.

I would love to say "oh i see where you are going wrong, you missed this" but I just dont know what you are not getting!
And the spreadsheet is a comparison of apples with apples: exactly the same starting position, exactly the same time frame, massively different end.
All the dividend trading part for the first month (only the first month!!!!) is doing is compressing the time it takes to recycle your debt. You either do it with QUARTERLY distributions from an income fund or you do it DAILY with dividends. It really is no more complex than that, except you get the side effect of having some capital losses (on PAPER only!!)

 

Ah ... we have a terminology problem.

What the Taxman calls income and what an Accountant or investor calls income are two different things.

s44 ITAA36 states that all distributions from retained profits are assessable income.

However, if you have just bought shares cum dividend, you have just purchased the retained profits as your investment capital. When you receive a distribution of those retained profits earned before your purchase you are receiving back some of your original capital.

You have turned some of your capital into assessable income as far as the Tax Act is concerned, and yet no income has been earned by the company whilst you were a shareholder. Your investment has been reduced in value by the distribution but the Taxman takes some of it.

If you put some money in the bank for a brief moment and then take it out again then there is no income earned and no tax is paid when your original capital is withdrawn.

As regards the spreadsheet, there is no trading other than the very first month to generate "assessable income" to pay down your non-deductible account. It is immediately withdrawn, the tax liability quarantined and the rest (up to the original $100k limit) is invested in a growth fund (see sheet 2).

The difference is that the extra cash flow from your tax savings on interest deductions are reinvested in both cases (after paying down non-deductible debt & redrawing in the income fund case).

Cheers,

Rob

 

Hello Rob and Coop

I am still trying to get my head around this one. I understand dividend stripping very well, and the concept is explained very clearly in the Eureka Report's article, "More than the Bare Essentials" by Cameron McNeilage, July 13 2007. Copyright prevents me from posting the article here, but I believe you could get a copy by taking out a trial to the ER.

Basically the franking credits are paramount, and the realised capital loss is valuable to offset against realised gains from elsewhere (eg income distributions from a MF).

But the original post was a query about the tax ramifications of dividend stripping. Let me ask it this way:

1. I use borrowed money to buy shares cum dividend;
2. I receive a fully franked dividend, and I hold the shares for the length of time required to receive the franking credits (ie >45 days if I get >$5k credits in a year, but in many small investor cases, one day is enough, since you need to see $16666 in FF dividends to suffer the holding rule);
3. I sell them ex-dividend, for a capital loss equal to the change in share price plus brokerage costs;
4. I bank the dividend into my PPOR to pay down non-deductible debt;
5. I repay the loan with the capital proceeds, leaving a shortfall in the loan, which will grow over time;

Now as I see it, the purpose of the loan was to derive assessable income. But once I have sold the shares, there is not going to be any further assessable income from the assets purchased under the loan, so has the purpose of the loan changed?

Example, I take out a $30,000 investment loan and buy CBA shares. They go ex-dividend ($800 FF) and drop equal to the dividend. I suffer a capital loss of $870 (including brokerage). I repay $29,200 to the investment loan (I don't capitalise brokerage). The $800 shortfall sits in the loan accruing interest, say $70 in the first year.

Is the $70 tax deductible?

With no assets capable of deriving income left in the investment loan, the purpose of the loan is no longer to derive assessable income. The original purpose may have been to derive assessable income, but circumstances have changed.

Of course I can see a simple solution: don't sell all of the shares, keep a small parcel, equal in value to the loan shortfall. It might not be a marketable parcel, but that's a different problem!

 

Hi Rod,

When I try to answer too many points in one post it seems to get confused.

I will just address the interest deductibility in this one.

Where the funds are used to gain your assessable income, the interest expense is deductible.

If you suffer a loss whilst earning your assessable income that leaves you with a debt after you have ceased the exercise then you need to look at the reason why the debt is still on hand each year.

If you cannot afford to repay the debt in later years, then the interest expense is still deductible due to the occasion of the loss being to earn assessable income. (e.g. FCT V Brown).

However, if you could afford to repay but chose to divert funds to private use then it could be argued that the debt had lost its connection with your assessable income.

If the original exercise was just to recycle debt to gain a tax advantage, it could be argued to be non-commercial or Part IVA applied if the keeping of the debt on hand is purely to gain a tax advantage.

Cheers,

Rob

 

not to get this going again but i thought a spreadsheet might help people reviewing this..

This is the top 20 dividend payments for this half of the year. There is only 14 as 6 pay on the same date. If you apply 100k to the exercise you would get 43.5k of divendends at a cost of 46k (5.8% actual cost).

However it needs to be pointed out that if you were an individaul you would hit your FC limit on the 5th trade. If say your wife then took over, she would hit it on her 4th day (9 all up). Im not sure how FC works in trust, say if the trust gets 20k in FC can it distribute 4 lots of 5k to people??

Id imagine Part IV would cant before youd been doing it to long. However this strategy might be even more benefit when combined with captial gains (as discussed in the other thread).

This doesnt cover the risk premium for any of these shares being in the market on the div date. Thats for people to work out if its suitable...

 

Not aware of any reason why a trustee would get an exemption from the 45 day holding period at risk ?

If you were stumping up the money for an associate to trade in excess of your $5000 exemption, would the ATO claim you were the beneficial owner ?

It is curious why the market does not fully price in franking credits.

Does this indicate that the majority of investmet funds cannot use them, or don't actually care about the wealth of their unit holders ?

Or does it indicate significant non-resident investment. Even more important now most securities are exempt from CGT for non-residents.

Cheers,

Rob

 

Yeah that is strage, the market usually acts completely rationally!!

 

I reckon this is absolutely true. The managed fund industry is set upon pre-tax returns, so FCs don't come into it. If they started quoting after tax returns, then FCs could be factored in. Since the MF industry is such a massive part of the market, FCs are not generally valued.

I reckon the burgeoning SMSF market are cottoning onto the value of FCs, where tax is 15% and FCs are 30%. This will drive up the value of FF shares.

Meanwhile, this is where the individual direct investor wins; eg CBA at 4.5% FF -> 6.4% gross. This matches interest from a high interest savings account, and then there's growth in share price and dividends as a bonus.

(Pretty obvious where I prefer to keep my money!)

 

Yep,

If a SMSF holds $100k of CBA shares paying 4.5% FF and $100k in cash @ 6.428%. Then ignoring expenses (like audit fee & ATO levy - both deductible).

Assessable Income:
Dividends $4,500
FC $1,928
Interest $6428
Total $12856

Gross Tax Payable = $12,856 x 15% = $1,928

Net Tax Payable = Gross Tax Payable - Franking Credit
= **ZERO TAX**

So the SMSF can hold a diverse portfolio and reinvest its income tax-free using partially some securities paying fully franked dividends.

Of course I would recommend a more diverse portfolio, but you get the idea.

Cheers,

Rob