The 45 Day Rule
Franking credits from dividends can reduce or eliminate the tax you have to pay on your investment earnings, including any capital gains you may receive. If you receive any franked dividends on Australian shares, then the 30% prepaid tax on the dividends can be offset against any tax payable. The pre-paid tax is known as franking credits, and they work as a tax credit or offset. All dividend investors and especially shorter term traders should understand the implications of the 45 Day Rule.
When the dividend imputation system was introduced in 1997 it quickly became obvious that traders could game the system by buying shares on the last cum-dividend date and selling them the following day ex-dividend. The typical result would be that of the trader receiving the dividend, while incurring an equivalent capital loss and qualifying for the franking credit with only overnight risk in holding the stock – a potentially lucrative statistical arbitrage opportunity.
On the 1st of July 2000 the Australian Tax Office (ATO) sought to rectify this anomaly and implemented the 45-day rule. Under this rule, investors must hold the stock “at risk” for at least 45 calendar days, not including the day the stock was acquired or disposed of, in order to qualify for the imputation credits with regards to the franking on the dividends received. So in effect the trader must hold the stock on 47 days, or 46 nights. With regards to preference shares the same rule applies although rather than 45 days the required holding time is 90 days excluding the buy and sell dates.
By “at risk”, the ATO has stipulated that the position can only have 70% of the total exposure protected by hedging. That is a minimum delta of 0.3 must be maintained. For example, if an investor holds a long put option over the stock being used to take advantage of the dividend payment, then this options position can only hedge up to 70% of the total stock position and the combined position must maintain a minimum delta of 0.3. This essentially forces the investor to have some exposure to the market in order to receive the tax benefit of the franking credit.
There are a number of exemptions to the 45-day rule, although these are mainly provided to smaller investors. The main exemption is for investors limit the total franking credits to a total less than $5,000 in a year. These investors are exempt from applying the 45-day rule. However, the $5000 exemption does not apply to self managed super funds (SMSF’s). This is because a SMSF in not a “natural person” as required by the legislation.
The 45 Day Rule can be complicated and there have been many rulings requested of the ATO to clarify aspect of timing and hedging. If you are uncertain how to interpret the 45 Day Rule then you should seek professional tax advice.
The Liberal government has proposed changes to the franking credit system to help finance the parenting leave policy. The key change is that the company tax rate will drop to 28.5%, and a 1.5% levy will be imposed on larger companies. This will potentially reduce franking credits available to investors and traders by 5%.