Shares are a key investment class, providing investors with growth and tax effective income. They provide protection to investors against inflation and are an essential asset class in all but the most conservative of portfolios. Shares are a way for investors to buy part of a company and share in its future growth.

Inflation

Inflation erodes the value of investments. The graph below shows how the value of $100 in 1970 has fallen to $9.19 by 2005. Investing in shares can protect against this erosion.

Growth and Income

A well managed company will retain sufficient profits to grow the business and pay out the remaining profits to shareholders as dividends. The growth increases the value of the shares. Shares also offer income in the form of dividends. In fact as the value of a company increases over time this in turn leads to higher
dividends.

This combination of growth and income is very powerful over time. The following table shows how some well known shares compared to cash investments from December 1990 to December 2005.

Tax Effect

Albert Einstein once referred to compound interest as “the most powerful force in the
universe”. If he was alive today, he may well consider the most powerful force to be the “franked dividend”.

Shares not only offer rising levels of income but also offer dividends that carry tax credits. Unlike interest income, which is fully taxable, franked dividends carry a tax credit of up to 30%. The following table demonstrates the different tax results for two taxpayers on different marginal tax rates. For ease of explanation, it assumes the same rate of return for dividends and the term deposit.

The news is even better for those on lower marginal tax rates. For super funds and pension funds, if you don’t pay enough tax to use the full 30% franking credit, you can receive the unused credit as a cash refund from the ATO. For tax free pension funds that means the franking credit is refunded in full.

Like all forms of investing, shares carry risk. Clearly, investors should expect more volatility and risk from a share portfolio than from a cash or term deposit investment. However, blue chip shares such as those used in the example above, carry far less risk than more speculative tech or resource shares. Diversity is also a key tool in reducing risk. On the other hand, investors also need to be mindful of the risk of not earning enough on their investments and not having enough to retire on. Shares should be a key element in any portfolio structured for growth and tax effective income.

Andrew Condell

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Share options are often offered to executives as an alternative form of remuneration. Both domestic and international companies offer options to align the interests of the executives with that of the shareholders.

The options are usually structured in a way that allows the executive to buy the shares at a discount price. It is common for such executives to find themselves with large holdings in options for a single stock. A common mistake with these forms of remuneration is for the executive to sell the shares at the time of exercising their options. This saves the executive from having to fund the options purchase from their own monies or from borrowings. It may also enable the executive to quickly realise a profit; however this can be problematic from a capital gains tax perspective.

If the recently acquired shares have not been held for over 12 months any realised capital gain will be fully taxable. The executive will not benefit from the 50% reduction that is available after 12 months.

One obvious solution would be to simply hold the shares for 12 months before selling them so as to benefit from the 50% Capital Gains Tax concession. The problem with this is that the value of the shares may reduce during this time. Often the executive has had to outlay a significant sum to acquire the shares and sometimes from borrowed monies. This represents a high concentration; high risk exposure.

To protect the value of the shares and minimise the risk, a “Collar Facility” can be used. A collar puts a floor under the share price protecting the holder against falls but also places a cap on the up side thereby limiting the potential gain on sale. It’s like an insurance policy that allows the shareholder to hold the shares for 12 months, limit the risk and qualify for the 50 percent CGT concession.

The collar allows the holder to enjoy some further up side while protecting the down side, and to continue receiving ordinary dividends and franking credits. The most popular collar is a zero cost collar. It requires no cash outlay however the gap between the floor and cap will be relatively narrow with limited upside.

If you are prepared to pay for a collar the gap between the floor and the ceiling can be widened with a potential for greater up side. Clearly the limited up side is the cost you pay for the protection the floor offers.

Case Study

Let’s look at an example.

John is granted 10,000 XYZ options on 1 November 2003. The option exercise price is $10 and all options will vest 1 November 2006 (share price is $25). John needs to borrow monies to be able to exercise his options and after receiving advice, he would like to hold the shares for at least 12 months to reduce his capital gains tax.

John can use a ‘Zero Cost’ collar, which would set a protection price of $20, and a cap price of $30. John is protected if his shares fall below $20 and he will be able to benefit of share price increase up to $30. John will also be able to borrow up to the protection level from a margin loan facility to be able to fund the exercising of the options.

At the end of 12 months, John has the option to keep his shares, sell his shares, or extend the collar for a future term. If he sells his shares, only 50 percent of the gain will be assessable for capital gains tax purposes.

There are a number of other considerations when exercising options so please ensure you speak with your financial adviser to ensure you are making the most of your options.

Brendan Gallagher


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After some mid year volatility, investors were rewarded in the past quarter with Australian and overseas sharemarkets rallying.

A number of economic indicators point to a weakening of US economic growth. Currently it looks as though the US economy is heading towards a soft landing however a hard landing cannot be completely discounted. There is a slowdown in US housing, however this is being offset by strong consumer spending, lower oil prices, favourable inflation data, and stable interest rates. The US Federal Reserve's view is that “the economy is likely to expand at a moderate pace”.

The US sharemarket has enjoyed a strong run in the past quarter thanks to strong corporate earnings and relatively stable economic conditions.

In Europe and Japan, business confidence has improved. Falling unemployment, lower oil prices, and relatively strong economic growth have also boosted European consumer confidence.

Strong gains in the US sharemarket had a positive effect on world markets. The German DAX jumped 10.33% for the quarter, the Japanese Nikkei was up 6.10% and Hong Kong Hang Seng rose by 7.97%.

In Australia, inflation continues to be above the Reserve Banks target range of 2-3% resulting in another interest rate increase. Employment growth continues to be strong with unemployment now at 4.6%, down from 5.2% a year ago. This strong employment growth, together with falling petrol prices has driven consumer confidence up in October.

The Australian sharemarket enjoyed strong gains thanks to increased merger and acquisition activity, strong commodity prices and strong gains in the US.

The outlook for Australia and many overseas markets remains positive. What impact the slowdown in US housing has on consumer spending will be watched closely. This could have a negative affect on both US and international sharemarkets.

Sharemarkets locally and globally are currently looking fully valued, particularly resource stocks. It’s getting harder for investment managers to find quality stocks that aren’t over priced. The rising tide has been very kind to most investors over the last few years. It’s a time now where skill and careful stock selection will make a big difference in the outcomes investors are able to achieve.

Brendan Gallagher

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Parents can now provide limited Guarantees on their children’s home loans getting them started earlier and saving them expensive mortgage insurance fees. If your child is wanting to get into their first property, but finding it hard to save a deposit, the new version of the traditional parental guarantee could be the solution.

In our last newsletter, I discussed the rising popularity of the “No deposit” or “100%” home loans. I also mentioned that although the interest rates for these loans are now on par with standard loan rates, the set up costs, in particular mortgage insurance, was still high.

There have been some amusing television commercials lately promoting the use of the parental home as additional security to enable the first home buyer to “finally move out of home” and avoid these large upfront fees. A number of major lenders are now offering an enhanced version of the traditional parental guarantee on home loans, whereby a family member can now specify a limit to the guarantee, rather than potentially being liable for the entire loan amount.

For example, suppose young Miss Jones wishes to purchase her first property for $350,000. Although on a good income and living at home, she has only managed to save a $10,000 deposit after spending the last couple of years paying off her credit cards.

Even as a first home buyer, paying no stamp duty and receiving the $7000 First Home Owners Grant, she will still only have a 5% deposit to put down, meaning she will need to borrow 95% of the purchase price.

Normally, she would incur a one-off upfront mortgage insurance fee of approximately $6,000. However, a limited guarantee of just $65,625 from Miss Jones’ parents, grandparents or sibling, secured by property, would allow her to avoid paying that fee.

No matter what happens, the guarantor’s potential liability is limited to the guarantee amount, in this case $65,625.

At a later date, once the loan amount equals 80% or less of the unit’s value (either by the value going up, the loan being paid down, or a combination of both), the guarantee can be easily extinguished.

Limited guarantees can also be useful where the borrower simply fails to meet the strict eligibility criteria of mortgage insurers. There may be a credit default, unusual income/work situation, or the property being bought may be unacceptable for mortgage insurance. In these cases a guarantee can help the borrower get over the line.

When considering these facilities, there are a number of factors to compare:

• Who can provide the guarantee? Some lenders only allow it from a parent, other allow it from the spouse, grandparents, parents and even siblings.
• Does the lender need to take a 1st mortgage over the guarantors’ property, or is a 2nd mortgage acceptable? This can be very important if the
guarantors’ property still has a mortgage in place.
• Can multiple guarantees be granted over the one property? Important if there are several children potentially requiring assistance.
• What are the additional fees involved? For example, additional valuation fees, guarantor documentation fees, etc.
• Does using a guarantee restrict the choice of loan products?
• How easy is the release of the guarantee? Can the guarantor request release at any time (even before the debt to security ratio falls below 80%)? What fees will be payable (new valuation, loan variation fees etc)?

Other types of guarantees
A guarantee does not always need to be for the purpose of providing additional security. Sometimes the borrower has a sufficient deposit, but can’t evidence sufficient income to support the loan. In this instance, the guarantor can provide a “servicing support guarantee”, meaning they agree to assist the borrower to meet the loan repayments. Unfortunately these guarantees are usually for the entire loan amount (ie they can’t be limited to a specific amount).

Did you know:
The $7,000 First Home Owners Grant is still available if the only property you (or your spouse) have previously owned was:-

• an investment property, and
• it was purchased after 1 July 2000, and
• you have not lived in it for a continuous period of 6 months.

Matthew Carpenter

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