David French | 18/02/2009 3:47:11 PM

This article was originally published in The Morning Bulletin in January 2005

Many people think that investments available on the Australian Stock Exchange are limited to shares. In fact, there is a multitude of investment types available. As far as earning a return goes, each investment type has certain characteristics.

Ordinary shares are the most commonly traded security in Australia. Shares represent a part-ownership of a company and consequently investors are exposed to most of the risks of investment, and in return they are entitled to most of the rewards. Ordinary shares might pay dividends, and through an appreciation of the share price, provide the opportunity for capital growth. Companies that consistently pay Australian tax will generally have franked dividends and will not normally have consistently large losses in their recent past. While other factors need to be considered, these dividends could be a good indication of an attractive investment. Contrary to popular belief, however, receiving a fully franked dividend is not the same as receiving a tax-free dividend. Franking credits reduce the cash that you have to pay the Australian Tax Office - they don’t reduce the overall tax bill. A fully franked dividend is, in effect, the same as receiving a dividend from pre-tax profits.

Convertible notes are another type of investment. They are a type of corporate debt in that they are loans made to a company. These loans are at a fixed interest rate and have the right to be either redeemed by the investor for cash or may be converted into ordinary shares (at a predetermined date or within a certain time period). In the event of company failure, corporate debt ranks higher than equity. Consequently, convertible notes offer investors more protection than ordinary shares. The real value of that protection, however, depends on the ranking of the debt, and the assets of the company.

Investors can also invest in a portfolio of securities. These are called Investment Trusts and investors can buy units in that trust. A Trust Deed contains the rules of the trust, its investment guidelines and how income and other benefits will be distributed to unit holders and to other beneficiaries. The returns from these trusts can come from distributions or dividends which are paid to investors and can also result from gains in the value of the investments held by the Trust.

Investment Trusts usually concentrate on one area of investment and they are entitled to distribute the income they receive in the same form as the money was received. Investment Trusts can pass on the benefit of franking credits, capital gains and depreciation allowances, as if you held the underlying assets in the trust directly. Trust distributions commonly include all of the other distribution types.

A number of new share issues and investment trusts offer tax-deferred distributions. In these cases, a total dividend can have a tax deferred component which reduces the investor’s cost basis of the units. In other words tax deferred distributions are really a return of investors’ own capital and tax is paid at the concessional capital gains tax rate when the investor sells the trust.

For a tax-deferred distribution to be an effective strategy, the investment must be generating sufficient income to offset the capital return. For instance, a company building a road might offer a tax-deferred return of 6 per cent, until the road can take traffic. The company collects money from investors, and invests that money until it is needed to pay for the construction of the road. Large depreciation allowances are available to offset what would otherwise be taxable income. Because the company’s tax bill is zero, it can keep the earned income, but pay back an equal amount of shareholder’s capital. This leaves the cash position of the company unchanged, while investors receive a non-taxable distribution. As noted earlier, the distribution does however reduce the cost base of the investment, and capital gains tax is paid on the difference between the sale price and the reduced cost base. If an investment has been held for more than a year, capital gains tax is levied on only half of the capital profit – an obvious benefit.

The Investment Collective (AFSL 471728) is a non-aligned financial planning and investment firm specialising in providing tailored financial and investment advice for individuals and small business. Capricorn Investment Partners Limited's services include financial planning, share trading, portfolio management, insurance broking and self managed super fund administration. Additional information on services provided by The Investment Collective Limited can be found by following this link. Readers are reminded that this document has been prepared for general information purposes only, and any advice contained herein has been prepared without taking into account your financial objectives, situation or needs. Readers are advised to see their financial advisor prior to acting on any general advice.

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