An age-old question since the imputation credit system came into being in the 1980s in Australia – “Are franked or unfranked dividends better?”. This is an all too common question received by accountants, tax specialists and financial advisers alike during elections, as well as annually during tax time.

A popular topic with politicians and investors, with arguments for and against its implementation, franking credits and franked dividends. For a detailed insight into the world of “Franking Credits” and “Franked Dividends”, visit our new and updated Ultimate Franking Dividend Guide.

With two years until the next election, the Australian share market on the rise, and the economy out of a recession as 2020 comes to a close, reviewing your portfolio and shareholdings to determine whether unfranked dividend stocks are the right investment choice is potentially something a savvy investor should consider.

To understand the questions around what dividend is “better”, we have to consider the basics behind dividends and the impact franking credits may have on an individual’s (or SMSFs) taxable income.

Dividends are transfers of something of value to a shareholder by a business. Certain distributions are exempt for tax purposes from being dividends.

Generally speaking, dividends obtained from company profits are beneficial to Australian citizen recipients, who may also be entitled to the Australian income tax franking credits charged by the corporation to receive those profits.

The Advantages of Unfranked Dividends

A franked dividend is when a business distributes to shareholders a percentage of its profits and adds a tax credit from 0 to 100% of the tax value for any amount of tax paid on that amount.

The method of imputation taxation is quite unique to Australia and New Zealand, which has made it an easy target for governments trying to raise government revenue and decrease Australia’s debt dependency, but to the disdain of shareholders.

An interesting thing to note is that a majority of the dividend-paying companies on the ASX are international companies, domiciled outside of Australia. An oversimplified way to conceptualise this is, that given these companies are incorporated overseas, they rarely pay tax in Australia and as such, they don’t have the option to pay out franking credits.

The Advantages of Franked Dividends

Fully franked dividends mean the company has already paid tax on the money at the company tax rate of 30%. So that the money isn’t being taxed by the ATO twice, you’ll receive a franking credit for the tax already paid on the dividend by the company. This means while you do need to include the dividend in your total taxable income, you’ll receive a discount credit which will reduce your taxable income by the amount already paid by the company.

Because dividend payments are a form of income, you do need to include these in your total taxable income when you file your tax return. However and as mentioned above, thanks to the franking credits system in Australia, you often won’t need to pay much tax on your dividends (or any at all).

What Is Dividend Yield?

The dividend yield is calculated as a percentage and represents the total dividends received in relation to the cost paid for the shares. The dividend yield is determined by deciding which proportion of the share price is returned as income to the investor. The dividend yield lets investors evaluate similar businesses, as it helps determine which company shares will generate better yield.

Why do some companies not pay franked dividends?

Not all benefit from franking credits in the same way. For example, the everyday investor may receive a reduction or refund on their tax return whereas self-funded pensioners are positioned more favourably in the current imputation system as they are able to claim the maximum tax benefit. As such one may question that when given the option, why don’t companies just frank their dividends to 100%?

Although not the norm, one example might be for corporations that make up a significant portion of their revenue from non-taxable income, such as tax-exempt sales of fixed assets (i.e. real estate investment trusts or REITs) or have substantial offshore earnings. In this case, the attachment of franking credits may not be possible, since these are allocated by the company from tax paid in Australia.

Something which you may notice is that the overwhelming majority of the constituents of the S&P/ASX 200 index will pay fully-franked dividends to mitigate the tax consequences for their shareholders.

Simple corporate finance is the other major factor affecting franking credits, being what is ideal for the actual and planned makeup of shareholders of a company.

Instead of paying a dividend to shareholders, a lot of smaller, emerging businesses will reinvest any profits made back into the business to help it develop. Many investors are okay with this because if the business is growing, the value of their shares will also increase.

It is also necessary to remember that there is never a guarantee of dividends. Each corporation decides what the amount of the dividend will be and if, yearly, there will even be a dividend payment at all. So just because a business pays a good dividend in one year, that doesn’t mean that a repeat will occur the following year.

So, what is better? Franked or Unfranked Dividends?

In short – there is no definitive answer.

While your tax situation can benefit from franking credits, it is wise to always seek qualified tax and financial planning advice. As everyone’s situation is different, it would be difficult to conclude that one strategy would be better than another in the longer term.

In Australia, 49% of adults own shares and other listed securities on the Australian Securities Exchange (ASX) according to the 2020 Australian Investor Study.

  • In the wake of COVID-19 and its worldwide effects on humanity as a whole, the Australian share market was not spared its own trials and tribulations as a result of the global pandemic.
  • At the time of writing, Australia has been tracking well in its economic recovery compared to most other developed economies.
  • In the June 2020 quarter, Australia saw a 7% decline in GDP, followed by a partial recovery in the September quarter, with economic activity rising 3.3% (in seasonally adjusted chain volume terms).

Despite this, the Australian economy and its share market are not out of the weeds quite yet. The lasting effects are yet to be seen as we commence our recovery, and investor sentiment has started to shift, with investors directing their focus more strongly on the future sustainability of dividends, fully franked dividend income and “defensive” investing during these uncertain times.

Many investors may however, not completely grasp the concept of dividend-paying shares and their benefits, nor do they understand the concept of fully franked dividends and unfranked dividends, franking credits and imputation credits, as well as the interaction they have in relation to personal tax obligations.

This comprehensive introductory guide will be the first guide in our multi-part series of smart investing in dividend-generating investments for individuals and Self-Managed Super Funds (SMSFs).

Before we dive into the world of franking, it is important to first understand how dividends work to build wealth for investors.

What Are Dividends?

When you purchase shares in a listed company, such as one listed on the ASX, you become a part-owner of the business. Dividends are your portion of the profits.

Dividends reflect a payout to shareholders from the earnings of an organisation as a way of rewarding their investment in the business.

Payment of a dividend is fully up to the discretion of the board and if they choose to do so, more often than not, dividends are paid twice a year.

Assuming you purchase shares at $1.00/share and a dividend of 10 cents per share is payable each year, you’ll realise a return of 10%.

Although dividend-paying shares are seen by many Australian investors as an attractive investment in providing a steady stream of passive income to live off, others will seize the opportunity to reinvest the profits to further boost their assets.

Types Of Dividends

There are three major types of dividends:

Interim Dividend
This is a dividend which is distributed before annual profits have been determined by the organisation. Typically, it will be issued at the same time as the interim financial statements of the company, usually six months into the financial year.

Final Dividend
When a company reports its earnings for the entire financial year, this dividend payment is issued. Some businesses will only pay a final dividend.

Special Dividend
These are bonus dividends which are usually higher than the regular distributions a company earns in the form of dividends. When it generates increased revenues over a certain financial period, a company may pay a special dividend to its shareholders.

Not all businesses will pay all types to their shareholders and some may not pay any dividends at all.

What Is Dividend Yield?

The dividend yield is calculated as a percentage and represents the total dividends received in relation to the cost paid for the shares. The dividend yield is determined by deciding which proportion of the share price is returned as income to the investor. The dividend yield lets investors evaluate similar businesses, as it helps determine which company shares will generate better yield.

Dividend Reinvestment Plan

Rather than accepting the dividend payment in your bank account as cash, some companies offer what is called a Dividend Reinvestment Plan (DRP for short), which allows you to opt-in to the use of dividend distributions, used to purchase additional shares.

There are many benefits to doing this but the main one is that you can use the revenue to purchase additional shares without paying any brokerage. It’s also a good passive investment opportunity for steadily increasing your shareholdings in a business with minimal input required. It’s a strong investment strategy for set-and-forget – when you opt-in, the DRP process quietly takes place in the background.

One drawback to opting into a DRP is that you are unable to acquire the cash for other day-to-day expenses. You are unable to set the share price which will apply to the DRP and on the day of the dividend payout, the shares are automatically acquired on your behalf at market price.

The Relationship Between Dividends, Franking & Tax

There is another feature of dividends that makes them much more appealing than other passive investment options like savings accounts and term deposits: tax advantages.

In Australia, businesses may attach to their dividends what are known as ‘franking credits,’ which represent the amount of tax already paid by the company.

Dividends are not “double taxed” in Australia unlike in many other countries worldwide. Companies that distribute franked dividends pay their tax on their profit at a corporate tax rate and then allocate the balance to shareholders.

In order to satisfy their individual tax obligations, the shareholder gets the deduction for the tax already paid by the corporation.

To avoid double taxation, the Hawke-Keating Labor Government formulated the concept of franked dividends in Australia and adopted the dividend imputation system in 1987. Before this, Australian companies would pay corporation tax on earnings, and then if they paid a dividend to shareholders, this was taxed as part of the income of the individual.

Under this scheme, Australian businesses continue to pay company tax and post-tax dividends to shareholders but may determine how much tax they pay to be “imputed” for the dividend they paid.

Dividends are paid on revenue subject to Australian income tax, which is 30% at present. This ensures that shareholders earn a refund on earnings distributed as dividends for this 30% in tax already paid by the company.

Such dividends are referred to as being ‘franked’. Franked dividends have a franking credit attached to them which reflects the amount of tax already paid by the corporation. Franking credits are also known as imputation credits.

For any tax the company has paid, you are entitled to earn a refund. The Australian Tax Office (ATO) will refund you the difference if your top marginal tax rate is less than the company’s tax rate.

What Is The Difference Between Franked & Unfranked Dividends?

There are two main kinds of dividends that you can obtain from businesses which you have invested in – franked and unfranked dividends (a third if you count “partially franked dividends”).

You earn an imputation credit when collecting a franked dividend. An imputation credit is a tax credit already paid by the corporation. This stops the taxation of your money twice.

A business that pays a 30% tax on all its income will pass on to its shareholders the full 30% of the tax already charged. If a corporation made $100 and paid $30 in corporate tax for example, It will distribute $70 in dividends and $30 in credits for franking. This would be an example of a fully franked dividend.

Unfranked dividends are where a company remits a dividend to its shareholders without a franking credit attached to it.

Why Do Some Companies Pay Unfranked Dividends?

If a business does not pay the full Australian company tax rate of 30% on all its earnings, it can only produce sufficient franking credits to pay a partially franked dividend.

Unfranked dividends are not uncommon when you invest in businesses that do not pay company tax in Australia. Although they may have generated revenue which may be made available to pay their investors, they may not pay tax in Australia (due to being domiciled overseas for tax purposes).

A company is not eligible to give you a tax credit if it does not pay tax in Australia – this results in an unfranked dividend, should they decide to distribute profits to their shareholders.

You receive an unfranked dividend if a company is unable to give you any imputation credits on the income earned from the dividend – indicating the business has not paid tax in Australia on the income which has been distributed to you.

What Are Franking Credits?

Franked dividends have a franking credit linked to them that reflects the amount of tax already paid by the company. As such, franking credits, also called imputation credits, are an investor tax break. They are credits given to Australian investors collecting dividends from companies who pay tax in Australia.

Franking credits are also known as credits of imputation. They are passed on to shareholders where dividends are paid, and where the tax has already been paid for by a corporation. Franking helps avoid taxes from being paid twice by a shareholder. They’re known as credits because they’re received and applied as a tax offset.

For any tax paid by the company, you are entitled to earn credit. The Australian Tax Office (ATO) will reimburse you the difference if your top tax rate is less than the tax rate of the business.

A completely franked dividend indicates that the corporation has paid tax on the whole dividend, so all the tax paid on the dividend is earned as a franking credit by the shareholder.

Franking credits are refundable to persons whose cumulative franking credits are in excess of their yearly assessable income tax liability. This will raise the income of persons with fully franked shareholdings owned through retirement funds that do not pay tax (such as SMSFs) and other individuals earning under the marginal tax rates threshold in comparison to the 30% corporate tax rate.

Personal Income Tax

Share dividends are deemed as income and as such, are treated accordingly with other earnings. Where dividends have been franked, the credit’s one applied as a tax offset to reduce tax payable on taxable income.

The 45-Day Rule

To be eligible to claim franking credits in personal tax returns, the 45-day rule (occasionally referred to as dividend stripping) requires shareholders to hold the stock “at-risk” for at least 45 days (inclusive of the purchase date and selling day).

Individuals will not receive the franking credits on the dividends earned if they have kept your share for less than 45 days. The rule is intended to avoid the claim of franking credits by shareholders who keep shares for a limited period and then sell them as soon as they qualify for a dividend. Both individual taxpayers, companies and SMSFs are covered by the law.

Exemption To The 45-Day Rule

For certain private shareholders, the 45-day rule is not strictly applied. By implementing the small shareholder exemption, the ATO has allowed small shareholders to be excluded from this stringent regulation.

The Small Shareholder Exemption allows shareholders with a cumulative franking credit of less than $5,000 to claim their franking credits in their tax returns for the financial year, even though they may not have kept their shares at risk for a maximum of 45 days.

How Do You Calculate Franking Credits?

In practice, franking credits can boost your return on investment.

In 2000, the Australian government made franking credits fully-refundable, meaning shareholders could reduce their tax liability past zero and receive cash refunds.

Here’s how it works in practice:

  • You hold 1,000 XYZ Limited shares. XYZ makes a $100 pre-tax profit and pays $30 in corporation tax – the corporate tax rate of 30%. With $70 in after-tax benefit left with XYZ.
  • The Australian Taxation Office receives $30 in tax from XYZ Limited. The ATO also incurs a $30 franking credit obligation – basically an “IOU” to XYZ Limited’s shareholders.
  • You are now earning $70 in dividends and a $30 tax credit from the ATO as a shareholder in XYZ Limited. Your taxable income, therefore, is $100. 45 per cent is the maximum marginal tax rate. You, therefore, incur a $45 tax obligation, 45% of $100. Your tax liability, however, is reduced by $30 in the value of the franking allowance. Your final tax liability is reduced to $15 if you trade in your franking credit.
    It is essential to mention that for shareholders who pay no income tax, excess franking credits also apply. Meaning, if your marginal tax rate is for example 0%, you’re retired or otherwise not in paid employment, this would enable you to claim the full $30 cash credit.

In 2007, when the Australian government made benefits paid from taxable sources such as superannuation benefits tax-free for those over 60, the franking strategy for older investors gained momentum. Many untaxed retirees will now collect dividend imputation payments, a cash reimbursement, from the government in accordance with the 2000 amendments.

This was restricted in 2017 by the government of Malcolm Turnbull, which limited the super tax-free status to accounts of less than $1.6 million.

Franking Credits & SMSFs

SMSF (Self Managed Superannuation Fund) trustees may potentially lower the tax liability owed by their fund by choosing to invest in completely franked Australian securities.

The company tax rate for businesses under the $50mil gross turnover threshold will be 25% from the 1st of July 2021 (30% is the typical company tax rate in Australian, as mentioned above), while the maximum amount of tax paid by an SMSF is just 15%. This makes it an enticing tax break for SMSFs buying fully franked stocks with high yielding dividends. If a large portion of the investment portfolio of the fund consists of entirely franked securities, their net tax bill can be greatly reduced.

The franking credit will offset the tax payable on the dividend if an SMSF earns fully franked dividend income in the accumulation process. Franking credits can also be used to minimise or reduce taxes due on all other SMSF profits, including the tax on capital gains, rental income and tax on concessional contributions. In the absence of any other taxable income from the SMSF, the ATO shall provide the SMSF with a cash refund for the company tax charged.

When the SMSF tax rate is lowered to 0% through the pension process, franking credits become much more valuable since the full value of the franking credit is returned to the SMSF.

For high-income earners trying to reduce the amount of tax levied on concessional super contributions, franking credits may be especially beneficial. The tax on concessional super contributions is expected to rise from 15% to 30% for individuals earning over $300,000. Individuals may look at raising the investment of their SMSF in fully franked Australian shares, rather than investing additional funds in super.

Proposed Franking Credit Reforms & Why They’re Controversial
The Labor government has repeatedly claimed that a backdoor for rich investors is the franking credit scheme. The opposing view is that many retirees aren’t affluent and rely on franking credits as a main source of income. Nevertheless, economists estimate that the government loses around $5 billion a year for franking credit deductions.

While most governments offer some form of tax relief on dividends, the Australian scheme is unique because it facilitates the conversion of imputation credits into cash. New Zealand, by comparison, provides imputation credits but the tax bill of a shareholder can only ever be reduced to zero.

Labor has suggested that Australia return to its pre-2001 scheme (which resembles New Zealand’s) where franking credit refunds outside of superannuation will be scrapped. In March 2019, opposition leader at the time Bill Shorten revealed Labor’s intention to restore the dividend imputation scheme to the original 1987 format by scraping excess franking credit cash refunds.

The problem is especially troubling for the SMSF industry since SMSF funds will not be eligible for refunds under this scheme, while standard super funds will be.

So What Is Better – Franked Or Unfranked Dividends?
While franking credits can be advantageous for an individual’s particular tax situation, it is always best to seek input from professional accounting or tax specialists and financial planning advice to determine what investments are right for you.

More information about investing in securities listed on the ASX which show both solid growth performance in terms of capital return and dividends for investors, contact the experts at Flagship Investments Limited (ASX Code: FSI) on 1800 FLAGSHIP (1800 352 474).

About Flagship Investments Limited

FSI is an investment company providing its shareholders with access to an expertly crafted portfolio of quality, growing Australian companies. For more information, call FSI today or contact@flagshipinvestments.com.au and we will endeavour to connect with you as soon as possible to discuss your franked dividend goals.

Almost every sharemarket investor loves LICs. What’s not to like about a low-cost way to get allocation to the market through a quality manager….and be able to do some income planning along the way!

LICs are world-renowned for their ability to be able to pay a dividend each year. As long as they are solvent they can declare a Dividend and pass through franking the portfolio has earned plus any franking generated by it paying tax. Australians love LICs for good reasons.

Graph 1

Chart 1: Source IIR. April 2021 LMI Monthly Update

Australian Equity LICs after Covid-19

Now that we have gone a full year since the onset of Covid-19 we are able to review the way that many LICs have managed their dividends through a falling market followed by a sharply rising market. While most have maintained their dividends it is worth looking a little closer to ask how sustainable some of those dividends may be. While we won’t speculate how other LICs will fare going forward it is clear that FSI has a responsible Dividends policy and its payments are supported by long-term strong performance.

In the recently released March quarter LIC/LIT review by Independent Investment Research (IIR) they observed that investors should look closer to ensure that the LIC they have invested in is maintaining a stable dividends policy.

As IIR noted with an estimated (overall) 25% decrease in dividends paid by ASX companies over 2020 it was no surprise that in 1H’FY21 most equity reliant LICs paid out more in dividends than they reported as Net Profit- creating payout ratios greater than 100%, as seen in Chart 1 above. While eyebrows may raise here it should be noted that this was only a 6 month period and many LICs that have low portfolio turnover, may not have generated “book profits” to Dec 31 and some have International Exposure that generates minimal dividends.

Chart 2: Source IIR. April 2021 LMI Monthly Update: # of Years LIC can maintain current dividend levels given the latest reported retained earnings/profit reserve

Look beyond the headline yield

While the pay-out ratios are interesting, IIR noted that investors should be more interested in the sustainability of Dividends that LICs pay.

As can be seen in Chart 2, were LICs to maintain the same dividend amount, Australian Equity-focussed LICs have on average a little over 3 years of dividend coverage.

Investors in Flagship Investments can take comfort that the dividends the Board makes are responsible, sustainable, and backed by investment performance and it has more than six years of Dividend coverage.

LICs for all stages of the cycle

With the ability to always pay dividends LIC investment managers can focus on investing through the cycle and look for portfolio growth, rather than feeling pressure to generate income from their portfolio to bolster the LICs dividend reserve.

Investors who favour LICs should look beyond the headline historic yield and ensure that its performance has justified and supported the Dividend payments. They should also research how sustainable future dividends may be. While markets go up over the long run there is volatility along the way and any extended declining or even flat market may see some LICs exposed for returning capital and not providing real dividends. What could compound the futility of paying unsustainable dividends is that Boards may have depleted the investment fund size just prior to the market recovery.

LICs that are holding years of reserves will be able to ensure their shareholders continue to enjoy more steady income streams through the investment cycle and the investment manager has artillery (capital) to invest into a rising market.

Chart 4: Source Bell Potter. LIC Yield Comparisons

Setting a responsible Dividend policy

The Board of a LIC adds value by declaring the right amount of dividends. Their objective is 3-fold. First to provide shareholders with growing and reliable income streams while Secondly ensuring the strong-performing investment manager is provided with capital to deploy into the market and finally that they are not shrinking the portfolio by simply giving shareholders a dressed-up return of capital.

With this in mind, we can look at the research produced by Bell Potter LIC/ LIT analyst Hayden Nicholson to look at Yields paid by Australian Equities LICs. Readers can look across various data metrics such as Yields paid, dividend reserves, and underlying performance of a LIC to form their own opinion of whether that LICs yield (dividend) has been responsible and is sustainable through a cycle.

 

Chart 5: Source IIR. April 2021 LMI Monthly Update: NTA and Share Price performance

Flagship speaks from a position of Authority

Flagship Investments’ objective includes providing shareholders with continued growth in fully franked dividend income. It does this through professional, disciplined management of the investment portfolio and not charging shareholders a management fee – with the manager being remunerated only on a performance basis.

In this performance table produced by IIR, we can see that FSI is a stand-out performer in both NTA growth and Share Price return.

Chart 4: Source Bell Potter. LIC Yield Comparisons

Extending this performance to the most current Bell Potter report dated 11 June 2021, which also looks at the 10-Year performance we see extended FSI performance and outperformance.

Flagship Investments Limited (ASX: FSI) has been a strong performer since it first listed in December 2000.

The Market recognises Flagship performance

Chart 7: Source Bell Potter. LIC Yield Comparisons

In the Bell Potter LIC March quarter report respective Pre-Tax Premiums and Discounts are plotted within each LICs area of investment focus. FSI can be seen as near parity to its share price.

Chart 8: Source Bell Potter. FSI Share Price and NTA growth

Considering its long-term profit that was generated by strong portfolio performance, its outperformance to the market and peers, a constant and responsible dividend, and its record high NTA and Share Price this would be of no surprise to FSI shareholders.

Positive forward sentiment

In recent investment commentaries the investment manager of the FSI portfolio Dr Manny Pohl, AM, has continued to indicate a positive sentiment towards the markets. Articles and Interviews with Dr Pohl and the investment team can be read and watched through the Flagship website and also the Investment Manager’s website.

Shareholders can have confidence in the ability of the manager to continue its strong performance and the board to deliver rewarding and responsible dividend outcomes.

Important Note and Disclaimer
This article is provided for educational purposes only and should not be considered as financial advice. Please consult professional advice before making any investment decisions.

In Australia, 46% of adults own investments listed on the Australian Securities Exchange (ASX), either directly or through a Self-Managed Super Fund (SMSFs). That figure equates to 9 million adults who possess investments outside of their home and superannuation funds.

With more and more investors focusing on the sustainability of dividends as a result of the COVID-19 pandemic, it is now more than ever fundamental to understand how dividends (whether fully franked or not) are calculated and their impact on an individual’s income and tax obligations.

What are fully franked dividends?

To understand how franked (and unfranked) dividends are calculated it is important to start with the basics.

For a detailed insight into the world of “Franking Credits” and “Franked Dividends”, visit our new and updated Ultimate Franking Dividend Guide.

To recap some points from the article:

  • When you invest in shares, you essentially own a piece of a company.
  • The size of that piece is determined by how many shares you own, a ratio of how many shares have been issued by the company.
  • Whether privately held or publicly listed (such as the Big 4 Banks), the most common method for companies to distribute profits to its shareholders is through a “dividend”.
  • As a shareholder, you are entitled to a portion of the company’s profit in the form of this dividend. Not all companies will distribute their end-of-financial year profits and pay dividends.

Dividend Imputation introduced the concept of franking credits. The original purpose of the dividend imputation regime was to avoid the double taxation of company dividends when it was implemented in Australia in 1987. Australia was the first nation in the world to adopt this regime to prevent double taxation.

Dividends may be fully or partially taxed at the corporate rate of 30% before being passed on to shareholders. These are called “franked” dividends.

There are three types of franked dividends:

  • Fully franked dividends – When the corporate tax rate of 30% has been applied to 100% of the dividend.
  • Partially franked dividends – A portion of the dividend has had the 30% corporate tax applied.
  • Unfranked dividends – No tax has been deducted from the dividend.

For any tax paid by your company, you are entitled to a refund. The Australian Tax Office (ATO) will refund your allowance if the top tax rate is lower than the corporation tax rate.

What are franking credits?

Franked dividends are entitled to a franking credit (often referred to as imputation credits) representing the amount of tax already paid by the corporation.

For the personal, everyday investor, this franking credit entitles the investor to receive, at the completion of their individual tax return, a credit for the tax already paid by the company on that dividend against their own income. Where the tax paid exceeds the marginal tax rate of the individual, the ATO will refund the cash difference.

What Is Dividend Yield?

The dividend yield is calculated as a percentage and represents the total dividends received in relation to the cost paid for the shares. The dividend yield is determined by deciding which proportion of the share price is returned as income to the investor. The dividend yield lets investors evaluate similar businesses, as it helps determine which company shares will generate better yield.

How is the franking percentage calculated?

The franking percentage is regarded as the extent to which an organisation has assigned franking credits to a “frankable” dividend. This is calculated by dividing the franking credit attributable to the dividend by the maximum franking credit allowed to be attributable to the distribution. This means that the franking percentage could still be 100% in circumstances where only part of the total distribution is frankable.

Example:
On the 30th of June 2020, ABC Ltd distributes $100,000 to its shareholders. ABC Ltd allocates franking credits of only $10,000 to the distribution, rather than the $20,000 maximum allowable in their circumstances.

The franking percentage for this distribution is calculated as follows:

($10,000 ÷ $20,000) × 100% = 50%.

How much tax do I pay on franked dividends?

There are two ways you can obtain profit if you own shares in a business: by selling the shares once they’ve risen in value, or from dividends paid by the business if it decides to distribute profits to its shareholders. Dividends can be a great way to generate a regular income from your investments but, much the same as any form of income you earn, you may have to pay tax.

As a shareholder, when you fill out your annual tax return you’ll need to include the dividend received plus the franking credit. You receive a tax credit for the value of the franking credit, which can be offset against other income.

It is important to speak to your accountant or financial adviser to understand the tax implications of your dividends.

A look back at the share market in 2020

Needless to say, the extreme volatility and the unexpected fall in the stability of asset values caused by the COVID-19 pandemic has had a tremendous effect on investors. Franking credits provide an important source of cash return to many eligible investors in Australia, especially mature-age wealth accumulators (aged from 45-59 years of age) and retirees (aged 60+).

Much of the effect is yet to be understood, and the full economic effects of the pandemic have yet to become completely evident. Data from the ASX has shown that 54% of respondents have made changes to their portfolios as a result of the pandemic. Further, the ASX Australian Investor Study of 2020 highlights that younger investors were especially mindful of learning during the crisis, with one in three stating that hedging strategies now hold a higher prior than in the past, while one in five will focus on liquidity and defensive assets.

An interesting takeaway from the report notes that investors across a variety of demographics will focus more intensely on the future sustainability of dividends.

Investors adore them and politicians argue over during election time – franking credits have been a mainstay of the Australian taxation system since 1987. Yet, there continues to be an air of confusion surrounding the treatment of franking credits received from franked dividends, and the impact on an individual’s personal income.

Dividend imputation was introduced in the 80s to end the double taxation of company profits. Under this new system, tax paid by companies was attributed or “imputed” to investors. Australia was the first country to introduce a dividend imputation regime.

As we should now know, dividends are a portion of the earnings of a business issued to reward its shareholders. Since a dividend is a form of income by the Australian Taxation Office (ATO), you would normally pay tax on it as you would on your hard-earned salary.

This is where franking credits enter the picture.

What are franking credits?

An easy way to think about franking credits is to class it as some sort of compensation from the ATO for double-dipping in tax payments, where tax has already been deducted once.

Dividends are received from earnings already taxed by the ATO, which currently stands at 30%. This means that shareholders earn a discount on earnings distributed as dividends for the tax paid by the company.

This is called ‘franked’ dividends. Franked dividends are entitled to a franking credit representing the amount of tax already paid by the corporation. Franking credits are often referred to as imputation credits.

For any tax paid by a company, a shareholder is entitled to a credit for that amount. The ATO will refund you the difference if your tax rate exceeds the tax rate of the company.

The “45-Day Rule”

Fully franked dividends mean the company has already paid tax on the money at the company tax rate of 30%. So that the money isn’t being taxed by the ATO twice, you’ll receive a franking credit for the tax already paid on the dividend by the company. This means while you do need to include the dividend in your total taxable income, you’ll receive a discount credit which will reduce your taxable income by the amount already paid by the company.

Because dividend payments are a form of income, you do need to include these in your total taxable income when you file your tax return. However and as mentioned above, thanks to the franking credits system in Australia, you often won’t need to pay much tax on your dividends (or any at all).

What are the laws governing franking credits and ordinary income?

As per the Income Tax Assessment Act 1997 (Cth) (ITAA97), franking credits constitute “assessable income (statutory income)” under Section 6.10 of the ITAA97.

Franking credits do not fall under the legal definition of “ordinary income” under Section 6.5 of the ITAA97, which typically income received from “direct or indirect sources” such as wages for individuals.

How do franking credits impact my tax?

Surplus franking tax offsets of those individuals and superannuation funds are generally refundable.

It ultimately comes down to the marginal tax rate and the dividend franking rate. You may gain any of the franking credits back as a refund if the dividend is completely franked and the marginal tax rate is below 30% (or all of them back if your tax rate is 0%).

You may need to pay extra tax on your dividend if your marginal tax rate is over 30%.

Since dividend payments are a source of revenue, when you file your tax return, you will need to include these in your overall taxable income. However, you may not be required to pay a lot of tax on your dividends due to the franking credit system in Australia (or any at all).

A shareholder counts both the dividend and franking credits as income when measuring assessable revenue, but the franking credits may be used to decrease the overall tax due. If the shareholder has any available franking credits and no further taxes to pay, the franking credits can be returned to the shareholder as a tax refund.

Please note: The information contained is general and does not constitute legal, taxation, or financial advice specific to your circumstances. For details about franking credits and the effect of your tax, consult with your accountant or tax advisor.

Trust the system – for now…

With the current operation of the scheme, a shareholder is able to use the franking credit to potentially reduce their own tax or obtain a refund if no tax is payable. In other words, either paying your tax with a refund or enjoying it is as good as cash. This is why you are expected to count franking credit as part of your personal, taxable income.

It is also worth bearing in mind that the legislation on the reimbursement of excess franking credits is periodically reviewed. It is always a good idea to check in with the ATO’s website to stay up to date with the new regulations on company tax rates and franking credits.

During the month we read with interest the NTA Report* which is produced by Bell Potter’s LIC/ LIT researcher Hayden Nicholson. Flagship Investments Limited (Flagship) is identified as a strong performer as per Table 1 noting LICs that invest in Large and Medium Australian companies, with Flagship’s comparative NTA and Share Price performance well above that of its peer group.

Table 1: Source Bell Potter

If we look into the Calendar Year 2020 Share Price Performance across those LICs and LITs covered by Bell Potter (Chart 1) we can see a positive share price return by Flagship which is highlighted in Red. In addition we can see that despite the market recovering quite strongly post-Covid19, and nearing its previous highs, many share price returns of LICs have not recovered well in 2020. Indeed many of the LICs which have generated positive share price return are international and thematic LICs.

Chart 1: Source Bell Potter

Looking deeper, and using 5 year performance (Chart 2) to see who have been strong performers over a longer time frame and using NTA not Share Price so as to identify the true driver of return we see 5 outliers that have each generated a return in excess of 10%p.a. In addition to Flagship these are ACQ (Acorn – which invests in Microcap and unlisted companies), RYD (Ryder invests in Medium and Small caps), MIR (Mirrabooka invests in Small Caps) and OZG (OzGrowth – small cap/ unlisted companies with a focus on WA based resource companies).

We can also see that most LICs have underperformed the return of the market (XAOAI – All Ordinaries Accumulated Index). Indeed Cash or Bonds may have been a better investment than most of these LICs, and would certainly have delivered less volatility along the way.

Chart 2: Source Bell Potter

SIZE PENALTY IN LICS

Bell Potter LIC/ LIT researcher Hayden Nicholson produces some exceptional research and regularly pulls apart LIC sector data to see if there are any observable trends or themes. One he measures is Discount to NTA. It should be noted that discounts are not a measure of the LICs NTA or Share Price performance but can identify trends and potential share price opportunities. Chart 3 identifies that collectively, discounts are clearly deeper in LICs with a smaller investment portfolio – by upward of 15% to their larger sized LIC counterparts. We can ask whether this discount penalty is deserved and is it based on performance.

Chart 3: Source Bell Potter

While a comprehensive answer would require a full LIC by LIC analysis, Bell Potter research provides enough information to suggest a basic answer- looking at the evidence of Chart 4 it would appear that in some instances at least, there is a significant disconnect between performance and discount, which could be based on nothing more than a prejudice against smaller sized LICs.

In Chart 4 below, we again highlight those top 5 performers to see whether the market respected their top NTA performance. While past performance is no guarantee of future performance it is nonetheless a strong indicator of management competence and ability.

What is clear and perhaps counter-intuitive is that of the LICs covered by this research, the ones which generated the best 5 year NTA performance are also those amongst those with the deepest discounts.

Chart 4: Source Bell Potter

It would appear that the market has detached itself from reality (“efficiency”) and does not look beyond portfolio size to actual performance.

At least in the instance of these smaller sized top-performing LICs this is an unfound prejudice preventing sufficient investors from paying a more realistic price to acquire future performance. And remember, they are still obtaining this at a discount, and with yield-expansion through Dividends paid on NTA.

Many LICs, such as Flagship are active in regards to promotion and awareness of their Investment Objective and Investment Performance. Flagship Investments does not rest on the laurels of strong portfolio and share price performance to extract maximum value for shareholders.

Like with Flagship’s investment portfolio performance and the direction of the lines in Bell Potter’s Chart 3, the direction of Flagship share price may be a process of “little by little…..day by day” until it finds a more suitable point that recognises its portfolio performance.

Nicholas Hayden holds the opinion that strong performing LICs should eventually be recognised by the market, irrespective of their size. He said:

“The LIC sector is virtually unrecognisable from 10 years ago and in another 10 may also be again. There are significantly more LICs, investors and investment strategies continuing to emerge. The sector is also primed with newfound opportunities following external shocks, wind-ups and market inefficiencies. In time these funds will be acknowledged for the utility and expertise they provide, with discounts on good performers continuing to narrow up. With many index hugging funds performing as expected, perhaps active managers need to be highlighted outside of discounts and portfolio size”

Time will prove when researchers are proven right in this. As all investors know, at the end of the day the only thing that matters is performance.

*Important notes to these charts: The author of this article has edited the original document through the use of the colour Red and has changed some chart numbers to assist with readability.

*Bell Potter Securities document disclaimer:

IMPORTANT DISCLAIMER – THIS MAY AFFECT YOUR LEGAL RIGHTS: Because this document has been prepared without consideration of any specific clients investment objectives, financial situation or needs, a Bell Potter Securities Limited investment adviser should be consulted before any investment decision is made. While this document is based on the information from sources which are considered reliable, Bell Potter Securities Limited, its directors, employees and consultants do not represent, warrant or guarantee, expressly or impliedly, that the information contained in this document is complete or accurate. Bell Potter Securities Limited does not accept any responsibility to inform you of any matter that subsequently comes to its notice, which may affect any of the information contained in this document. This document is a private communication to clients and is not intended for public circulation or for the use of any third party, without the prior approval of Bell Potter Securities. Disclosure of Interest: Bell Potter Securities Limited receives commission from dealing in securities and its authorised representatives, or introducers of business, may directly share in this commission. Bell Potter Securities and its associates may hold shares in the companies recommended. Bell Potter Securities Limited ABN 25 006 390 772 AFS Licence No. 243480. Data taken from 19 October Bell Potter NTA research document.

While we sit in the middle of government mandated self-isolation I have had many people e-reach out and ask how do I buy shares? This question has come from friends and family, from all levels of income, from all occupations. And at its heart it is relatively simple to answer – the more important question is what should I buy!

To buy shares is as easy as opening an online trading account. Most of the banks offer an account that can be linked to your everyday banking account and there are many businesses online that operate solely in this space. Personally, when I’m researching for the best option I test a few comparison websites like Canstar or Finder. The things you are looking for are-

  1. Reputable dealer – check AFSL registration details and security protocols
  2. Low fees – this includes brokerage, account keeping, entry and exit fees
  3. Ease of Use – if you can view the platform using a free trial this is a good way to test functionality, usability, reporting etc.
  4. Investing options – can you only invest in Australia? What about international? CFDs? indices?

If you don’t trust yourself with assessing an online platform, then a traditional stockbroker is another option. They monitor your portfolio and can buy and sell shares at your instruction. Again searching for a reputable person or organisation is paramount, a competent professional whom you can trust.

Once you’ve picked your provider, the next big question is what to buy…

Unfortunately, we can’t offer financial advice, we don’t know your circumstances, your goals or risk appetite. This is best planned in consultation with professionals. But, we can offer an option: Flagship Investments Ltd is a Listed Investment Company (LIC) that has been around for over 20 years. When buying a LIC you don’t just buy one share you buy into a company that owns a diverse portfolio of shares, professionally managed by the appointed Manager. The investment strategy behind Flagship Investments Ltd centres on the view that the economics of a business drives long-term investment returns and investing in high-quality business franchises that have the ability to generate predictable, above-average economic returns will produce superior investment performance. The Flagship Investments’ portfolio continues to outperform the All Ordinaries Index and paying semi-annual dividends continues to provide shareholder value.

We wish you the best of luck on your own investing journey!

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