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.
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.
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.