In Australia, 46% 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:
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.
When a company reports its earnings for the entire financial year, this dividend payment is issued. Some businesses will only pay a final 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 firstname.lastname@example.org and we will endeavour to connect with you as soon as possible to discuss your franked dividend goals.