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.