The number of people invested in the Australian Securities Exchange (ASX) has grown exponentially within the past few years, and with it, so too have the number of investment queries.
If you’re a new investor, Flagship is here to answer all your questions, such as “What is a franking credit?”, “Are there different types of dividends?”, “How do I calculate franking credits?” and more. We’ll give you all the information you need to help you navigate the stock market with ease and invest in your future wisely.
Why Are So Many Australians Starting to Invest?
- Dividend-paying shares and their benefits
- The dividend tax rate in Australia
- Franked and unfranked dividends
- Imputation/franking credits
- Calculating the franking rate/percentage
- How dividends impact personal tax obligations
What Are Dividends?
Before we dive into the world of franking, it is important to first understand what dividends are and how they work to build wealth for investors.
When you purchase shares in a listed company, such as one listed on the ASX, you become a part-owner of the business. As a part-owner, you’re entitled to your share of the company’s profits in some form. 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, these dividends are paid to shareholders 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 10% return on your investment each year you remain a shareholder.
Australian investors can use their dividend-paying shares in one of two ways. They’ll either use them as a steady stream of passive income to live off, or they will reinvest them into their portfolio to further boost their assets.
Are There Different Types Of Dividends?
Interim Dividends
This type of dividend is distributed before annual profits have been determined by the company. Typically, it will be issued at the same time as the company’s interim financial statements, usually six months into the financial year.Final Dividends
When a company reports its earnings for the entire financial year, this dividend payment is issued. While some businesses will issue a shareholder with both an interim dividend and a final dividend in the same financial year, other businesses will only issue a final dividend.Special Dividends
These dividends are one-time payments issued to shareholders when the company profits are unusually higher than its regular earnings. If a company generates increased revenues over a certain financial period, it may pay a special dividend to its shareholders.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. This helps investors evaluate similar businesses to determine which company shares will generate better yields.
What is a 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). A DRP allows you to opt-in to a scheme that uses your dividend distributions to purchase additional shares in a company.
There are many benefits to doing this, but the main one is you can use the revenue generated from your dividends to purchase additional shares without paying brokerage fees.
A DRP also provides a good passive investment opportunity to steadily increase your shareholdings in a business with minimal input. 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. This means that on the day of the dividend payout, the shares are automatically acquired on your behalf at market price.
The Relationship Between Dividends, Franking, and 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.
Thanks to the dividend imputation scheme, the tax on dividends is different in Australia. This is because dividends here are not “double taxed”, unlike in many other countries worldwide. Companies that distribute franked dividends pay tax on their profits at a corporate tax rate before allocating these profits to shareholders as dividends.
In order to satisfy their individual tax obligations, the shareholder receives a credit with every dividend to represent the tax already paid by the corporation. This is known as a franking credit.
What is a Franking Credit?
Franking credits, also known as imputation credits, are issued alongside partially or fully franked dividends as a representation of the amount of tax already paid by the company. They’re known as credits because they’re received and applied as a tax offset.
Share dividends are deemed as income and, as such, are treated accordingly with other earnings. When franking credits are issued alongside dividends, they are applied as a tax offset to reduce the amount payable on the shareholder’s taxable income.
Australian companies pay a 30% corporation tax on their earnings before distributing them as dividends. Then, once shareholders receive these earnings as dividends, they are taxed again as part of the shareholders’ income. Before franking credits were introduced, shareholders would receive no compensation for this double taxation.
To avoid double taxation, the Hawke-Keating Labor Government adopted the dividend imputation system in 1987, introducing the concept of franking credits and franked dividends in Australia.
Under the dividend imputation scheme, Australian businesses continue to pay company tax on their earnings before they are given as dividends to shareholders. Once these dividends are distributed, the franking credits now entitle shareholders to a refund on the earnings they receive.
These credits prevent double taxation on dividends by acting as compensation for the 30% in tax already paid by the company. The Australian Tax Office (ATO) will refund you the difference if your top marginal tax rate is less than the company’s tax rate. This can lower tax payments and raise income for any of the following individuals:
- People whose cumulative franking credits are in excess of their yearly assessable income tax liability
- People with fully franked shareholdings owned through retirement funds that do not pay tax (such as SMSFs) and;
- Other individuals whose marginal tax rates are less than the 30% corporate tax rate
What is the Difference Between Franked and Unfranked Dividends?
There are two main kinds of dividends you can obtain from the businesses you have invested in. These are known as franked and unfranked dividends.
Dividends issued with imputation/franking credits are called fully or partially franked dividends, meaning the company has either paid tax on the whole dividend or part of it. 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.
As we now know, both fully and partially franked dividends exist to prevent the double taxation of company profits.
A business that pays a 30% tax on all its income will pass on franking credits equal to the tax already charged. If a corporation made $100 and paid $30 in corporate tax, for example, it would distribute $70 in dividends and $30 in credits for franking. This would be an example of a fully franked dividend.
Dividends given to shareholders without franking credits are known as unfranked dividends. These dividends are issued by companies that have not paid any tax on their profits before distributing them to their shareholders.
Why Do Some Companies Pay Unfranked Dividends?
Unfranked dividends are not uncommon when you invest in businesses that do not pay company tax in Australia. Although they may have generated revenue that may be distributed as dividends to their investors, they may not be required to pay tax in Australia (usually due to being domiciled overseas for tax purposes).
A company is not eligible to give its shareholders a tax credit if it does not pay tax in Australia. This means that, should a company decide to distribute profits to its shareholders, these profits would be received as unfranked dividends.
How Do You Calculate Franking Credits?
Franking Credit Example: A Practical Look
To better illustrate franking credits, let’s consider an example where Company XYZ distributes a $1,000 dividend with a franking credit of $300. This section will guide you through the calculation and implications of such scenarios.
Proposed Franking Credit Reforms and why They’re Controversial
The Labor government has repeatedly claimed that the dividend imputation scheme is essentially just a backdoor for rich investors looking to dodge taxes. 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 each year due to franking credit deductions.
While most governments offer some form of tax relief on dividends, the Australian scheme is unique because it can convert franking credits into ready money. 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, the opposition leader at the time, Bill Shorten, revealed Labor’s intention to scrap excess franking credit refunds and restore the origins 1987 dividend imputation scheme.
This caused problems in the SMSF industry since SMSF funds would no longer be eligible for refunds under the original scheme where standard super funds would be.
What’s Better — Franked or Unfranked Dividends?
Defining franking credits as part of our discussion helps clarify why both franked and unfranked dividends have their own unique benefits. While franking credits can be advantageous for an individual’s particular tax situation, it is always best to seek financial planning advice from a professional.
To learn about the benefits of both, head over to our article on franked vs unfranked dividends.
About Flagship Investments Limited
Flagship Investments (ASX Code: FSI) is an investment company providing its shareholders with access to an expertly crafted portfolio of quality, growing Australian companies. For more information about investing in the ASX, contact our team today by heading over to our Contact Page or calling us at 1800 FLAGSHIP (1800 352 474). We will endeavour to connect with you as soon as possible to discuss your investment goals.
A fully-franked credit example involves a company paying $100 in dividends and attaching a franking credit of $30, representing the tax already paid at the corporate level. This scenario assumes that the dividends are fully franked, indicating that the tax paid by the company matches the shareholder’s tax rate.
Franking credits define the dividends by offsetting the tax paid at the corporate level, thus potentially lowering your personal tax liability.
