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Fabulous franking: part II

This article appeared in the April 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

A simple formula to find companies that can pay high fully franked dividends.

Photo of Michael Kemp By Michael Kemp, Barefoot Blueprint

No one likes paying tax, so let's start with a question everyone asks: how much tax do I have to pay on my dividends? The answer lies in knowing how franking credits work. A July 2012 ASX Investor Update article touched on the concept of franking credits and this month we explore the topic further.

Dividends usually represent a partial distribution of company profits - partial because most companies choose to retain a proportion of earnings to reinvest in the business. The tax you pay on your dividends depends on two things: your marginal tax rate and how much tax the company paid before you received the dividend. Here's an example.

Karen owns shares in a company that has paid a dividend of 70 cents a share. She receives this after tax has been paid by the company at the company rate of 30 per cent. So for every dollar the company pays out, 30 cents goes to the Australian Tax Office (ATO) and 70 cents to shareholders.

To calculate what tax Karen must pay takes three steps.

First, we notionally add back to Karen's 70-cent dividend the tax already paid by the company (the 30 cents it forwarded to the ATO), which gives a figure of $1, often referred to as the grossed-up amount.

Second, we apply Karen's rate of personal income tax to the $1 (let's say 46.5 per cent), so that gives her a tax obligation of 46.5 cents.

Third, the good news. Because the ATO has already received 30 cents from the company, Karen only has to pay 16.5 cents a share. The additional tax paid by Karen represents the difference between the corporate tax rate (30 per cent) and her marginal tax rate (46.5 per cent).

What of shareholders whose marginal tax rate is below the 30 per cent corporate tax rate? The news is even better. They will receive a partial (and in some circumstances total) refund of tax already paid. The ATO will refund the difference between the personal tax rate and the tax already paid by the company.

This process is referred to as dividend imputation, because the word impute means assign. The ATO imputes or assigns the tax already paid (30 cents) so Karen only has to pay the difference (16.5 cents). The term "franking credits" refers specifically to the tax already paid by the company on earnings before they are distributed as dividends.

A company's franking account

You will hear reference to a company having a franking account. This is not an account containing money, but simply a record of the tax that has already been paid by the company. Some things add to the account, others reduce it.

When the company pays tax or receives a franked distribution from another company in which it has a shareholding, the company's franking account increases. If the company pays out a franked distribution to its shareholders, it decreases. There are several other reasons why the franking account can decrease; for example, when the company receives a tax refund from the ATO.

When shareholders receive dividends with franking credits attached, these franking credits are paid out of the company's franking account. And because franking credits are ultimately only of use to shareholders, companies are usually quick to pass them on.

Why some companies pay higher franking credits than others

Dividends are not always fully franked. This can arise when a company does not generate sufficient tax credits; for example, if it earns income overseas or experiences losses rather than gains. Under these circumstances the franking account might be insufficient to pay a fully franked dividend to its shareholders, which means the dividend could be partly franked or it might not be franked at all.

A dividend that has a franking credit attached is referred to as a franked dividend. Dividends with no franking credits are referred to as unfranked dividends. These dividends cannot be grossed-up; hence the tax payable in the shareholder's hands is calculated by applying the shareholder's marginal tax rate to the dividend they receive - with no adjustment. Where dividends are partly franked they are grossed-up only by the franked portion.

It is easy to determine the dollar amount of the franking credit attached to any dividend you receive. Companies supply a dividend statement to shareholders and this shows, as a separate item, the amount of the franking credit.

Alternatively you can calculate it yourself, as shown in the following examples.

An example: IAG vs. AMP

Insurance Australia (IAG) and AMP Limited (AMP) are two companies in similar industries but with different levels of franking attached to their dividends.

IAG is a general insurance group with operations in Australia, New Zealand, the United Kingdom and, more recently, Asia. AMP is an Australasian wealth manager and life insurer with core markets in Australia and New Zealand. IAG pays a fully franked dividend; AMP does not. This means neither their dividends nor their dividend yields are directly comparable (unless adjusted for tax differences).

Here is a worked example to show what adjustments you need to make to compare them. Let's assume your marginal tax rate is 46.5 per cent (including Medicare levy).

IAG's most recent full-year dividends totalled 17 cents (fully franked), which means after tax you will have received 13 cents. That's the all-important figure - how much of the dividend actually ends up in your pocket.

To derive this figure first calculate the franking credit attached to the dividend:

Dividend x Corporate Tax Rate
(1 - corp. tax rate) x franking proportion

17 cents x 0.3
   0.7 x 1.0
= 7.286 cents

Grossed-up dividend = 24.286 cents (17 + 7.286).
Now apply your marginal tax rate of 46.5 per cent.
Equals an after-tax return of 13 cents per share.

AMP shareholders received two partly franked dividends in the most recent full operating year. Each dividend was 12.5 cents. One was franked at a rate of 55 per cent, the other at 65 per cent. Using the formula above the attached franking credits per share were:

12.5 cents x 0.3          12.5 cents x 0.3
   0.7 x 0.55           +        0.7 x 0.65
= 17.98 cents

And the final after-tax amount you received was:
23 cents per share.

How to tell if a company is capable of paying higher franking credits

You can determine the franking credits your company has accumulated in its franking account by referring to the company's most recent financial statements. Look in the notes to the financial statements under the heading "Dividends" (easy to find these days with financial statements on line). Find the annual report on Google and search for "franking credits". The notes will show the balance of the franking account at balance date (the end of the financial year).

There might be additional information, such as how many franking credits are attached to the income tax payment provided for in the current financial statements; and how much the franking credits balance will be reduced as a result of the dividend declared in association with the reported profit result.

This all goes to show how important it is to check the franking credits attached to any dividends that companies pay, particularly those with overseas operations. If you don't, you might be comparing oranges with apples.

About the author

Michael Kemp is chief analyst at The Barefoot Blueprint.

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