High-yield times: why franking credits multiply dividends

Everyone loves a tax cut but the recent income tax changes announced by the Government make it even more important for people to understand what the after-tax returns on their investments are.

Any tax change that puts more cash in the hands of many taxpayers is good news but the focus tends to be skewed towards spending it rather than investing or saving the extra cash.

The proposed new income tax threshold levels – expected to begin in the 2005/2006 year and subject to Senate approval – give a boost to one of the most powerful yet least understood tax relief mechanisms: imputation credits.

Put simply, imputation credits (also known as franking credits) are a tax offset for Australian residents who receive dividend income from an Australian-based company.  Many Australians own shares directly, mainly in ‘blue chip’ companies like Telstra, BHP or the major banks, which usually pay a substantial dividend to their shareholders each year.

As well, many more people own shares in Australian companies through a managed fund. The difference with a managed fund is that the franking credits received from the underlying shares are taken into account and a franking level is calculated for the fund. The fund manager then provides investors with a tax statement after the end of the financial year, which details franking credits and other distributions received which can be used to complete their tax returns. Whether investors own such shares directly or through a managed fund the dividends and attached imputation credits will flow through to them.

So while a large proportion of the population benefits from imputation credits very few are aware of how the system works and how to use it to extract the maximum advantage.

The logic of the imputation system – first introduced by the Keating Government in 1987 – is to avoid double taxation of company profits. Before the introduction of imputation credits a company’s profit was taxed first at the appropriate corporate rate and then again in the hands of the company’s shareholders at their own marginal tax rate when they received a dividend (also commonly referred to as a distribution) from that profit.

Today, shareholders receive a cash dividend along with franking credits (equal to the amount of tax paid by the company on its profit) which are then used to offset income tax payable on an individual’s annual tax return. It is important to note that on the tax return the full dividend (called the ‘grossed-up dividend’ and which equals the cash received plus the franking credits) must be declared as income with the franking credits used as a tax offset.

Because the corporate tax rate in Australia is 30 per cent, the maximum imputation credit attached to a dividend will be 30 per cent of the grossed-up dividend. If a dividend has an attached franking credit at the 30 per cent company tax rate it is referred to as ‘fully franked’. Sometimes, depending on how much tax a particular company has paid on its profits, the ‘franking rate’ will fall below the 30 per cent mark and investors will only receive a partially franked dividend.

Assuming investors have received a fully franked dividend, however, if their marginal tax rate is at 30 per cent or below, the net effect of the imputation system is that they would have received tax-free income equal to the full distribution (cash dividend plus franking credits).

Even better news for those whose marginal tax rate is below 30 per cent is that imputation credits in excess of income tax liability can be refunded in cash by the ATO. This extremely useful feature of franking credits can be taken advantage of by individuals as well as complying superannuation funds, including self-managed (or DIY) super funds. Given that super funds pay only 15 per cent tax on income, imputation credits can certainly add substance to any retirement dream.

The example below illustrates how franking credits affect the after-tax dividend income across the marginal tax levels in the 2005/2006 tax year, which takes into account the proposed new thresholds.

The new tax scales franking benefits

Assumptions:
- Tax on distribution is levied at the marginal rate of tax
- Medicare levy and surcharge are excluded from the calculations
- Any other available tax offsets are excluded from the calculations

With the threshold levels set to jump again in the 2006/2007 tax year (the 42 per cent tax rate cutting in above $70,000 and the top 47 per cent rate hitting those earning over $125,000) even more Australians than ever will fall in the 30 per cent marginal tax level and will therefore be able to take full advantage of the imputation credit system.

But even without the latest tax relief, and irrespective of an individual’s marginal tax rate, franking credits have made ownership of Australian shares one of the most attractive ways to generate a tax-effective income stream.

Compared to bank deposits, for instance, the case for investing in Australian companies as a source of income is compelling. Unlike shares in Australian companies, bank deposits – whether in a savings account or term deposit – do not attract imputation credits.

Critics of share investments often point to the volatility of the stockmarket compared to the apparent surety of a fixed-term investment with a bank. And while it is true that dividends paid out by listed companies vary from year to year, most major Australian companies tend to issue generous dividends supplying investors with a stable source of tax-effective income.

Many fund managers, such as Vanguard, have designed products to take full advantage of the imputation system – investing in companies which have a record of paying high, fully-franked dividends. Most of these funds are labelled with an ‘imputation’ tag but all will vary in the exact nature of the companies they own and in how much they charge investors in fees. It would pay to fully investigate the features and costs of any ‘imputation fund’ before investing or seek expert financial advice.

Any investment requires careful consideration of risks and potential rewards but the Australian government has created a powerful incentive for investors looking for tax-effective income.

The imputation system is no free lunch but then again you don’t have to leave a tip either.

For more information or to order a chart showing the performance of the Australian sharemarket since 1900 visit www.vanguard.com.au.

This article dated June 2005 is prepared by Vanguard Investments Australia Ltd ABN 72 072 881 086 AFSL 227263 (the Manager) which is solely responsible for its contents. It is provided for general purposes only. The Manager, its employees or officers accept no responsibility arising in any way for errors or omissions. Initial applications for investment in any Vanguard fund may only be made on the application form attached to a current Product Disclosure Statement (PDS). All PDS documents are available by contacting Vanguard or via website at www.vanguard.com.au.

ASX is interested in your feedback, please email us any comments on this article.