This article appeared in the July 2012 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.
In a low-return environment, franking can make a big difference.
By Michael Kemp, author
It's a shame phrases such as dividend imputation, franking credits and tax-deferred income are used, because ascribing a "jargon" language to simple concepts turns most people cold. If I had my way I would rename most tax, business and economic principles using simple English.
This article aims to lift the fog surrounding the who, what, where and why of tax payable on share dividends.
Individuals, companies or trusts all pay their pound of flesh to the Australian Taxation Office and that's fair enough if we want government to operate. But before 1987 a large group of Australians were paying more than their fair share - owners of shares had to pay tax on company profits twice. The first hit was at the company level before dividends were distributed, the second from shareholders, payable at their personal income tax rate.
The Hawke-Keating government didn't think it was fair either and in 1987 introduced dividend imputation, which ended the taxing of company profits twice. Forget the fancy title - understanding how the system works is fairly straightforward.
How dividend imputation works
In abolishing double taxation of dividends the government had a choice: eliminate the tax at company level or personal level. The system of dividend imputation we have now effectively eliminates the tax paid at company level. To show how it works we can use an example looking at things from the perspective of a typical shareholder, Joe Citizen.
Consider a company pays a dividend of 70 cents per share. This distribution is made after tax has been paid at the company rate of 30 per cent. So for every dollar the company pays out, 30 cents goes to the taxation office and 70 cents to shareholders.
To calculate the amount of tax Joe pays, we undertake three steps.
First, we add back to Joe's 70-cent dividend the tax already paid by the company, that is the 30 cents it previously forwarded to the ATO. This gives our original figure of $1, the amount the company had before it paid tax and a dividend. This is often referred to as the grossed-up amount.
Second, we apply Joe's rate of personal income tax (let's say 46.5%) to the $1. That gives the tax payable in Joe's hands - 46.5 cents.
The third step is the good news. Because the ATO has already received 30 cents, Joe only has to pay another 16.5 cents per share to meet his tax obligation.
The additional tax paid by Joe represents the difference between the corporate tax rate and his marginal income tax rate. What of a shareholder whose marginal tax rate is below the 30 per cent corporate tax rate? Even better news - he receives a cheque in the mail because the ATO refunds the difference between his personal tax rate and the corporate tax rate.
Why is this referred to as dividend imputation? Imputed means "representing" or "assigned". The tax paid by the company is assigned to the shareholder.
Franking credits represent the tax paid by a company on the earnings it has distributed as dividends. You will also hear reference to the franking account, which is not an account containing money but simply a record of the tax that has already been paid by the company. Franking credits are paid out of the franking account and because franking credits are only of use to shareholders, companies are usually quick to pass them on.
It is easy to find out the size of the franking credit attached to any dividend you receive. Companies supply a dividend statement to shareholders, either by email or post. This states, as a separate item, the amount of the franking credit. A dividend that has a franking credit attached is referred to as "a franked dividend".
What determines the level?
Dividends are usually 100 per cent franked for companies paying tax on Australian-derived income. But dividends are not always fully franked. For example, when a company generates income overseas or experiences losses rather than gains, the franking account can be insufficient to pay a fully franked dividend. Under these circumstances the dividend could be partly franked or might not be franked at all.
Dividends with no franking credits are referred to as unfranked dividends. These 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. This is clearly shown on the dividend statement. It will be listed as an actual dollar amount.
Most shareholders benefit
Franking credits are attractive to most shareholders (exceptions are mentioned below). But this has not always been the case. Until 11 years ago, franking credits were wasted on Australian taxpayers in low tax brackets. If the franking credit (the tax the company had already paid) was more than what the shareholder would have paid by applying their personal tax rate to the grossed-up dividend, then too bad - the ATO kept the difference. In other words, the franking credit was wasted, either wholly or in part.
That changed on July 1, 2000. Since then the ATO has refunded unused franking credits, which has benefited superannuation funds and those on the lower rungs of the PAYE tax scale.
Fine-tuning the Tax Act
Like all tax codes, Australia's has developed special exemptions and additions over time - the bells and whistles that convert something that started off being simple into something more complex. Below are a couple of these changes:
In 2003 New Zealand companies could choose to offer franking credits on Australian tax paid.
Holding period eligibility rules were introduced, that to be eligible to use franking credits certain requirements had to be met. Either you:
- Had to have owned the shares for a minimum continuous period of 45 days; or
- Had total franking credits for the year of less than $5000.
This meant short-term traders could not claim the franking credits. However, small holders were exempt provided they had not arranged to pass on the benefits to someone else.
Real estate investment trusts (REITs)
Distributions made by REITs require a special mention. They are typically untaxed in the trust's hands (that is, they don't come with franking credits attached) but are taxable in the hands of unitholders. Calculating the tax liability is not straightforward. It is determined after adjusting for tax concessions such as depreciation allowances and tax-deferred income. The proportion of tax-deferred income varies depending on an REIT's particular circumstances.
About the author
Michael Kemp has had a long career in Australian financial markets. Following the release of his first book, Creating Real Wealth, in 2010, he now works as a freelance financial writer. Read more about him here.
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