Dividends: Franked and Stripping Dividends
If you are an Australian resident for Tax purposes then you are able to take advantage of a tax arrangement designed to avoid the 'double taxation' of company profits where companies pay tax on their profits and Shareholders who receive the dividends must still pay income tax upon their receipts. To encourage domestic share ownership, the federal government introduced dividend imputation in 1987. Known as ?franking?, this countered the issue of double taxation.
Put simply, an Australian-based investor who holds Australian shares (or share funds) is entitled to a franking credit equal to the amount of the company tax paid. Franked dividends are those paid by a company that has paid company tax.
Example
- assume a company tax rate of thirty percent:
- If a company pays out all of its earnings each year through dividends and achieved earnings before tax of $10.00 per share, it would pay tax of $3.00 per share and then distribute to shareholders the $7.00 as a dividend. With the introduction of franking credits, the company now also gives the share investors $3.00 in franking (or imputation) credits.
- Subsequently, when the shareholder submits their tax return, they add up the $7.00 dividend and $3.00 franking credit and declare $10.00 per share in pre-tax income. Then they apply whatever tax (from their personal tax bracket) is paid on this $10.00.
- So, investors on a 15% personal tax rate who would normally have to pay $1.50 of tax, however as $3.00 company tax has been paid by the company to the Australian Tax Office, the share holder is 'owed' the difference of $1.50 by the Australian Tax Office.
- Those on a rate of 48.5% rate would normally pay $4.85. However, as thirty percent tax has already been pre-paid by the company, they only pay the difference between the 48.5 % and 30% tax already paid. In this case they only have to pay tax of $1.85.
To be eligible, the company has to be registered for franking and that the holder of the relevant shares upon which the dividend has been paid has held the shares for 45 days (or 90 days in the case of preference shares). If not, the tax benefit of the franking credits will be denied. Additionally, this rule will not apply to individual shareholders who receive less than $2,000 in franking credits per annum on all shareholdings.
Importantly, a company is not required to pass on all credits to shareholders. The degree of passing-on is the percentage of franking, eg a 75%-franked dividend is one upon which only 75% of the maximum possible attachable credits have in fact been attached to that dividend.
So how do you maximise the advantage that franking offers Dividend Stripping?
An investor can squeeze more profit out of dividend payments by choosing a portfolio of fully franked stocks that; are about to go ex-dividend, have a reasonable dividend yield and have historically re-couped their dividend drop-off in the share price soon after the dividend has been paid, thereby fully benefiting from the dividend, franking credits and the recovering share price. Please click here for a dividend stripping example
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