Smart Investor, Getting Started June 2013

Smart Investor, June 2013

Getting Started

Franking credits

Investors in Telstra received a letter recently: an interim dividend statement for the period ending December 31 2012. Alongside details of their shareholdings, investors will have read this sentence: “This interim dividend of 14 cents per share is 100% franked at the company tax rate of 30%.”

The author holds 1,500 shares in Telstra, so in my case, the letter also had a line like this:

Shares Held: 1500

Dividend rate: 14 cents

Unfranked amount: $0

Franked amount: $210

Divided paid: $210

Franking credit: $90.

Everyone’s familiar with a dividend: it’s an occasional payout of earnings by a company to its shareholders. For big Australian blue chips like Telstra and the banks, the dividend represents one of the main reasons investors want to hold their stock, for a steady and predictable stream of income no matter what happens to the price of the shares themselves. But what about franking? What’s that about?

Franking credits represent the tax a company has paid on the earnings that have been paid out as dividends. Companies pay dividends from after-tax earnings, so they’ve already paid tax on what they distribute to you.

Once you get a dividend, you pay tax on it, because dividends are a form of income. But Australia operates under what is known as an imputation system, which means that a company distributes its dividends with franking credits equal to the tax it has already paid – and you can get that tax back.

This isn’t quite the same as saying the dividends are completely tax free, because the company pays tax at the company rate of 30%, and you pay tax at a different rate, depending on your total income. But what you can do is net one against the other.

So, if you’re on the top tax rate of 46.5% (including the Medicare levy), then you won’t get your dividends completely tax free, but you will only pay 16.5% on them: 46.5% minus the 30% in company tax that was already paid. If you’re on the 34% band, you’ll pay 4% on the dividends. The box gives a costed example of how this works in practice.

A dividend that has had the franking credit’s effect built in to it is known as a grossed-up dividend. The exact percentage of a grossed-up dividend (or yield) therefore depends on what tax rate you’re on, because it’s going to be worth more to you in terms of cash in the bank if you’re on a low tax rate than a high one.

You might see the expression ‘fully franked’. What does that mean? Well, sometimes dividends or other distributions have a franked and an unfranked component. Sometimes, companies won’t have paid 30% on all of their earnings; perhaps they’re subject to a tax break, or they’ve made losses in previous years that they have then carried forward. If that happens, then the franking credit may only apply to part of the dividend. If a dividend is fully franked, then the whole lot carries a franking credit; if it is partly franked, then only a certain percentage of it carries a franking credit, and the rest does not.

The franking issue has some interesting outcomes for investment strategy. For example, if you’re on a high tax rate and your spouse does not, you might decide to buy shares in your partner’s name so that they can receive a full refund of franking credits, which the high-tax investor would not. If you’re a retiree with pension income that is tax exempt, you can use the refund of the franking credits to supplement your pension income.

In particular, people with self-managed super funds can glean a great deal of benefit from franking credits. Like all super funds, SMSFs pay a tax rate of 15%, so if a fund invests in shares with a 30% franking credit, then the excess credit can offset tax payable on other investments, contributions or interest.

One thing to be aware of: there is something called a holding period rule which requires you to hold shares for at least 45 days in order to be able to receive franking credits over $5000. That’s top stop people flipping stocks very quickly just to gain the franking credits. A more sensible approach is to buy and hold good quality stocks with high franked dividends and gain the many benefits over time.

BOX: An example

Last year you bought 300 shares of BHP Billiton for $33 each, for a total investment of $9,900.

On March 28, BHP paid an interim dividend of 55.57 Australian cents per share. The dividend was fully franked, meaning BHP had already paid 30% tax on it.

Your income from this dividend was A$166.70: 300 shares x 55.57 cents.

However, with it came a franking credit worth $71.44: that is, 30% of the $166.70. You don’t get that franking credit up front as income. But you declare it in your tax return, where it is claimed back as a rebate.

So the real value of this credit depends on what tax rate you’re on.

If you’re on 0% tax, then you get a $71.44 tax rebate: far from paying tax on your dividend, you have received a windfall. If you’re on 46.5% including the Medicare levy, then you still get taxed on the dividend, but only at 16.5% (46.5% minus the 30% BHP already paid), or $27.50.

So the 0% tax rate investor effectively gets a dividend of 166.70 + 71.44 = $238.14 by the time the tax is all settled.

And the 46.5% tax rate investor effectively gets 166.70 – 27.50 = $139.20.