Franked Dividends - How Do They Work?

This chapter will save you money, investors make mistakes all of the time due to lack of knowledge. Once you understand dividend imputation, you’ll be miles ahead.

Life before dividend imputation

Paul Keating introduced changes to the taxation of dividend income which have had extraordinarily positive effects on Australian companies, investors, and the Australian economy as a whole.

Before dividend imputation, Companies made whatever profit they made.  Then they paid company tax.  Out of their after tax income, they paid dividends.  These were then taxed, again, as income to shareholders.  Here's what happened back in the bad old 1970s when the company tax rate was 46% and the top personal rate was 65%:

Of every $100 in company profit, more than $81 could go as tax!  Companies therefore had little incentive to make profits.  Instead, many simply borrowed massive amounts of money so that their interest expense ate up any profit they made.  They used the money to buy lots of assets and hoped that these assets would appreciate and that shareholders would benefit through a growing share price. 

In 1985, then-Treasurer Keating introduced the dividend imputation system, which took effect in 1987.  Under this system, companies can pass credits for company tax payments through to their shareholders.  These franking credits are attached to dividends paid.

The tax changes from 2000 and 2001 made imputation even more attractive, by making excess franking credits (meaning those beyond the amount necessary to reduce your tax to zero) refundable in cash.

So how does it work?

A company pays tax at the company rate of 30%.  For every $100 of income, it has $70 left over after tax.

Example 1

Individual

The company in this example pays all of its after-tax income in dividends, and your proportional share of these dividends happens to be $70.

You would receive a $70 cash dividend with a $30 franking credit attached to it. 

Assuming you’re on the top marginal tax rate, you go through the following steps to work out the tax treatment of your dividend.

 

1.  You add your cash dividend and the franking credit to calculate your “grossed up” income.  This is $70 + $30 = $100.

2.  You apply your marginal tax rate of 48.5% to this amount.  Your notional tax payable is 48.5% ´ $100 = $48.50.

3.  You then subtract the franking credit of $30.  Your tax payable is therefore $48.50 - $30.00 = $18.50.

Note on the above example if you margin rate is low then 30% you will receive a refund of the excess franking credits.

As an example, if you’re on the 19% marginal tax rate, you would receive the $70 dividend totally tax free.  In addition, you would have the $11.00 tax credit left over.  This amount would reduce the tax you pay on any other income you may have by $11.00.  If you don’t owe that much tax, you’ll receive any amount left over as a cash refund.  This means that the $70 dividend is actually worth $81.00 in real cash in your pocket.  Excellent!

Brilliant dividends v. dumb taxable interest

The other way to look at it is to compare dividend income to interest income.

Suppose that same person, on the 19% marginal tax rate, received $70 as dumb interest income.  This would be subject to 19% tax ($13.30) so the total benefit to the investor would be only $56.70.

To this person:

·         A franked $70 dividend is worth $81.00.

·         Interest income of $70 is worth $56.70

 Example 2

 Super Fund

The company in this example pays all of its after-tax income in dividends, and your super funds proportional share of these dividends happens to be $70.

The super fund would receive a $70 cash dividend with a $30 franking credit attached to it. 

As a super fund only pays tax at a rate of 15% it will receive a refund on the excess franking credit.

 

1.  You add your cash dividend and the franking credit to calculate your “grossed up” income.  This is $70 + $30 = $100.

2.  You apply your marginal tax rate of 15% to this amount.  Your notional tax payable is 15% ´ $100 = $15.00.

3.  You then subtract the franking credit of $30.  Your tax payable is therefore $15.00 - $30.00 = -$15.00 or a refund of $15.00. 

If you have started a pension in your super fund and you are over age 60 then you will receive the full $30 in franking credits back as a refund from the ATO. Pension income on people over age 60 is tax free.

What could be nicer than paying no tax on dividend income? Getting a tax refund from the ATO!

A fully franked dividend is worth 1.4285 times as much as the same amount of interest income.      

If you work through the math, you’ll find that this multiple applies regardless of your marginal tax rate.  In all cases, a franked dividend is worth 42.85% more than an equal amount of taxable interest income.  This even works if you’re on a 0% marginal rate.  Because the franking credit is refunded to you in cash, you receive a full $100--42.85% more than the $70 nominal dividend. 

This multiple depends only on the corporate tax rate, so if that changes from 30% you'll have to adjust the multiple. 

Can you lose your franking credits?

Prior to the 2000/2001 tax year, it was possible to accumulate enough franking credits that some would be wasted, in the sense that once you had reduced your tax liability to zero, and credits had no further value. 

Since 2000/2001 excess franking credits are refundable, this topic can be put to rest forever.  Franking credits are good, in all cases:  they reduce your tax bill and they can produce cash refunds, no matter who you are or what your tax rate is.

There is one very rare situation in which franking credits can be lost. 

If your shares are held in a trust, and that trust makes a net loss during a particular year and therefore has no distributions to make to beneficiaries, then franking credits received by the trust during that year can be lost. 

This is a most unusual situation which normally won't arise if you simply hold assets in a trust which does not carry on a business which could produce negative net income.  It would also be possible to trigger this problem within a trust if you were to have high levels of borrowing within the trust, so that the interest expense overwhelms the income and delivers a net loss.  Realised capital losses would not trigger this particular problem, only operating losses.