Dividend franking explained

JP · Member

Dividend franking explained

Australia's system of dividend imputation, also known as franking, is a very important concept for new investors to grasp. The system, introduced by the Labor government in the mid-eighties, might seem a little complicated at first but, by the end of this page, it shouldn't be. Before we get into the nuts and bolts, though, we should take a look at the history of the system.

Imputation is designed to avoid 'double taxation' of company profits. The best way to show how it would work without the system is to take a look at how things functioned in the United States until very recently. There, under the old system, corporate profits were taxed twice: once at the corporate level and again at the individual taxpayer's level when received as dividends. This led to very low dividends in the US as companies chose to retain profits to help shareholders avoid that second layer of taxation. It was more profitable, after all taxes, to deliver wealth to shareholders through increased share prices rather than through dividends. In such an environment, retaining and reinvesting profits is the correct decision-at least according to finance theory.

But in practice it led to many stupid capital allocation decisions like ill-thought out takeovers. Companies spent the cash flow that would probably otherwise have been better paid out as dividends. While Australian companies haven't escaped irrational capital allocation decisions, our imputation system does promote a more generous dispersal of profits through dividends. If Aussie CEOs had the excuse of double taxation to justify a low dividend, there would probably have been that many more dumb 'strategic acquisitions' in the last decade (it beggars belief doesn't it?).

So how does imputation work? Along with your real cash dividend, the company gives you franking credits that represent the amount of tax already paid by the company. Let's illustrate how this works with a hypothetical example.

Company X, which pays out all of its earnings each year through dividends, achieved earnings before tax of $1 per share. It sends a cheque to the Tax Office for 30 cents and writes another for 70 cents and sends it to shareholders as a dividend. Along with the dividend, the company gives investors 30 cents in franking (or imputation) credits, representing real cash sent to Canberra as tax. And here's an important point: you only get the franking credits in respect to earnings made-and taxed-in Australia. Sadly, these franking credits won't buy you lunch-not outside the ATO staff canteen anyway. So how do you get value from them? It all comes to the fore at tax time. When you fill in your tax return, you add up the 70-cent dividend and 30-cent franking credit and declare $1 per share in pre-tax income. Then you calculate what tax you should have paid on this $1. Investors on a 15% tax rate should pay 15 cents of tax while those on a 48.5% rate should pay, you guessed it, 48.5 cents. For the first investor, the tax office says 'you should have paid 15 cents, but the company has already paid 30 cents on your behalf. So we owe you 15 cents.' The second investor (investor 3 in the table) however, owes the tax office the difference between their 48.5% rate and the corporate tax rate. So they owe the tax office 18.5 cents.

Now, let's take a look at what would happen without the imputation system. Shareholders receive the dividend of 70 cents without franking credits and simply pay tax at their top marginal rate.

The investor on a 15% rate would pay an additional 10.5 cents tax (0.15 times $0.70) and keep 59.5 cents ($0.70-$0.105). That's a fair way behind the 85 cents they would keep after tax with the imputation system.

And for the investor on the top 48.5% tax rate, the difference is similarly stark. On their 70-cent dividend they would pay 33.95 cents tax, leaving just 36.05 cents in their pocket from $1 of pre-tax corporate earnings. That compares with 51.5 cents under the imputation system.

The crux of the current system is that it taxes Australian-based income once, at your marginal tax rate. If your tax rate is higher than the company tax rate, you cough up the difference. If it's lower, the tax office sends you the difference. That way, dividends are taxed at the same rate as your Christmas bonus or interest earned on your bank account. And that, in our opinion, is fair.

SHOPTALK Fully-franked-means the company has paid tax at the corporate rate on the entire dividend. A partly-franked dividend means that some of the dividend is fully-franked, while the remaining portion is unfranked and therefore fully-taxable.