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Franking credits can put money in your pocket, but caution is key
With cash returns on term deposits remaining relatively low, shareholders can benefit from the favourable tax treatment of dividend income. But caution is warranted: investing for dividend tax benefits alone can be dangerous to those looking to keep their capital intact, as investments in Telstra or National Australia Bank highlight.
Dividends paid by Australian companies are taxed under a system known as imputation, whereby the tax a company has already paid on its profit – 30 per cent, or 25 per cent for small companies – is imputed, or attributed, to its shareholders as franking credits attached to the dividends they receive. The investor can then use these credits to reduce income tax liability or receive them as a tax refund, depending on the applicable marginal tax rate.
The dividend imputation system is designed to stop the double taxation of company profits, and it can make investing in companies that pay fully franked dividends tax effective, especially when an investor’s marginal tax rate is lower than the company tax rate.
If, for example, a company pays a fully franked dividend of 70 cents from its after-tax income, an investor in that company would receive a franking credit of 30 cents. That is, the company has already paid 30 cents of the tax obligation.
At tax time, the investor would need to declare $1 as taxable income; that is, the 70 cents dividend payment plus the 30 cents franking credit. If an investor’s marginal tax rate were 19 per cent, reflecting less than $45,001 in taxable income, they would pay 19 cents tax on that income, and thus would be returned 11 cents from the franking credit in their tax return, and their total after-tax dividend income would be 81 cents.
If the investor were to earn less than $18,201 and so not pay income tax at all, they would get the full 30 cents credit back. That means the Australian Taxation Office would refund the full amount of the franking credit, or 30 cents, so the dividend income after tax would be $1.
“But if the investor sits in a higher tax bracket than the company rate, he or she won’t get a refund of any of the franking credit and will need to pay additional tax over that which the company has already paid,” Bruce Brammall (pictured), author and and financial adviser at Bruce Brammall Financial, explained. “So, shareholders on the lowest marginal tax rate benefit the most from franking.”
And superannuation funds pay tax at 15 per cent on their earnings while in the accumulation phase, even less than lower-income earners, so most super funds will receive refunds of franking credits every year.
Value of franking credits shouldn’t guide investments
Given this, there are some things investors can do to optimise their tax situation. For example, couples on different tax rates may wish to buy shares in the name of the person who enjoys the lowest marginal tax rate to maximise the refund of franking credits.
Similarly, a retiree with a tax-exempt pension income can use the refund of the franking credits to supplement their pension income. Franking credits also represent money in the bank to self-managed super funds that pay a tax rate of 15 per cent.
However, while investing in companies that pay fully franked dividends can be an effective taxation strategy, that alone should not guide a person’s investment decisions, Brammall said.
“A company, for example, that falls in price from $20 to $10 and originally paid a 5 per cent dividend, the dividend yield would become 10 per cent,” he said. “There’s a reason for that high yield, and very often it’s because the share price has fallen considerably. You also need to remember the dividend yield is generally historical and can be cut back at any time.
“So, buying companies which pay high dividend yields can be a trap. Telstra was a good example of this. Many analysts warned that Telstra wouldn’t be able to keep paying high dividends, and its price then fell because its high-dividend payout was arguably not sustainable.”
Many investors who bought Telstra shares 10 years ago when they were trading around $5 would be sitting on a big capital loss of almost 20 per cent, Brammall added. Tax should never be the primary determinant of a decision to buy shares, he said – the after-tax situation needs to be fully considered against other investment and wealth-building opportunities.
