Full credit to dividend franking

At Intelligent Investor we simply adore dividends. They may not be very sexy, but in a corporate world littered with half-truths and empty promises—and they’re the good bits—dividends do at least provide a bit of black and white. A company can either put money in our bank accounts or it can’t, and we much prefer the ones that can.

The word ‘can’ here is important, though, because a dividend may not be the best use of a company’s cash—there may be projects to fund that offer a higher return on capital than shareholders could make for themselves. But it’s a great sign if a company is making enough cash to have to worry about this—and the option of paying a dividend does draw a line in the sand when management comes to consider such projects (or at least it should).

So the idea is that company boards should make decisions about their use of cash based purely on whether the company or its shareholders could make the best use of it. The sad reality, though, is that managements frequently feather their own nests and concentrate on building up their empires.

Temptation

And, as if there wasn’t already enough temptation for companies to hold on to cash, it used to be the case that money paid out as dividends was taxed twice— once when the company paid tax on its profits and once when the individual recipients paid tax on their dividend income. Quite apart from being unfair, this biased the system in favour of companies retaining—and, often, squandering—their profits.

To balance things up a bit, the Labor government of the mid-1980s introduced a system of dividend ‘imputation’, also known as ‘franking’. The way it works is that when a company pays you a dividend, you may also get some ‘franking credits’ (also known as ‘imputation credits’), representing the amount of tax already paid by the company.

Imagine, for example, that Company X achieves pre-tax earnings per share of $1 and decides to distribute the whole lot, after tax, as a dividend. For each share, it sends 30 cents to the Australian Tax Office and the remaining 70 cents to shareholders as a dividend. Along with the dividend, however, shareholders also get 30 cents in franking credits, representing real cash sent by the company to Canberra as tax. And here’s an important point: you only get the franking credits in respect of earnings made—and taxed—in Australia.

It all comes out in the wash at tax return time. When you fill in your return, you add the 70 cent dividend to the 30 cents of franking credits and declare $1 per share in pre-tax income. You then work out the tax you should be paying on this $1. Investors on a 15% tax rate (and who fall below the Medicare threshold) should pay 15 cents, while those on a 48.5% rate should pay, you guessed it, 48.5 cents.

For the first investor, the Tax Office says: ‘You’re due to pay 15 cents, but the company has already paid 30 cents on your behalf. So we owe you 15 cents.’ To the higher-rate taxpayer, however, the Tax Office says: ‘You’re due to pay 48.5 cents, and the company has paid us 30 cents on your behalf, so you owe us the other 18.5 cents.’ The table sets out how this all adds up.

Unfranked: uncool

With a dividend that is entirely unfranked, though, (perhaps because the profits were earned, and the tax paid, overseas) shareholders would simply receive the dividend of 70 cents, without any franking credits, and then pay tax at their top marginal rate.

Investors on a 15% rate would pay an additional 10.5 cents tax (0.15 times $0.70), leaving them with 59.5 cents ($0.70 minus $0.105)—some way behind the 85 cents they would have kept after tax under the imputation system.

For investors on the top 48.5% tax rate, the difference is similarly stark. They would pay 33.95 cents in tax on their 70 cent dividend, 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.

Finally, if a company has paid Australian corporate tax in respect of some, but not all, of its dividend, then only part of the dividend will qualify for franking credits and the dividend is said to be ‘partly franked’. For a dividend that is 80% franked, for example, you’d treat 80% as though it was fully franked and the other 20% as unfranked.

The maths can become a little hairy, but the crux of the franking system is that it ultimately taxes Australian-based income once, at the shareholders’ marginal tax rate. If your tax rate is higher than the company tax rate, you cough up the difference. If it’s lower, then you get the difference back. So your share of Australian corporate profits is taxed at the same rate as your Christmas bonus or the interest on your bank account. And that, in our opinion, is fair.