Beware of tax change to dividends

Investors looking for stocks paying high-dividend yields will need to be alert to changes to company dividend policies, following recent adjustments to their accounting and tax treatment.

Companies have more flexibility when it comes to paying dividends these days but they also face some uncertainties about tax treatment, because of a new Australian Taxation Office ruling.

Equity investors, unsure about when they will start to see capital gains on their shareholdings again, have turned to stocks paying high yields. But they need to understand how dividend payments are changing. They also need to think about their yield strategy so they can avoid "yield traps" and other pitfalls when chasing dividends.

In June 2010 the government changed the Corporations Act to give companies greater flexibility in the way they pay dividends. Prior to the change, companies had to pay dividends out of profits.

The amendment to the act removed the specific reference to profits and replaced it with a balance-sheet test for paying dividends. As long as a company's assets exceed liabilities by an amount sufficient for the dividend payment, then the company can declare a dividend.

What the change meant was companies could pay dividends up to the value of their net assets. As long as a company had cash or debt capacity, it could pay a dividend. This was a welcome development.

Dividend certainty

A number of companies, particularly listed investment companies, moved to provide certainty about dividend payments by committing to making regular payouts, whether they made a profit or not. However, the change to the Corporations Act raised an issue for the ATO. When dividends were paid out of profits, they could be franked.

But now dividends can be paid out of amounts other than profits, the ATO has questioned whether franking credits can be attached to the dividend.

The ATO put out a ruling last December. It says although profits are no longer referred to in the relevant section of the act, the concept of profits as the source of dividend payment continues to be relevant to the assessment and franking of dividends for taxation purposes. The ATO's view is that a company with accumulated losses that pays a dividend may be deemed to have paid shareholders out of share capital.

In such a case it would not be franked and would be treated as a capital gain, not income. This might apply even if the company had made a profit that year but had accumulated losses. The ATO's ruling is a draft and may be revised.

A senior accountant, who did not want to be named, says: "Investors will be attracted to companies that make a commitment to pay regular dividends. But they need to make sure the company is in a position to frank its dividends."

Total returns

Yields have been the driver of sharemarket gains over the past few years. Macquarie Equities has calculated dividend yields delivered 70 per cent of the Australian sharemarket's total return (share price growth plus dividends) since the financial crisis.

Fund manager BlackRock agrees. In a report on dividend investing issued in March, it says: "Long periods of zero or negative capital growth are the norm in real [inflation adjusted] terms.

"The United States market index, the S&P 500, is around the same level it was a decade ago.

"But dividends have driven the cumulative income return up by 40 per cent over that period."

To achieve that total return, investors must reinvest their dividends, unless they are retired and want to use them for income. BlackRock has found dividend yields have kept pace with all but the most extreme inflationary environments and high-dividend stocks outperform other stocks during periods of low or no economic growth. However, BlackRock warns not all high-yielding stocks are a good buy.

Companies that offer a high yield but do not increase the actual dividend amount over time tend to be poor performers long-term.

Researcher Morningstar agrees investors should look for stocks whose dividends increase over time.

It compares BHP, whose dividend has increased from 19? a share in 2002 to more than $1 a share today, with Telstra, whose dividend has increased from 22? a share to 28? over the same period.

A growing dividend is an indicator that the company is growing its earnings and paying out a constant share to investors.

Yield trap

A $10,000 investment in Telstra a decade ago would be worth close to $11,000 today, while a $10,000 investment in BHP would have grown to more than $50,000 over the same period. BlackRock says investors should always consider total return, even in periods when there is very little capital growth.

It says changes in the capital value of a stock (its share price) may be greater than the value of the dividend in any 12-month period.

Morningstar says investors risk falling into "yield traps" when they go looking for high-yield stocks.

Some companies trade on high yields because their stock price reflects a lack of confidence in the business and its ability to sustain earnings growth and dividend payments. Morningstar says dividends in the 6 per cent to 9 per cent range are sustainable, while anything higher is risky and should be investigated thoroughly.

Fund manager Russell Investments updated investors in its Russell High Dividend Australian Shares exchange traded fund in April, saying its had weighted its fund to bank stocks.

A portfolio manager at Russell Investments, Scott Bennett, says: "Banks are looking to strip excess capital from their balance sheets. The most likely outcome will be a number of share buybacks."

Russell expects the fund to have a yield of 6.5 per cent this year.

How dividend franking works

Dividend franking was introduced into the tax system to stop the double taxation of company profits.

The system gives shareholders a credit for the tax already paid by the company.

The Australian Taxation Office looks at a dividend this way:

Assuming that the company is paying the full rate of corporate tax (30 per cent), a dividend of $100 would be assessed as income on which 30 per cent tax had already been paid.

To calculate the pre-tax amount of dividend, divide the dividend payment by 0.7. The $100 dividend is then grossed-up to $142.86, of which tax of $42.86 has been paid by the company.

Dividends can be fully franked, as in the example above, or partially franked if the company has not paid the full rate of tax or earns income overseas (which cannot be franked).

If the shareholder's marginal income tax rate is 30 per cent, there is no more tax to pay on the dividend.

If the shareholder's marginal rate is 37 per cent or 45 per cent, the tax to be paid will be the difference between the shareholder's marginal rate and the company tax rate applied to the grossed-up dividend.

If the shareholder is on a marginal rate of 15 per cent, the company has paid too much tax on their behalf and the shareholder is entitled to offset the amount of the excess tax against other taxable income.

If the shareholder on a low marginal rate has no other taxable income to use as an offset, they can claim a rebate for the excess tax paid by the company.