How franking pays off

Australian investors have been able to significantly enhance their sharemarket returns over time through dividend franking credits, and that’s not about to change anytime soon.

Franking credits are designed to stop the double taxation of income from shares by allowing an investor to claim a tax refund for company tax already paid.  Since the introduction of franking credits in 1987, the average market return (capital growth and income) has been 11% a year (to the end of June 2013), in line with returns from the Australian sharemarket over the past 110 years. 

During this time franking credits, assuming a level of franking of 70% across the market, have provided investors with an extra 44% of returns – a nice additional source of returns through either reduced tax, or tax refunds. That’s quadruple the average market return.

As David Gilmour explains today, the Australian Tax Office is moving to outlaw an activity known as “dividend washing” – whereby investors have been able to effectively double-dip on dividend franking credits. (See his article Dividend washing dries up).

But investors utilising franking tax credits as a legitimate tax offset need not worry, and that means the hunt for stocks delivering attractive yields that incorporate a high percentage of franking will continue unabated.

Franking credits (or imputation credits) are an important part of the investment landscape. The most recent ASX Long-Term Investment Report (to the end of December 2012) showed that for 10-year returns for superannuation funds, franking credits helped increased Australian share returns from 8.9% (pre-tax) to 9.3% after tax.

How franking credits work

• A company earns $100;
• It pays tax on this at the rate of 30% ($30), leaving $70 to pay to investors as dividends;
• The dividend of $70 is paid to investors, and along with the $70 of cash is a $30 ‘franking credit’ – or prepayment of tax that the investor (in this case a self-managed super fund) can use;
• The super fund has to pay 15% tax on the ‘grossed up’ value of the dividend – that is, the cash and franking credits.  In this case it is 15% on $100, so $15 tax is due.
• But the investor has a $30 tax credit (from the franking credits) so, after paying $15 of tax they will receive a $15 tax refund in cash, to go with the $70 of cash income from the shares;
• After company tax and superannuation earnings tax and the tax rebate, the investor will be left with $85.

Extra returns from franking credits

Franking credits are an ‘unpriced’ source of returns for investors. That is, the introduction of franking credits as a source of returns should not reduce the growth or income from Australian shares over time – it is an additional source of returns. 

There are various justifications for this, including that franking credits have no value to many overseas investors, so they will only invest in Australia based on expected satisfactory returns from cash income and capital growth.

Different tax rates

Pension superannuation investors, and investors paying 0% and 19% income tax rates, will have their after-tax returns increased by franking credits. Indeed, superannuation funds in pension modes and people paying tax at the 0% rate will receive all of their franking credits as a tax refund.

Those investors facing income tax rates of 32.5%, 37% and 45% will still have to pay some tax on dividends received – although franking credits will offset the majority of tax payable.

Investors in managed investments

Investors in managed investors – for example listed investment companies and managed funds – are able to have franking credits distributed to them.  A look at the history of the distributions from a managed investment will give you a sense of the tax effectiveness of the investment.  Managed funds often have distributions that include capital gains from the trading of the fund, and it’s worth paying particular attention to how tax effective their distributions are.

The 45-day rule

For investors on lower tax rates, especially SMSFs, a possible strategy presents itself. Could an investor just buy shares on the day before they trade ex-dividend (that is trade without the rights to the dividend), qualify for the dividend and then sell them the day later – and in that way benefit from the franking credits received with the dividend?

As appealing as this strategy may seem, there is a ‘45-day rule’ that generally means investors must hold shares for a 45-day period to claim the benefit of franking credits.  This makes the strategy very risky, as alongside trading costs and possible capital gains tax costs, you are also exposed to short-term sharemarket movements.  A 3% fully franked dividend (a half-yearly dividend for a share paying 6% fully franked income) will have franking credits with a value of just over 1% of the share value.  If you are paying some brokerage and some capital gains tax, even a small fall in the value of your shares over the 45-day period that you have to own them will eat into your franking tax benefit very quickly.

Calculating the value of franking credits

If you have a fully franked dividend, you can calculate the value of franking credits by multiplying the cash dividend by 3 and then dividing by 7.  For example, a $70 cash dividend will have franking credits of:  $70 x 3 ÷ 7 = $30.  If the dividend is partly franked, say 80%, you then need to multiply the answer by 80%.  In this case $30 x 80% = $24.

Conclusion

A retired investor, with a 0% tax rate (for example a superannuation fund paying a pension) who had just invested in the average market portfolio in 1987 when franking credits were introduced would have received an extra $440,000 of returns on a $1 million investment over the past 25 years from those franking credits. 

They are an important part of the investment landscape in Australia, and add a tax benefit to the attractive way that dividends tend to increase over time.

Scott Francis is a personal finance commentator, and previously worked as an independent financial advisor.