How to gross up dividends

If you've been a little overwhelmed by our recent Investor's Colleges then hopefully this one will deliver some respite. We're going to discuss dividends from the perspective of someone who's new to investing.

Put simply, dividends represent the amount of after-tax earnings distributed to shareholders. That's a pretty straightforward concept. But in Australia, it's complicated slightly by our system of dividend imputation.

Now, don't get us wrong – the dividend imputation system is fair for shareholders and represents an important advantage of investing in Australia over, say, America. To demonstrate, let's look at an example.

Example

Take a fictional company paying out all of its after-tax profit as dividends. If Company A makes $1,000 in pre-tax profits it will have to pay company tax on that amount, currently at a rate of 30%. This means that Company A will pay $300 to Canberra, leaving $700 available to shareholders.

Initially, let's assume you are the sole shareholder. You will receive a cheque for $700 and a tax invoice which will show $300 of 'imputation credits', sometimes called franking credits. This amount represents the tax the company has already paid on your behalf.

So, if your marginal tax rate is 43% the taxman will deem you to have earned $1,000 – a tax liability of $430. Given that $300 has already been paid on your behalf (the imputation credit) you will owe another $130.

If your marginal tax rate is, say, 30% then you won't have any further liability. And, if your rate is lower again, then you will actually receive a refund on the excess imputation credits. This system is a much more favourable outcome than the double taxation that occurs in many other countries.

In the US you would be up for income tax on the face value of the dividend received ($700).

In Australia, if the company has paid no income tax and has no franking credits available from previous years then it may pay an unfranked dividend. In this case you would be liable for income tax on the entire dividend amount you received because the company hasn't paid any tax on your behalf.

Franking

Companies may also pay partly franked dividends. That's why our earnings tables usually include the level of franking.

It's unfair to directly compare a stock paying fully-franked dividends with one paying unfranked or partly franked dividends. You have to 'gross up' first. Here's the formula:

Grossed up dividend = dividend x (1 (franking level x (tax rate/(1-tax rate))))

A worked example should make that ugly mess easier to understand. Let's say you want to compare an unfranked dividend of $120 with a 50% franked (at the current corporate tax rate of 30%) dividend of $100 to see which is more attractive. The unfranked dividend is simply worth $120. That's the easy part.

To arrive at the comparable figure for the partly franked amount take the $100 and multiply it by 1 (0.5 x (30/(1-30))).

This simplifies down to $100 x 1.243, or $124.30. So in this case the partly franked dividend is more attractive. That wasn't too hard was it?