The terms ‘cut the grass’ and ‘mow the lawn’ are different ways of saying the same thing.
So it is with ‘franking credit’ and ‘dividend imputation’. Both describe the tax treatment applied to company dividends paid to shareholders.
Prior to 1987, company dividends were subject to double taxation e.g. Company made a profit of $1,000 and paid 30% company tax ($300). The shareholder received the dividend (after tax profit) of $700.
But then the $700 was subject to the shareholder’s personal income tax rate. Let’s assume their personal tax rate was 40% ($280 tax). Of the initial $1,000 profit, the government received taxes totaling $580 and the shareholder $420.
The introduction of the imputation system (franking credit) lowered the shareholder’s tax burden. In effect shareholders receive a tax credit for the company tax paid on the dividend. Franking credits represent the tax the company has already paid on the earnings it has paid as dividends.
Using the same numbers in the above example, the tax treatment of a fully franked dividend is…
Company profit of $1,000 taxed at 30% company tax rate ($300).
The shareholder receives the after tax profit of $700. For tax purposes, the shareholder declares a grossed up (actual dividend plus company tax paid) dividend of $1,000.
Based on the shareholder’s personal tax rate of 40%, the tax payable is $400 minus the $300 company tax already paid. The shareholder’s net tax liability is $100. Under the imputation system, the $1,000 profit is split $400 to the government and $600 to the shareholder.
The above example is of a fully franked dividend – a profit taxed at 30% company tax rate.
An unfranked dividend is where company tax hasn’t been paid (due to losses, writedowns etc.). In this case the unfranked dividend is fully taxable in the hands of the shareholder.
The reason fully franked dividends are popular with self managed superannuation funds (SMSF’s) is the difference between the company tax rate and the tax rate paid by SMSF’s.
A super fund in the accumulation phase pays 15% tax on earnings and zero tax on earnings in pension phase.
The $1,000 grossed up dividend paid to a SMSF in accumulation phase would be taxed at 15% ($150). The SMSF gets to deduct the company tax credit ($300) and therefore get a refund of $150.
The SMSF in pension phase has a zero tax liability on the $1,000 grossed up dividend and would receive a full refund of the $300 company tax credit.
For example in the past 12 months Commonwealth Bank of Australia [ASX: CBA] has paid out a fully franked dividend of $3.61 per share. On the current share price of $73.80 this equates to a yield of 4.9%. When you add back the franking credit, the GROSSED up dividend is 7%.
That’s very attractive compared to most savings accounts.
In an environment of falling interest rates it’s easy to see why SMSF investors have eagerly chased companies paying fully franked dividends. However, chasing yield can be dangerous – especially if shares are at a premium. That extra few percent in income could come with a hefty capital cost if the market falls.
Prudent, value orientated investors know a tax effective income isn’t the basis for investing. The investment must firstly represent sound (and preferably, discounted) value. If the income stream has a ‘tax sweetener’ that’s a bonus.
The ability to access quality direct shares of your choosing is one of the main attractions for investors establishing an SMSF. A 7% income stream with minimum middleman costs (except for accounting and audit fees) lets investors keep the lion’s share of the income to fund their retirement goals.
With lower rates of return on capital, it’s not hard to see why the SMSF sector is one of the fastest growing in the financial services industry.
But be warned – the control, independence and lower cost structure afforded by having a SMSF comes with responsibilities. Step outside the rules and guidelines and you’ll most certainly feel the taxman’s wrath.
Over the coming weeks I’ll go into more detail on the do’s and don’ts of investing in a SMSF.
Editor, Gowdie Family Wealth
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