Dividends from your share portfolio are a great way to build up your wealth but not many people understand the tax implication relating to the derived income.
This article attempts to share some light into the topic so read on.
Keep in mind that imputation credits is another term that may be used to refer to Franking credits. These two concepts are identical.
These credits are an indication of the taxes that have already been paid in relation to your investment. They are only applicable to Australian shares, and even then, only to the portion of earnings that those Australian firms have made within Australia and paid Australian company tax on. This restriction applies solely to corporations based in Australia. You can reduce the amount of tax that you would have been forced to pay if it weren’t for these credits.
Example of a Franking Credit.
Imagine for a moment that you are a shareholder in Westpac. The bank makes all of its profits in Australia (let’s pretend that it does), where it is headquartered, and the business has paid tax on those profits to the Australian government. If you are a shareholder, you have the right to receive a dividend payment equal to a portion of the company’s profits. A franking credit will be appended to these payouts when they are distributed. This is not a monetary payout made to you, but rather a credit that can be applied against the payment of your taxes. It is a reflection of the fact that tax equal to thirty percent of the corporate profit that is being distributed to you in the form of a dividend has already been paid. If it weren’t for the franking credit, this income would, in essence, be taxed twice: first when the firm generates a profit, and then again in your hands when it’s received as a dividend. The franking credit prevents this double taxation from occurring. From this vantage point, it would appear that franking credits are quite apparent and essential; nonetheless, Australia is one of an extremely small number of countries that has this provision.
It is possible that you do not own individual Westpac shares but rather own them via a fund in some capacity. That won’t be a problem at all since the funds will just add up all of the franking credits that they get and then pass them on to you, the investor. At the end of the year, the Internal Revenue Service sends you a tax statement that specifies the credits to which you are entitled.
Because this provision is not in place in other countries, Australian corporations have a tendency to pay out more generous dividends than their counterparts in those countries. This is one of the consequences of the existence of franking credits. The dividends paid by firms in the United States are significantly lower than those paid by companies in Australia, which average 4%, as compared to the dividends paid by companies in the United States. Instead, publicly traded corporations in the United States typically utilise their profits to purchase back their own shares. This practice results in increased returns for the shareholders who continue to hold onto their stocks and circumvents the problem of double taxation.
The return that you get from your Australian shares might be effectively increased thanks to franking credits. If you have an investment property that brought in $1,000 in revenue or if you received $1,000 in interest from a term deposit, then you will be required to pay the maximum tax rate that applies to your income. If, on the other hand, you receive this same amount of income as a franked dividend, then the tax equivalent of $430 will have already been paid on it, and you will only be responsible for making up the difference between that amount and your personal tax rate. In point of fact, if your individual tax rate is lower than thirty percent, you are eligible to obtain an excess franking credit as a refund. This is something that can be extremely appealing to retirees in particular, as they are on a tax rate of zero percent. After receiving the return on their franking credit, an individual who does not have to pay taxes will have the equivalent of $1.43 in their hand for every dollar in fully franked dividends that they get.
The accumulation phase of super funds results in a tax rate of 15%, but the pension phase results in no tax at all. This makes super funds another major beneficiary of franking credits. The additional tax credits that they receive over and beyond their tax rate are, in fact, an additional dividend that comes in extremely handy.
However, it is interesting to note that individuals who are subject to the highest marginal tax rate will actually experience a slightly better outcome if they generate their returns through capital gains. This is because of the capital gains tax discount of fifty percent that is applied when an asset is held for more than one year.
This disparity in results underlines the significance of developing individualised financial strategies. When certain conditions are met, you want a portfolio that prioritises franked dividends, whereas when other conditions are met, you want a portfolio that prioritises capital growth. And of course, you don’t base every decision you make about the design of your portfolio solely on tax considerations either.
You might come across a tactic known as dividend stripping, which is made possible in part through franking credit allocations. When you do this, you acquire shares of a firm, hang onto them for a relatively short length of time — just long enough to collect the dividend — and then you sell those shares, taking the money you made from the sale and investing it in another company that is on the verge of paying a dividend. It is important to keep in mind that the tax office requires that you have held the shares for at least 45 days before you can be eligible for the corresponding franking credit that results from such a dividend. Trading on such a short time frame is not at all something that we would suggest to anyone, but I felt I ought to highlight this just in case you recognise it in other places.
Franking credits are a significant contributor to the return on Australian shares, and as such, it makes sense to understand the mechanics behind it.
