What a fantastic response to the Switzer Investor Strategy days in Melbourne and Sydney (next time, I hope we can cover Adelaide, Brisbane and Perth)! The thing that blew me away, apart from the level of engagement and the quality of the questions, was the thirst to learn more about tax effective investing. While you should never invest for tax reasons alone, understanding how you are taxed is so important, because the return you get to keep is after the Australian Taxation Office (ATO) takes their share. Here are the questions I get asked most often.

Why aren’t all dividends franked?

Dividend imputation is a system that is unique to Australia. It was introduced in 1987 by Treasurer Paul Keating to eliminate what was then referred to as the double taxation of company profits.

For example, if a company made a profit of $100, it paid company tax of $30. If the after tax amount of $70 was then paid as a dividend to a shareholder paying tax at the highest marginal rate of 49%, the shareholder paid another $34.30 in tax and got to keep $35.70. Of the original $100 profit, $64.30 had been paid in tax to the ATO.

Dividend imputation eliminates double taxation by allowing each shareholder to recognize that the company has already paid (in this case) $30 in tax. Shareholders only pay tax if their marginal tax rate is above the company tax rate, or if below, get a full or partial refund of the tax the company has paid.

So, why aren’t all dividends franked?

It is an Australian system and the ATO only recognises tax that has been paid to it. When Australian companies have business operations and earn revenue overseas, they usually pay tax in those jurisdictions. Back in Australia, the ATO recognises that they have already paid tax overseas, so they are not required to pay tax here. If they haven’t paid any Australian tax, they can’t frank their dividends.

Companies like CSL (CSL) or Resmed (RMD), which earn more than 90% of their revenue outside Australia, pay little or virtually no Australian company tax. Accordingly, their dividends are unfranked.  Some companies have a more even split between onshore and offshore business and can partly frank their dividends (an example is Macquarie, which has 40% franking).

The other reason that companies can’t frank their dividends is that although they might have an operating cash surplus and are in a position to pay a dividend, they aren’t paying any tax due to the use of non-cash taxation deductions, such as amortization or depreciation. Examples include Transurban (TCL) and Sydney Airport (SYD). Both these companies have substantial depreciation or amortization charges (due to the capital investment required to build the infrastructure), and are now spinning off considerable cash, which can be paid as a dividend. As they aren’t paying any company tax, they can’t frank these dividends.

How does dividend imputation work?

So that every shareholder gets the same benefit (the tax to be paid is reduced by the tax that the company has already paid), it works as follows.

Firstly, both the dividend in cash, and the non-cash franking credit (sometimes called an imputation credit) is included in your taxable income. Both amounts are included upfront, so that the whole profit is being taxed in the hands of the shareholder.

Next, tax is assessed at your marginal rate.

And then, the imputation credit is applied again like a refundable tax offset.

In the example below, we have three shareholders with three different tax rates – an individual paying tax at the highest marginal rate of 49%, a super fund in the accumulation phase paying tax at 15%, and a super fund in pension phase paying tax at 0%. Each shareholder receives a $70 fully franked dividend, which carries with it imputation (or franking) credits of $30.

After tax, the shareholder paying tax at 49% gets to keep $51 of the $70 dividend. The super fund in accumulation will receive a net $85 (the $70 and the refund of $15 of excess imputation credits), and superfund in pension $100 (the $70 dividend, plus the refund of $30 of imputation credits).

After tax income on $70 franked dividend

Compare these outcomes to an interest payment of $70.

After tax income on $70 interest

The franked dividend generates higher after tax income – a factor of 1.42 times higher than an unfranked dividend or interest payment. This is the power of dividend imputation.

One small qualification relates to the time value of money. Generally, you have to lodge your tax return before imputation credits (in the case of super funds) are refunded by the ATO. If there is a period of time between the receipt of the dividend and the lodging of the tax return, the benefit is reduced.

How do I compare yields?

To compare the yield on a franked share investment to the yield on an unfranked investment (such as a share paying an unfranked dividend, rental income on a property, interest on a term deposit or bond), we “gross up” the franked yield to take into account the benefits of the franking credits.

For a 0% taxpayer, multiply the dividend yield by 1.428. For a fund in accumulation, multiply by 1.214. Or use the table below.

How do I pay no tax on tax-deferred income?

Finally, let’s deal with tax-deferred income, which can make investing in property trusts and infrastructure assets more attractive to higher rate taxpayers.

This is income that is paid as a distribution by a property trust or infrastructure asset, and relates to timing differences where the trust’s distributable income is higher than its taxable income due to things such as depreciation charges on the underlying assets.

Tax-deferred income is attractive because it is not assessable – that is, it’s tax-free. It does, however, reduce the cost base for capital gains tax purposes.

Let’s take an example. Suppose you invest $10,000 in a property trust. In its first year, the trust pays a distribution of $600, of which $400 is tax deferred income and $200 is taxable income.

In your tax return, you only show $200. The other $400 is tax-free. However, your cost base for capital gains tax purposes is reduced by that $400 to $9,600. When you finally come to sell the asset, you will pay capital gains tax on the difference between the sale price and the reduced cost price of $9,600.

If you are an individual, you will only pay tax on half the gain. If your fund is in accumulation, it will pay tax on two thirds of the gain. And if your fund has now moved into pension phase, it won’t pay any tax on the capital gain. In this case, your fund won’t have paid any tax at all on the tax-deferred income.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.