The divide(nd) of income: how to invest for franking credits
Unusually in the world of Australian finance terminology, the words ‘franking credits’ and ‘fully franked dividends’ carry emotion. It’s a concept that can kill electoral hopes, let alone fuel income dreams. More than half of the companies listed on the S&P/ASX 200 either fully pay or partially pay franked dividends. So, what are franked dividends and why do investors want to invest in companies that offer these?
What are franking credits and franked dividends?
A franked dividend is when a company pays out their after-tax income to investors with a tax credit. When it comes to tax time, the investor only needs to pay tax on that dividend to the extent that their own marginal tax rate exceeds the rate of tax the company has already paid on that dividend income. If their marginal tax rate is less, the investor may be able to claim a refund of the tax.
The idea is that the same income isn’t double-taxed.
Sound clear as mud? The following example from Dr Don Hamson, Managing Director, and Dr Peter Gardner, Senior Portfolio Manager at Plato Investment Management can help illustrate what this means in practice.
If a company makes $100 million pre-tax profit, they pay the 30% company tax rate which is $30 million, so there will be $70 million of after-tax profits left over. If that company pays a dividend of $70 million, equal to its profits, there will be a $30 million tax credit if it’s paid as a fully franked dividend – because the company has already paid $30 million in tax.
The investor experience might look like this (courtesy of the ATO).
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Why zero-tax investors love franking credits
Where things become really interesting is for investors with tax-free income such as charities or retirees with pension phase superannuation balances of less than $1.7 million. These investors can actually use the franking credits to receive a refund on top of the dividend paid so in the example previously of the $70 dividend with a $30 franking credit, a zero-tax investor would receive a tax refund of $30.
For zero-tax investors, franking credits are (except for some discounting for the time value of money as franking credits are only refunded when an investor fills out their tax return) almost as valuable as cash dividends. Thus they should be a big part of a zero tax investor’s income and total return. Hamson & Gardner
While there are a few countries that offer franking credits, Australia is the only country to offer refunds of unused portions of the credits.
Hamson and Gardner believe this is unlikely to change any time soon either, though they suggest some changes to the superannuation regime to be less generous to high net worth investors may come in time. It was a major factor in the Australian Labor Party losing the Federal Election in 2019 with many retirees concerned by the impact to their after-tax income. Neither major Australian party has raised any change to the franking credit regime since.
To really demonstrate the value of franking credits in Australia, the below chart by Plato Investment Management demonstrates the after-tax value of $1 of pre-tax income for different investor types.
(Click image to enlarge)
The franked dividend landscape in Australia
Not all companies pay dividends, let alone franked dividends. There are 91 companies listed in the S&P/ASX 200 index that pay fully franked dividends as at 1 June 2022. Some well-known examples include Commonwealth Bank Australia (ASX code: CBA), BHP (ASX code: BHP) and Wesfarmers (ASX code: WES).
If a dividend is partially franked, it means the company paying it has only paid a portion of the tax and the investor pays the remaining proportion if applicable. A reason a company may do this is if some of the company’s revenue has been generated in other countries meaning tax has been paid in those countries instead. Some examples of companies in this situation are CSL ltd (ASX code: CSL) and Computershare (ASX code: CPU).
The number of companies offering fully franked dividends has remained largely consistent over time.
Australia also has an arrangement with New Zealand called the Trans-Tasman Imputation measures allowing NZ companies operating in Australia and paying Australian tax to offer franking credits if they choose to opt in.
There are a range of reasons a company listed on the ASX might not pay franked dividends. One reason may be if they are domiciled overseas for tax purposes so therefore do not pay Australian tax.
Franking credits are obviously appealing to investors, but they also appeal to companies because they are tax efficient, and they encourage investment.
Investing for franked dividends
A good tip for any investor focused on a dividend income stream – let alone franking credits – is to consider the sustainability of the dividends. By that, I mean, can the company afford to continue to pay the dividends it has paid in the past and is there consistency in the value of those dividends.
Hamson and Gardner have typically found that companies in more defensive, less cyclical industries offer more sustainable dividends, such in consumer staples like Woolworth (ASX code: WOW) or Coles (ASX code: COL). They also view electronics as having moved towards being a consumer staple rather than their historic categorisation as consumer discretionary.
Investors should be wary of just focusing on the highest dividends – for some companies, a lower franked dividend can be a sustainable strategy and just as worthy of being part of an income stream.
It’s worth noting that even companies offering smaller franked dividends can be worthy of incorporating and still be sustainable. Off-market buybacks can also be a source of franking credits as excess credits are distributed to investors through these schemes.
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Getting started
There are a range of ways you can seek out investments with franked dividends. Managed investments such as actively managed funds or passive ETFs may offer franking credits on distributions depending on their holdings or investors could look at Australian listed companies which offer franking credits.
You can discover a range of investments here.
Frequently asked questions
What are franking credits and franked dividends?
A franked dividend is when a company pays out their after-tax income to investors with a tax credit. The tax credit is known as a franking credit and the investor can use it as credit on their taxes.
Are franking credits and imputation credits the same?
The terms franking credits and imputation credits are interchangeable. The system of franking credits and dividends is known as the Imputation system. When people speak of imputation credits or franking credits, it refers to the fact that companies have passed on tax credits to investors that investors can use to offset their tax returns.
How are franking credits calculated?
Franking credits are calculated using the below equation.
Franking credit = (dividend amount / (1-company tax rate)) - dividend amount.
How do I use franking credits in my tax return?
For the latest guide along with current marginal tax rate, please refer to the ATO website here.
How do I find out if my investments offer franked income?
One of the easiest ways to find out is in your annual returns from the investment which should outline total income, including any amounts that have franking credits attached. You can also contact the issuer of any managed investments you hold to discuss what holdings they have which might have franking attached. For direct shares, looking at historic behaviour can be a useful indicator.
This article is part of our new Investment Guide series. If there is a topic you would like to learn about next, please leave a comment below.
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