Making sense of franking credits this reporting season

As off-balance sheet items in Australia, the size of franking credits – aka imputation credits – per listed company isn’t that easy to find out.

But as a general rule, companies that have been making large profits and hence paying high levels of corporate tax – while not distributing a large proportion of these profits to shareholders – are likely to have large franking credit balances available.

Admittedly, some stocks like to hoard their franking credits. But the larger the franking credit balance, the greater the capacity for a company to pay future special dividends or off-market buybacks at some future point.

But remember, simply having a high franking balance does not necessarily mean a company will succumb to short-term pressure and return it to shareholders, especially if they need the funds to continue growing.

How they work?

Franking credits are the tax a company pays on the earnings before it pays out to you (the shareholder) dividends, which are typically declared twice annually. Ideally you should be looking for what are called ‘grossed-up’ dividends which have the franking credits built in.

Remember, not all dividends automatically have franking credits embedded within them, here’s how it works.

When companies pay less than 30% tax on their earnings – due to either a tax break, or previous year’s losses carried forward – their dividends or other distributions will have both a franked and unfranked component.

Given that they’re also a form of income, you’re typically required to pay tax on dividends. But under Australia’s imputation system – whereby companies distribute dividends with franking credits equal to the tax already paid – you’re entitled to get that tax back in the form of a rebate when you declare your own tax return.

That doesn’t mean dividends are necessarily tax-free. How much tax you get back comes down to your personal tax rate.

If it’s lower than the 30% a company pays on tax, the difference goes into your back pocket as a rebate. However, if your tax rate is above the 30% company tax rate, you’ll only be out of pocket by the difference between the two.

Useful example

Toni owns shares in a company that pays her a fully franked dividend of $700, and according to her statement there’s a $300 franking credit which represents 30% tax the company has already paid.

For tax purposes, Toni declares $1,000 of taxable income, but if her marginal tax rate is 15% – which equates to $150 tax on the dividend – she’d entitled to receive a refund on the difference, which in this case is $150.

Of course, those on different tax brackets will receive different refunds, and in some cases may have to top up this tax.

The impact of franking credits

With consensus estimates now pointing to a fall of up to 7.1% in earnings per share (EPS), the affordability of dividend payout ratios is likely to come under even greater pressure during this reporting season.

For example, while CBA has maintained payout ratio at between 70-80% of profits, there is a clear consensus that total payout ratios for the big-four banks will eventually have to settle around 50%.

Like it or not, stocks with either hefty franking credits and/or war chests of cash are not only more likely to maintain their payout ratio, but have the capacity to increase their dividends or issue special dividends, and these are the stocks you should look to invest in.

Important as tax considerations are, they shouldn’t be the primary determinant of the investment decisions you make. But if you’re in any doubt over the impact of fully franked dividends, take a look at the table below.

The impact of  franking credits on your tax bill

Investor 1

Investor 2

Investor 3

Investor 4

Cash dividend

$0.70

$0.70

$0.70

$0.70

Franking credits

$0.30

$0.30

$0.30

$0.30

Taxable income

$1.00

$1.00

$1.00

$1.00

Tax rate

0%

15%

30%

46.5%

Tax payable before franking credit

$0.00

$0.15

$0.30

$0.465

Tax owed (rebated) after $0.30 franking credit

($0.30)

($0.15)

$0.00

$0.165

Post tax dividend income

$1.00

$0.85

$0.70

$0.535

 

Tricks and traps

There are compelling reasons why couples on different tax rates may wish to buy shares in the name of the one who stands to receive a full refund of franking credits.

Similarly, a retiree with a tax-exempt pension income can use the refund of the franking credits to supplement their pension income. Franking credits also represent money in the bank to self-managed super funds (SMSF) that pay a tax rate of 15%.

But if you’re buying a stock with the express desire of receiving a fully franked dividend, remember that for any franking credits over $5,000 you’re required to hold shares for a minimum 45 days.

It’s equally important to put yield in the right context, as it can appear to be more attractive on the back of a falling share price.

Likewise, a yield of 5% today will be eroded if the company releases a surprise announcement, or changing business dynamics threaten to undermine a company’s competitive advantage.

That’s why investors looking for dividends to provide a certainty of income, need to ensure they search for companies with strong balance sheets and sustainable cash flows, with future growth prospects that are heading in the right direction.

Keep an eye on stocks issuing dividends disproportionately smaller than their earnings, as they have the capacity to increase payout ratios over time.

The best place to start is to search for companies paying high quality dividends.

Ten high quality stocks, forecast to pay attractive dividend yields, to check out in more detail include:

Stock

Forecast ROE

Historical ROE

Dividend yield

ERM Power

7.83%

34.36%

7.97%

Platinum Asset Management (PTM)

63.39%

59.04%

7.86%

Harvey Norman Holdings (HVN)

11.63%

10.69%

7.73%

CSR (CSR)

13.71%

10.49%

7.41%

Vita Group (VTG)

47.88%

65.87%

6.58%

Westpac Banking Group (WBC)

15.13%

15.89%

6.48%

Perpetual (PPT)

21.31%

25.51%

6.12%

Spotless Group (SPO)

16.05%

18.88%

5.88%

Commonwealth Bank of Australia (CBA)

17.41%

18.18%

5.62%

Intecq (ITQ)

11.00%

26.90%

4.67%

Source: Skaffold 12/02/16