There are two ways in which an investor can obtain a return on share investment. The first is known as an income return, and the second is known as a capital return.
Income Return – Dividends.
Income return comes in the form of dividends. A dividend is a portion of the company’s profits. Dividends can be paid out of profits from previous years.
The ANZ Online Dictionary defines a dividend as follows:
Different classes of shares (ordinary vs preference) give rise to different rights to dividends. However, the essential principle for all types of share is that dividends are the profits of the company apportioned out to the shareholders.
S.254T of the Corporations Act (2001) sets out the circumstances in which companies may not pay dividends:
Circumstances in which a dividend may be paid
- A company must not pay a dividend unless:
- the company‘s assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and
- the payment of the dividend is fair and reasonable to the company‘s shareholders as a whole; and
- the payment of the dividend does not materially prejudice the company‘s ability to pay its creditors.
It is the duty of the directors to decide whether these circumstances have been met, and also to decide whether and how much dividend to actually pay. This is determined by s.254U of the Corporations Act 2001, which states:
Other provisions about paying dividends (replaceable rule–see section 135)
- The directors may determine that a dividend is payable and fix:
- the amount; and
- the time for payment; and
- the method of payment.
- Interest is not payable on a dividend.
While dividends are paid out of company profits, not all company profits must be paid out as dividends. Profits that are not paid out are referred to as ‘retained profits.’ Retained profits are discussed below.
The ANZ Online Dictionary defines dividend yield as follows:
For an individual share, the rate at which dividends are paid is often known as the ‘dividend yield.’ When used to describe shares generally, the dividend yield is calculated by dividing the most recent dividend (annualized if there is more than one dividend payment per year) into the current share price. For individual investors, the dividend yield is more accurately obtained by dividing the most recent dividend payment (again annualized if necessary) by the price that a shareholder actually paid for the share.
As of February 2016, the average dividend yield for a company in the S&P/ASX 200 Index was 4.7%. This rate was calculated by dividing the most recent dividend payments by the market price of the shares to which they relate.
Dividend imputation allows a shareholder to claim a tax credit for tax paid by a company on its profits before a dividend is paid out. Dividend income is taxable income in the hands of most shareholders. But, when a company pays tax on profits before it pays a dividend, if that dividend was then taxed in the hands of the shareholder, then the same amount of money would effectively have been taxed twice: once at the company level, and once at the shareholder level.
To counter this, shareholders receive a tax credit for the relevant amount of tax paid on the dividends they receive. This means that the tax paid by the company is imputed into the shareholders tax affairs.
Dividends paid out of after-tax profit are known as ‘franked dividends.’ The basic idea is that the same profit should not be taxed twice, and that the profit of the company should be taxed at the marginal rate of the shareholder, rather than the flat rate of the company.
The basic logistics of taxing franked dividends are as follows:
- The company pays tax on its taxable income at the company tax rate (currently 30%) and records this tax as a credit in a notional account called a ‘franking account’
- When the company pays a dividend, it determines the extent to which the dividend is paid out of taxed profits, debits its franking account and advises its shareholders via a written dividend statement of the amount of the cash dividend and the attached franking credit
- The shareholder includes both the cash dividend and the attached franking credit in their assessable income computation; and
- The shareholder claims a tax offset in their tax payable computation, equal to the value of the imputation credit; this tax offset, unlike most tax offsets, can generate a refund of tax.
This means that ultimately the amount of income tax paid on the company’s profits depends on the income tax profiles of its shareholders. If all of a company’s shareholders faced the 47% marginal tax rate, then all of its income would ultimately be taxed at that rate. If all of a company’s shareholders faced a nil tax rate, for example because there were super funds paying allocated pensions, then all of its income would be ultimately taxed at 0%. This means that income derived through companies, like income derived through trusts, is ultimately taxed in the same way as it would have been had it been derived directly by the underlying owners i.e. the shareholders or unit holders, as the case may be.
The franking credit system is subject to what is commonly known as the 45 day rule. Essentially, this rule states that a shareholder typically needs to hold a share ‘at risk’ (that is, essentially unhedged) for a period of 45 days in order to be able to claim the franking credit. There are exceptions, particularly for small shareholders with a total franking credit entitlement below $5,000.
Capital return is the return to an investor upon disposal of the investment asset.
Typically, the capital return is the difference between the price at which an investor buys an asset and the price at which they sell the asset, net of transaction costs. In shares, this is represented by the change in share price between purchase and sale. If the price rises after a share is purchased, the capital return is positive and is called a ‘capital gain.’ If the price falls between the purchase and the sale, the capital return is negative and is called a ‘capital loss.’
Before a share is sold, the difference between the price paid for an asset and the price for which it could be sold is known as an unrealised capital return. The return is unrealised because the asset has not been sold. With shares, the unrealised capital return is typically readily identifiable. The price at which a share is currently trading on the sharemarket is easily observed, and because one share is the same as another share of the same type in the same company, in most cases a shareholder can be confident that they would receive something close to the current market price were they to sell.
Unsurprisingly, the tax on capital gains is known as capital gains tax (CGT). Capital returns are often taxed preferentially. The most common preferential treatment is for an investor who holds an asset for more than 12 months to receive a 50% exemption on any CGT that is incurred. In most cases, what this means is that only 50% of the capital gain is added to the other taxable income of the investor (in the year of disposal). This feature of the taxation system is essentially designed to encourage people to own investments for more than 12 months. The exemption is typically available to individual investors and to investors doing so as the trustee of an individual investor. SMSFs receive a smaller, 33% discount on CGT.
Capital Return vs Income Return
Different shares often offer different rates of capital and income return, and investors may at times prefer one type of return to the other. Whether an individual investor has a preference for income return or capital return depends substantially on that investor’s income and tax situation. Investors who do not have alternative sources of income will typically prefer higher rates of income return from their shares. Conversely, investors who do have alternative sources of income will typically prefer capital returns, as in many cases these returns are taxed at lower rates.
Investors who are by definition in lower tax brackets, such as a self managed superannuation fund in pension mode, will typically not be fussed as to the mix of income and capital return (provided that they meet their minimum income requirements).