17 – Franked shares

Introduction

Franked shares are terrific investments. They have a huge advantage over other investments: the ultimate individual shareholder gets a credit for the tax previously paid by the company. In some cases all the tax is refunded to the shareholder.

If a shareholder’s marginal tax rate is less than 30% they in effect get two dividends: first the normal dividend paid once or twice a year by the company, and second a refund of all or part of the tax previously paid by the company when the shareholder’s tax return is lodged.

An example

A simple example based on ANZ shares may help explain.

Assume a shareholder receives $700 of cash dividends. These dividends are fully franked (ie paid out of profits declared to be fully taxed in the ANZ’s hands). The shareholder must include the $700 cash dividend in her taxable income, plus a further $300 representing the tax previously paid by the ANZ on the underlying profits.

This means a total of $1,000 appears in her tax return.

The amount of tax paid depends on her marginal tax rate. The lower her marginal tax rate the less tax she pays, or the greater her refund.

A range of possibilities is shown here:

  0% 15% 30% 40% 45%
Cash dividend $700 $700 $700 $700 $700
Franking credit $300 $300 $300 $300 $300
Taxable amount $1,000 $1,000 $1,000 $1,000 $1,000
Tax Nil $150 $300 $400 $450
Franking credit $300 $300 $300 $300 $300
Tax payable $300 Refund $150 Refund Nil $100 Payable $159 Payable

Another way of looking at franked dividends is to add back the tax benefits to get an equivalent pre-tax rate of return. If the ANZ shares pay a dividend of 7%, fully franked, this is the equivalent of 10% before tax. This is a very high effective dividend yield.

Franked shares will tend to be better investments than un-franked shares.

Franked shares usually relate to companies that are resident in Australia and pay predominately Australian income tax. Only Australian income tax generates Australian franking credits. Ex-Australia (i.e. every other country) taxes do not generate Australian franking credits.

This means in the long run and on average Australian shares will outperform ex-Australian shares. Not every share.  Not every year. But in the long run, and on average.

For this reason Australian shares should generally be preferred over ex-Australian, or international, shares. If you have two otherwise identical companies, but one pays tax in Australia and one pays tax in say the UK, the Australian company’s dividends, and hence its shares, will be more valuable in the hands of an Australian shareholder due to the franking credit phenomena.

In summary

Preferring Australian shares over similar international shares will generate tax driven superior returns: that’s what the dividend imputation system is all about.

And preferring (deep) blue chip shares, household names, that are held for the very long run and virtually never sold, will eliminate CGT and make a good thing even better.

An SMSF invested in say ten blue chip Australian shares will produce very good returns over time.

Anyone interested in shares should study this report: Russell ASX Long Term Investment Report.

Further reading

The Dover Way: Direct Investing.

The Dover Way: Dollar Cost Averaging.

The Dover Group