Dividend franking explained

Richard Hemming

There has been a great deal of noise over the issue of franking credits and what a potential Shorten ALP Government would mean. The purpose of this article is to make clear what the effects are, as well as to emphasise that sustainable income growth is more important than income per se, for any investor.

FRANKING EFFECT: THE NUMBERS

Below is a table that outlines the effect of the potential change. In simple terms, the current taxation policy encourages retirees to invest in high yielding fully franked dividend paying stocks such as the major banks and Telstra to monetise franking credits via a cash refund from the government. A company pays 30% corporate tax and under the current system; if you pay less than 30% tax, you still get the full value of those “franking credits”.

Under the changes proposed by the ALP you will only get those franking credits to the extent that you have tax payable. Hence, it is eliminating double taxation (which is what franking credits were originally designed to do, back when it was formulated by then-Treasurer Paul Keating in 1987) but will not provide refunds to those with excess franking credits, which are greater than the tax they have paid.

FRANKING CREDITS EXPLAINED BY THE NUMBERS

A table showing dividend franking numbers

As you can see from the table, taxes payable are calculated on the “gross dividend” which is the cash or net dividend received, plus the attached franking credits. The big impact from the ALP’s proposed changes will be felt by those with a marginal tax rate less than the company tax rate (currently 30%), because they no longer get the cash refund. There is no impact upon investors who are Australian tax payers on a marginal tax rate above the company tax rate.

It must be noted that the ALP amended its policy and has exempted full and part-time pensioners after listening to community feedback. This has exempted more than 300,000 low-income retirees from the policy.

WHAT ALP’S VIEW IS BASED ON

The ALP’s view overall is that the refunds of excess franking credits have become a burden on the budget because not only did Howard/Costello enable the use of 100% of the franking credits by investors who paid low rates of tax, but that this was combined with the zero tax rate applied to retirement income (up to balances of $1.6m). This is cold comfort to those self-funded retirees who made retirement plans based on the prevailing rules. The constant changing of rules by government makes retirement planning more difficult than it should be but does emphasise our point that it is income growth that counts more over time than income itself.

FRANKING IS GOOD BUT NOT THE KEY REASON TO INVEST

It’s important to note that franking credits have been good for companies and investors. When you look at the paltry 2.4% rate of return you get on a 12-month fixed term deposit. It’s no wonder Australian investors look to equities, particularly when franking credits can deliver a 40% plus boost to dividends paid to a qualifying shareholder. Franking credits incentivise companies to return capital to shareholders via dividends. They are effectively hidden value in a company because it doesn’t sit on the balance sheet and is only evidenced via a lowly note in the accounts.

Arguably, after Labor’s emphatic victory in the Victorian election late last year, the markets have priced the impact of these potential changes into current prices.

A COMPANY’S FUNDAMENTALS ARE WHAT COUNT

Ultimately, a company’s fundamentals remain much more important to investors. That is, how sustainable those dividends are and how much you have paid for those dividends. Investors in the past have paid too much for dividend streams. Alternatively, it is actually the companies that have paid too much! Telstra is a classic example. The company paid out more dividends than its cash flow warranted, failing to invest in growth and to take into account the competition arising as a result of the NBN. All the while it was eroding its balance sheet strength. Then the crunch came when the company could not maintain its fiction that profit margins were being sustained and it was forced to reduce its dividend payout.

WHICH BRINGS US TO SMALL CAPS

These companies generally have higher risk than their bigger counterparts, but because the universe on the ASX is so big, we are always able to find at least 10 small caps that measure up to our dividend paying criteria: strong operating cash flow versus total dividend; moderate net debt when compared with duration of assets; and dividend growth potential. Following the February reporting season, we’ll list our top dividend paying Small Caps. *Please note that Under the Radar Report is licenced to give general financial advice. Please seek independent advice on your particular circumstances.

About the Author

Richard Hemming

Richard Hemming (r.hemming@undertheradarreport.com.au) is an independent analyst who edits www.undertheradarreport.com.au, which provides investment opportunities in Small Caps that you won’t get anywhere else.

Under the Radar Report is licensed to give general financial advice only (AFSL: 409518). The author does not own shares in any of the stocks mentioned.

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