If you are an Australian share investor, chances are you are familiar with or have at least heard about franking credits. Their popularity among Australian shareholders is unsurprising given their tax implications on dividend income. With correct handling, franking credits can be used as a tax offset and a means of boosting your investment returns.
Before we can get into how to use these credits alongside investment returns best, there are more pressing questions to answer. Namely, what are franking credits exactly and how do they work? Fortunately, our latest article covers everything you need to know.
Franking credits, also known as dividend imputation credits, are tax credits for the shareholder of a company. In Australia, franking credits represent the amount in tax that a company has already paid on profits, distributed as dividends. Hence, the distribution of said credits by a company is often referred to as a 'franked dividend'.
This tax credit afforded to shareholders can then be used to offset their individual income tax return. The process attributes the tax already paid by the company to the shareholder. Therefore, depending on their marginal tax rate, franking credits can be used by investors to offset their tax liability. Leading them to reduce their income tax or even giving them a tax refund.
Franking credits were first introduced in Australia in 1987 by the Hawke Government. The process was created to prevent double taxation by the government on company profits.
This system is known as the imputation system, recognising the tax already paid on profits by a company. The imputation system then gives those who receive their dividends a tax credit known as a franking credit.
Prior to this, companies had to pay tax on their profits and, if they then paid a dividend, this dividend would be taxed again as income for the shareholder. For investors, this meant a higher amount of tax payable on their profits, deterring many from making an initial investment due to the sizable corporate tax rate.
In Australia, companies currently pay a 30% tax on their profits. If these profits are then distributed to shareholders as a dividend, the government will recognise this amount as a credit for the shareholder to offset their individual income tax return.
For a more in-depth understanding of franking credit operations, the process is as follows:
Imputation system overview
The system is the foundation of franking credits, working as an overseer to ensure the taxation of company profits matches the taxation of the shareholders.
Allocation of franking credits
A shareholder receives attached franking credits with their dividends as distributed by the company they invested in. The credit is equal to the tax the company has already paid on the profits being distributed. Essentially, it works as a confirmation ticket of the tax refund the shareholder can cash in to remove the tax the company has covered from their personal taxation.
The actual allocation of the franking credits is determined by the company's tax rate.
Once companies attach franking credits to their shareholder's dividends, it is sent off to said shareholders. The credits are then used to offset the shareholder's personal income tax liability.
However, if the franking credits outweigh said tax liability, the shareholder receives a tax refund or can reduce the liability.
The benefits of franking credits for shareholders are numerous, highlighting why they have become a more wanted feature in the investment industry. Overall, investors' investment returns and tax strategies are the areas in which the benefits are most notable, and capable of being optimised through franking credits.
There are plenty of other benefits associated with franking credits to look forward to. Notable ones you may be interested in include:
Benefit 1: Optimal investment returns
The usual returns on company investments can be further optimised through the support of franking credits. The franking credits attached to shareholder dividends can essentially increase the yield of the original investment.
Hence, investors afforded franking credits can potentially enjoy a higher after-tax return compared to investments without said credits.
Benefit 2: Reduced tax liability
Franking credits' main benefit is that they can be used to reduce an investor's tax liability. Once a shareholder receives their dividend income and its attached credits, they can then use the latter to offset their personal income tax liability.
All in all, this allows the tax already paid by the company on profits can be attributed to the shareholder as well. This is then leveraged to reduce the overall tax the shareholder owes the Australian Tax Office (ATO).
Benefit 3: No double taxation
Without the presence of franking credits, company profits would be subject to the corporate tax rate. In turn, the dividends paid to shareholders would also come with a personal marginal tax rate. Hence, the same income payment is being taxed twice over.
This double taxation is only presented by franking credits, ensuring that neither party involved in a company's profits are being hit with unnecessary taxes.
TThe term "franking" is expressed as a percentage and refers to the amount of tax that has already been paid on the dividend by a company. Hence, dividends can be either “franked” or “unfranked”. It is important to know the difference between the two dividends as a shareholder to determine whether or not you will be paying tax on your company investment's profits
Finally, unfranked dividends have no franking credits attached to the dividend. This means that the tax on company profits is to be paid by the investor since the company has not taken on that role.
Example of a fully franked dividend
A fully-franked dividend means that a company has paid tax on the entire dividend at the company tax rate of 30%. This rate is applicable to all Australian companies.
To get a clearer picture of what a fully franked dividend looks like, we will walk through a calculated example.
Let us say that the company known as XYZ Pty Ltd pays a 100% fully franked dividend. This means they are covering the full tax on their shareholders' assigned dividends.
The process for calculating the franking credit is as follows:
For investors interested in learning about how much tax they can have covered by franking credits, this example can help guide you on your own calculations. Otherwise, you can use the general formula provided below.
The actual formula for calculating franking credits is fairly simple. The amount can be calculated so long as you know the overall figure of the dividend income and how much tax your invested company is expected to pay.
Franking credit = (Dividend amount/(1 – company tax rate)) - dividend amount.
Essentially, in Australia, franking credits can be calculated by first taking the dividend amount and dividing it by one minus the company tax rate, then subtracting the dividend amount. Whether or not this final figure will be used to offset tax liability or as a refund will depend entirely on the shareholder's personal tax rate.
A franking credit refund is only available to a shareholder if they have excess franking credits following the payment of their owed tax. Often, you do not have to lodge tax returns to receive this refund, meaning you can enjoy the full amount of franking credits given to you.
In the case that individuals and trusts have excess franking credits refunded to them, they cannot pay them forward. Rather, they must essentially cash them into to offset take or as an additional income source.
However, companies are not able to refund excess franking credits. They may still benefit from these additional credits though by converting them into carryforward losses. These are losses that are carried forward into a company's future years’ net income to reduce their tax liability.
Income investors should be wary of only focusing on dividend returns and forgetting about capital preservation. In isolation, if a stock pays a dividend yield of 6%, it is seen as an attractive income investment. However, if the investor receives a 6% income return but the stock price falls 20%, the investor is losing out. Income should not be sought after at the expense of the investor’s hard-earned capital.
Investors should also look to avoid “dividend traps.” A lot of the time when you look up information about a company, there will be data on their trailing dividend yield. Trailing dividends are dividends that the company has paid out in the past 12 months.
However, just because a company pays out a certain amount of dividends in the last year does not mean it will be able to sustain this level in future years. It is more important to look at the forward dividend yield, which is the yield investors are expected to receive based on forecasted dividends in the next 12 months.
In the longer term, if the company invested in is facing a structural earnings decline, dividends will ultimately end up falling. Investors should look for companies that are growing their earnings, but not necessarily spending a lot to do so. If they invest a lot in their business to grow earnings, this may also come at the expense of paying out dividends to shareholders.
Investors should always be looking for companies with fully franked dividends. That is not to say that investors should avoid companies that pay unfranked dividends, particularly if they are solid companies that pay healthy dividends. However, you can usually add a few percents to the dividend yield for companies that pay fully franked dividends, depending on your tax situation.
As a general principle, to gross up a fully franked dividend yield you would simply divide the dividend yield by 70 and multiply it by 100. This is best illustrated with an example as seen below:
Say Company A has a dividend yield of 5% and their dividends are franked, whereas Company B has a dividend yield of 6%, but their dividends are unfranked. By applying this simplified formula, the actual grossed-up dividend yield investors of Company A receive is 7.14%. Company B’s dividend yield stays at 6% as there are no franking credits.
This demonstrates the power of franking credits, in which a company offering a seemingly lower yield is actually higher when the dividends are grossed up to account for franking. We re-emphasise the fact that this example only focuses on yield, and the investor would still need to consider future earnings potential and capital preservation when making an investment decision.
In light of the uncertain market conditions, companies that pay a healthy dividend is a relatively attractive. However, income investors should be wary of only focusing on dividend returns and forgetting about capital preservation.
In more uncertain macroeconomic and market conditions, investors should be looking at companies that are resilient and have a defensive earnings profile. Tougher macroeconomic conditions will result in some companies being unable to sustain their earnings levels. Markets may react badly to some of these results, which will lead to a decrease in share price and result in investors losing capital.
We suggest that investors look for companies with certain characteristics that will allow them to defend their earnings which will help sustain their share price.
This includes companies that aren’t overly exposed to the economic cycle, as well as companies that have pricing power or contracts that allow them to pass on higher costs. Other characteristics we look for are:
HALO Global offers investors a variety of features to help them identify better income opportunities including dividend monitors, forecasting tools, research and ready-to-invest thematic portfolios (known as Vues).
The Australian Equities Income Vue, from ASR Wealth Advisers, is a selection of high-quality companies that aims to generate the investor a solid dividend income as well as preserve capital. Along with healthy dividend yields, companies on this list offer:
Here at HALO Technologies, we do not just offer key insights into investment terms like franking credits. We also help investors create a strong portfolio wherein they can make the most of factors like said credits.
Some of Australia's most notable companies that offer investors reliable dividend incomes are carefully analysed by our professional team. Find your investment match through our handy market updates, or get in touch with one of our team members for a one-on-one demo.
HALO is always ready to help guide investors towards a more profitable future!
Deterra Royalties (ASX: DRR)
Deterra operates a royalty business model that is involved in the management and growth of a portfolio of royalty assets. The company’s royalties are predominantly sourced from BHP’s Mining Area C (MAC) in Western Australia’s Pilbara region, which is expected to make up around half of BHP’s iron ore production after the completion of the ramp-up of the South Flank mine.
Deterra has an attractive business model, with EBIT margins of approximately 97%. With no capital requirements, Deterra’s business model is to essentially collect royalty payments, with their small costs being employee expenses as well as a few other minor expenses. With little need to reinvest in the business, this allows Deterra to pay out most of their earnings to investors. Although royalties are tied to the price of iron ore, it is also dependent on the volume that MAC produces. With BHP currently ramping up MAC’s production capacity, earnings (and thus dividends) will be supported by this volume growth. This limits the downside of dividend payouts. The low-cost nature of BHP’s production practically ensures that the mines in MAC will continue to operate, which will support earnings and thus continued dividend distributions.
According to consensus forecasts, Deterra has a forward dividend yield of 7.83%. We do note that just as with the other companies paying fully franked dividends in our top 5, this figure is before it is grossed up to account for franking. Once grossed up, the actual dividend yield is higher.
Inghams Group Limited is Australia's largest integrated poultry producer. The business is vertically integrated, with a network of feed mills, breeder farms, hatcheries, broiler farms, processing plants and distribution centres across Australia and New Zealand.
We are attracted to the structural tailwinds that poultry as a protein source is experiencing. We anticipate positive tailwinds associated with changes in eating habits, with more consumers choosing higher-protein and healthier white meats over more traditionally favoured red meats. Furthermore, we expect the prevailing macroeconomic conditions to accelerate this trend. As consumers are facing tighter hip pockets due to inflation and increased mortgage payments, they will be looking to shift away from higher-cost red meats and towards lower-cost meats such as poultry. We also like Inghams due to the cost advantage per kilo and the versatility of chicken as a protein source, which is due to the size of the animal. We believe these tailwinds outweigh temporary headwinds including staffing issues and cost pressures.
We believe Inghams’ earnings will continue to be supported by the shift towards poultry as a protein source due to changing consumer preferences as well as current macroeconomic conditions. We expect this to underpin Inghams’ dividends moving forward. According to consensus forecasts, Inghams has a forward dividend yield of 4.80%.
Metcash (ASX: MTS)
Metcash is a leading wholesale distribution and marketing company, which operates through the food, liquor, and hardware segments. Metcash supplies stores such as IGA, Foodland and IGA Liquor, as well as hospitality venues. Metcash owns major hardware brands such as Mitre 10 and Home Timber & Hardware, whilst also being a wholesale supplier to independent home improvement stores.
Given that over 80% of revenue is generated from their food and liquor segments, this makes Metcash quite a defensive company, whilst retaining some cyclical exposure through their hardware segment. IGA is quite competitive in the Australian supermarket industry, holding about 10% of the market share. Given that Woolworths, Coles and Aldi are vertically integrated, they own their own distribution networks which they do not share with independent retailers. This leaves Metcash in a leading position to supply independent retailers, who remain competitive by catering to the local demands of the community. We are also attracted to Metcash due to its business model as a distributor. It is a capital-light business as the stores the company supplies to are owned by private enterprises. This allows Metcash to deliver strong returns on capital.
Given that non-discretionary food and liquor spending traditionally holds up throughout the cycle, we believe Metcash’s stable earnings profile will continue to underpin the company’s dividend payments. According to consensus forecasts, Metcash has a forward dividend yield of 5.42%.
Best & Less (ASX: BST)
Best & Less Group is an omni-channel retailer with a network of over 240 profitable stores across Australia and New Zealand, as well as a rapidly growing online presence. It operates under the Best & Less brand in Australia, and under the Postie brand in New Zealand, both of which are trusted ‘specialty value’ apparel retailers, strategically focussed on the baby and kids’ categories.
We are attracted to BST’s growth strategy aim which is centred around growing the retailer’s market share of the baby, kids, and womenswear categories. Its key focus is leveraging its current strength in the baby category to drive growth in lower penetration categories like womenswear. Due to the retailer’s core focus on relatively non-discretionary goods such as baby and kids' wear, Best & Less has a relatively defensive earnings profile. This is particularly due to the company’s position as a value retailer. As prices rise across the board, we expect more households to switch to lower-cost apparel retailers such as Best & Less in an effort to cut down on costs.
We therefore expect a combination of macroeconomic tailwinds and the execution of BST’s growth strategy to continue to underpin fully franked dividend distributions to shareholders moving forward. According to consensus forecasts, Best & Less has a forward dividend yield of 10.70%.
National Australia Bank (ASX: NAB)
Needing no introduction, NAB is one of the big four banks in Australia. NAB will see more of the benefits of interest rate increases in their FY23 earnings. Although higher interest rates increase credit quality risks, NAB has strong capital buffers to cover losses that the bank may potentially see during an economic downturn. We also expect the strong labour market to support a healthy credit environment. Even if it weakens, we believe it won’t reach a stage that will significantly affect NAB’s outlook, particularly given that the bank remains well-capitalised.
We therefore believe that the rising interest rate cycle will underpin a strong dividend payment in FY23, and that NAB has effectively reduced its downside risk due its strong capital buffers. According to consensus forecasts, NAB has a forward dividend yield of 5.64%.
All information contained in this publication is provided on a factual or general advice basis only and is not intended or be construed as an offer, solicitation, or recommendation for any financial product unless expressly stated. All investments carry risks and past performance is no indicator of future performance. Before making an investment decision, you should consider your personal circumstances, objectives and needs and seek professional investment advice. Opinions, estimates and projections constitute the current judgement of the author as at the date of this publication. Any comments, suggestions or views presented in this communication are not necessarily those of HALO Technologies, Macrovue or any of their related entities (‘we’, ‘our’, ‘us’), nor do they warrant a complete or accurate statement.
The opinions and recommendations in this publication are based on a reasonable assessment by the author who wrote the report using information provided by industry resources and generally available in the market. Employees and/or associates of HALO Technologies or any of the other related entities may hold one or more of the investments reviewed in this report. Any personal holdings by HALO Technologies or any of the other related entities employees and/or associates should not be seen as an endorsement or recommendation in any way. HALO Technologies Pty Limited ACN 623 830 866 is a Corporate Authorised Representative CAR: 001261916 of Macrovue Pty Limited ACN:600 022 679 AFSL 484264. MacroVue Pty Limited is a wholly owned subsidiary of HALO Technologies Pty Ltd. These companies are related entities with Amalgamated Australian Investment Group Limited ABN 81 140 208 288 (AAIG)
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