"Dividend Imputation in Australia"

Neil A Costa

People who use the stock market as a source of income can range from intra-day traders to long-term investors. I am best described as a longer-term trader, as I purchase stocks primarily to gain trading profits. Nevertheless, from time to time, I receive dividends that can be a very tax-effective source of income because of Australia's dividend imputation system. Other countries have similar systems, but the details vary from country to country.

Dividend imputation was introduced in Australia in 1987, and stopped the double taxation of company income. Prior to its introduction, companies paid tax on their earnings, then the shareholders paid tax on the dividends at their marginal tax rate - effectively giving the government double tax on the company's earnings.

The following example illustrates how dividend imputation in Australia works:

Let us assume that a trader followed my rules in my Stockmarket Master course and selected a strong stock called Consolidated XYZ. The trader held the stock for a period of many months, and during that time the company paid a dividend of $1,000.

As it happened, the company had paid tax on its earnings at the company tax rate of 34% (the company tax rate applicable after 1 July 2000). This means that the company has already paid the Australian Taxation Office 34% of its net profit prior to paying its shareholders the dividend. (For every $1,000 earned by the company, it paid $340 in tax, and had $660 that could be retained or paid out as dividends.)

For people who pay personal income tax at the top rate of 48.5% (including the Medicare Levy), their tax on their $1,000 would normally be $485. Consolidated XYZ, however, has already paid tax of 34%, or $340, on the $1,000. As a consequence, the trader would receive a credit for the $340.

Tax is then paid at the relevant marginal tax rate on $1,000, however an imputation credit of $340 is then claimed.

In this example, the trader will pay only 14.5% tax on the grossed up amount. This compares very favourably with the 48.5% he or she would pay on a fixed interest investment, for example.

Not all companies pay fully franked dividends. Companies can claim a range of tax deductions including losses made in previous years. This could mean that a company may not pay its full rate of tax in a particular year.

If a company has not paid any tax on its earnings, the dividend will not have any franking credits. The trader would receive no franking credit, and would therefore be taxed at his or her marginal rate. If the company pays tax at less than the company tax rate, a smaller franking credit will apply. Dividends are referred to as being fully franked, partially franked or unfranked.

People on lower marginal tax rates will pay tax at an even lower rate. In fact, if their marginal tax rate is lower than the company tax rate, they will receive the difference - that is, the full dividend and the tax rebate.

Company and individual tax rates change. Always ensure that you are using the correct rate.

Colin Nicholson, in his excellent presentation to the Australian Technical Analysts' Association Conference in October 2000, presented research findings that clearly showed than medium-term traders tended to be more profitable than shorter-term traders due to their lower transaction costs. Another advantage of taking a medium-term view of the market is that the likelihood of dividends being paid while the shares are held increases proportionately to the time they are held.

Dividend imputation makes income from fully franked dividends very tax effective indeed.

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