Recent research shows that 36% of the adult Australian population own investments listed on the stock market. That's nearly 6.5 million investors, some investing as individuals and some investing through Self- Managed Super Funds (SMSFs). Millions more own shares in privately owned companies, often family businesses which they own and run. The most common way for companies to pay returns to shareholders is by way of a cash dividend.
Significantly, whether you hold shares in a private company or a publicly listed one, the rules about how you're taxed on any dividends you receive as a shareholder are essentially the same.
Dividends are paid out of profits which have already been subject to Australian company tax which is currently 30% (for small companies, the tax rate is 25% for the 2022 year onwards). Recognising that it would be unfair if shareholders were taxed again on the same profits, shareholders receive a rebate for the tax paid by the company on profits distributed as dividends.
These dividends are described as being 'franked'. Franked dividends have a franking credit attached to them which represents the amount of tax the company has already paid. Franking credits are also known as imputation credits.
The shareholder who receives a dividend is entitled to receive a credit for any tax the company has paid. If the shareholder's top tax rate is less than 30% (or 25% where the paying company is a small company), the ATO will refund the difference.
Superannuation funds pay tax at 15% on their earnings whilst in the accumulation phase, so most super funds will receive refunds of franking credits every year.
How tax on dividends works
The taxpayer holds 1000 shares in ABC Pty Ltd.
ABC Pty Ltd makes $5 of profit per share. It must pay 30% tax on that profit which is $1.50 per share, leaving $3.50 per share able to be either retained by the business or paid out as dividends to shareholders.
ABC Pty Ltd decides to retain 50% of the profits within the business and to pay shareholders the remaining $1.75 as a fully franked dividend. Shareholders receive this with a 30% imputation credit which isn't physically received but which must be declared in the shareholder's tax return as income. This can then potentially be claimed back as a tax refund.
The taxpayer therefore receives $2500 taxable income from ABC Pty Ltd, being $1,750 dividend income and $750 franking credit, as follows:
Dividend income (@$1.75 per share x 1000 shares) | $1750 | ||
Franking credit | ($1750 x 30/70) | $750 | |
Taxable income | ($1750 + $750) | $2500 |
Applying that to different investors with different tax rates:
Investor 1 | Investor 2 | Investor 3 | Investor 4 | |
Tax rate | 0% | 15% | 32.5% | 45% |
Dividend | $1750 | $1750 | $1750 | $1750 |
Imputation credit | $750 | $750 | $750 | $750 |
Taxable income | $2500 | $2500 | $2500 | $2500 |
Gross tax payable | $0.00 | $375 | $812.50 | $1125 |
Franking credit rebate | $750 | $750 | $750 | $750 |
Tax payable/ (refundable) | (750) | ($375) | $62.50 | $375 |
After tax income | $2500 | $2125 | $1687.50 | $1375 |
So, Investors 1 and 2 both receive refunds.
Investor 1 might be a super fund in pension phase which doesn't have to pay tax at all and which uses the franking credit refund to fund the pension payments they are required to make. Alternatively, it could be an individual with no other source of income other than the dividends on these shares.
Investor 2 might be an SMSF in accumulation phase which uses the excess franking credit rebate to offset the 15% contributions tax.
Investor 3 would typically be a "middle income" individual who pays a minimal amount of tax despite having received $1750 in income.
Investor 4 would be a higher income earner who has to pay some tax on the $1750 dividend but has reduced his tax rate on this income considerably due to the franking credits attached.
When it comes to franking credits, the basic rule is that if the dividend is fully franked and your marginal tax rate is below the corporate tax rate for the paying company (either 30% for large companies or 25% for small ones) you can potentially receive some of the franking credits back as a refund (or all of them back if your tax rate is 0%). If your marginal tax rate is above the corporate tax rate for the paying company, you potentially need to pay additional tax on your dividend.
If you want to invest via direct shares it's worth targeting shares that pay high dividends and full franking credits.
When a company pays a dividend, it must provide each recipient shareholder with a distribution statement containing information about the paying entity and details of the dividend (including the amount of the dividend and the amount of the franking credit) which can then be used to help complete the relevant parts of your tax return. Public companies must provide you with a distribution statement on or before the day on which the dividend is paid but private companies have until up to four months after the end of the income year in which the dividend was paid to provide you with the statement.
In addition, public companies provide the ATO with information about dividends paid, which means that – provided the paying company has provided the information on a timely basis – the relevant parts of your tax return will be pre-filled.
Dividend reinvestment plans
In some cases, shareholders are given the opportunity to reinvest their dividends in additional shares in the paying company. If that happens, the cost base of the new shares for CGT purposes is the amount of the dividend (less the franking credit). Crucially, if you reinvest a dividend in this way, your income tax liability on the dividend is calculated in exactly the same way as if you'd received a cash dividend. That means you may have an income tax liability – and no cash to settle it with because the cash was all reinvested. That needs to be borne in mind when you consider whether a dividend reinvestment plan is right for you.
Bonus shares
Occasionally, companies will issue bonus shares to shareholders. These are not generally assessable as dividends unless the shareholder is given the choice between a cash dividend and a bonus issue in the form of a dividend reinvestment plan (as per above).
Instead, the bonus shares are taken to have been acquired for CGT purposes at the same time as the original shares to which they relate. This means that the existing cost base is apportioned over both the old shares and the bonus shares, leading to an overall reduction in the cost base of the original parcel of shares.
