I’m kidding, right? Nope. It’s true. At least sometimes.

Companies pay tax on their profits, and the government recognizes that tax shouldn’t be paid twice on the same profit, hence the wonderful world of franking credits.

For long term investors, dividends are a major part of the overall return, unlocking the amazing power of compound interest… assuming dividends are reinvested (as mentioned in Thinking of buying shares? – here’s a starting point).

Some shares pay 5% or more so that after 15 years investors can double their money from dividends alone… that is, even if the share price doesn’t move. Of course, share prices often double (or better) over the same period of time, as well.

Dividends are a share of companies’ profits so they vary, and some companies pay little or no dividend, either because they are not (yet… hopefully) profitable or because they are reinvesting their profits into growing the business.

Typically, large, well established ‘blue chip’ companies pay high, stable dividends but there tends to be variation across industries.  Mining companies for example, usually pay less than financial institutions. During the global financial crisis, however, even some of the banks dropped dividends by around 25%. Generally though, management knows that investors like dividend stability — and like steady growth even more — so most companies manage their dividends very carefully.

So what about the franking credits?

When companies distribute after-tax profits as dividends they come with a ‘franking credit’. This represents the amount of tax the company has already paid (so can vary from 0% to 100%).

Companies pay tax at a flat rate of 30%, so if your marginal tax rate is less than 30%, the ATO will pay you the tax credit as part of a tax refund. If you pay more than 30% tax, you will pay the difference between 30% and your top marginal rate. Even in this case, though, ‘100% franked’ dividends are very tax effective.

For example, Shareco pays a dividend of $700 in cash plus a franking credit of $300.

Let’s say your marginal rate is 19%. You declare $1,000 income (the cash dividend plus the franking credit). Your tax payable is: 19% of $1,000 that is $190, less the $300 franking credit, equals a tax refund of $110.

Alternately, let’s say your marginal rate is 37%. Your tax payable is: 37% of $1,000 that is $370, less the $300 franking credit, so you only pay $70 tax on the $700 cash you received.

And, as if that wasn’t good enough, costs incurred in earning dividend income are an allowable tax deduction. These include;

  • any management fees and amounts paid for advice relating to changes in the mix of investment
  • interest on borrowed money (borrowing to buy shares involves significant risk, though — have a look at Should you borrow to invest in shares?)
  • a portion of other costs if they were incurred in managing your investments, such as:
    • the cost of specialist investment journals and subscriptions
    • the cost of internet access and the decline in value of your computer.

As always, we suggest you seek personal financial advice before embarking on direct share investment.

What are your thoughts?

If you own shares directly, do you reinvest the dividends? Have you experienced the joy of franking credits?

Join the conversation — leave a comment below and let us know what you’re thoughts are.

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