Looking to earn a wad of cash from your shares in the form of dividends? Don’t be seduced. You’ll need to do your homework.
In some quarters, the relative value of a company is assessed based on its ability to pay dividends to shareholders. One argument is that companies that pay dividends are confident of future earnings growth. Another point of view is that companies paying dividends and not reinvesting the profits into the company have run out of ideas.
The Holy Grail of investing: dividends
Although the idea of receiving a cheque in the mail is appealing, and is, at times, referred to as “the Holy Grail of investing”, there are many tax implications associated with the payment of dividends. The company firstly pays tax on its earning, then the shareholder who receives the dividend payout must then pay personal income tax on the earnings. In this way, dividends are doubly taxed – clearly not an ideal situation.
Franking credits
Some shareholders are able to structure their affairs so that any dividends can be balanced by franking credits issued by a company to help reduce the individual’s tax bill. Fully franked shares or franking credits represent the tax paid by the company on its profits. These credits can be shared with the people receiving dividends, at the discretion of the company.
Most large industrial companies pay enough tax to be able to attach a full tax credit to their dividend - in other words, the dividends are fully franked. The company tax rate is currently 30 percent. A company's franking account is also recorded at this rate.
A fully franked dividend means that the whole dividend carries a tax credit at the applicable company tax rate. This provides the maximum benefit of dividend imputation to shareholders. The Stock Exchange Journal and Personal Investment Magazine are good sources of further information on this.
To state the obvious, you are unable to receive a tax credits on unfranked dividends.
Capital growth
Another way to earn income from shares is simply capital growth. As shares increase in value, to release their value they can be sold (but you will pay tax on the capital gain).
It is also possible to take dividends as shares rather than cash. Some companies encourage shareholders to reinvest their earnings by buying further allotments of shares.
Dividends – good value stocks?
There are numerous calculations used to evaluate whether or not dividend pay outs are sustainable by the company in question. These include dividend cover and the payout ratio. This is probably going to be of greatest concern to investors looking to buy into a company, trying to assess relative value. People who already hold shares in a company that decides to pay dividends are unlikely to refuse the payout! However, there may be a scramble for the franked dividends. People in a more difficult tax situation may elect to take their returns in the form of share parcels.
