Investing in shares can produce tax benefits. But it can also result in tax liabilities too. Terms such as “franking credits” and “imputation credits” (same thing) were frequently used during last year’s federal election (the Labor Party proposed to ban franking credit refunds). However, many people do not understand these concepts. So, this blog seeks to provide a simple overview of the possible taxation consequences resulting from investing in shares.
There are two types of taxes that could result from making an investment (including share market investments) being income tax and Capital Gains Tax (CGT).
Income tax and franking credits
Some shares pay investors an income which is called a dividend. This is typically paid twice per year (interim plus final dividend). The amount of the dividend can vary significantly (this is called the dividend yield – refer to this blog for a basic overview of investing in shares).
A company can declare and pay a dividend from profit after it has paid tax. The dividend imputation system was introduced in Australia in 1987 by the Hawke-Keating Labor Government. Essentially, it sought to avoid the double taxing of corporate profits. This is best explained as an example.
Assume listed company XYZ Ltd recorded a profit of $100. It would pay $30 in tax because the corporate tax rate is 30% for companies with turnover of greater than $50 million. So, its after tax profit is $70. If it paid the dividend to shareholders who are individuals on the highest margin income tax rate of 47%, they would pay $32.90 of tax (being 47% of $70). The amount of the dividend left after paying all taxes is only $37.10 meaning the effective tax rate is 62.9%! In this instance, company profits have been taxed twice – once in the hands of the company and then again in the hand of the shareholder. Hawke-Keating believed this double taxation was unfair.
So, how does dividend imputation work?
To avoid the double-taxing of dividends, shareholders obtain a credit for the amount of tax the company has previously paid. Using the example above, the company has already paid $30 in tax so the shareholders will obtain a credit for this amount.
The formula is: cash amount of dividend plus franking credit multiplied by the marginal tax rate minus the franking credits.
Therefore, using the example above, the cash dividend is $70 + $30 of franking credits X 47% – $30 franking credit = $17. So, the shareholder will pay an additional amount of tax of $17 when they lodge their tax return. This means the net dividend retained after all taxes is $53 ($100 – $30 – $17).
Imputation credit refunds
If the shareholder has an effective tax rate lower than the corporate tax rate, then they will receive a tax refund. A good example of this is superannuation funds. A super fund’s tax rate is 15%.
Therefore, a super fund will receive the dividend of $70 plus a refund of $15 (i.e. using the formula above; $70 + $30 X 15% – $30 = refund of $15). If the super fund is in pension phase, its tax rate is zero so it will receive a full refund of all imputation credits i.e. $70 + $30. This is what the Labor Party was arguing against last year i.e. that self-managed super funds shouldn’t be entitled to a refund.
International shares offer limited tax credits
Most foreign countries do not have an imputation system except for New Zealand. That said, you may be entitled to foreign tax credits resulting from receiving dividends. However, any credits will typically be relatively immaterial, and certainly not as generous as the Australian system.
How does capital gains tax work?
If you sell shares and for a profit, you may have to pay capital gains tax. If you have owned the shares for more than 12 months, you are entitled to discount your capital gain by 50%. The net capital gain is then taxed at your marginal tax rate.
Example: Karen purchased Afterpay Ltd shares in January 2018 for $6.50 per share. She sold these shares in January 2020 for $34 making a very healthy profit of $27.50 per share. Because she owned them for more than 12 months, she can discount the gain by 50% to $13.75. This gain is taxed at her marginal rate of 47%. So, she will pay approximately $6.46 per share in tax.
Different owners will produce different tax outcomes
The dividend imputation system means that the amount of tax you pay will be dictated by the shareholder’s tax rate:
- Superannuation fund (either in a SMSF or wrap product) – this is the most tax effective environment because it has a flat tax rate of 15% in accumulation phase (i.e. while you are still working) and zero in retirement (pension phase). This means that the amount of dividend will consist of a cash amount plus a tax refund. For example, over the past 12 months, Westpac paid a cash dividend of $1.74 per share and this was fully franked. This means there were $0.75 of franking credits attached to these dividends. Therefore, if a super fund that is in pension phase owned these shares, the total income that would receive is $2.49 per share ($1.74 + $0.75) or 9.9% p.a. If a super fund was still in accumulation phase, the after-tax dividend would be $2.11 or 8.4% p.a.
- Family Trust – if a family trusts owns shares it can distribute dividends and capital gains to the beneficiaries that would enjoy the best tax outcomes. For example, dividends can be distributed to persons on low incomes to receive full benefit of the imputation credits. Capital gains can be distributed to beneficiaries that have carried forward capital losses.
- Personal name – if you own shares in your personal name then obviously dividends will be taxed at your marginal rate.
A plan will find the most optimal structure
This demonstrates that depending on how you own shares, dividend imputation credits can significantly increase your after-tax income returns. When I develop a financial strategy for my clients, I take this into account.
For example, if a client has share investments in super and a family trust, then I might recommend that we invest in Australian shares in the super fund and international shares in the trust, to achieve the best tax outcomes. Of course, I’m not going to develop an asset allocation solely to maximise tax benefits. The asset allocation is developed without considering taxation. However, how that pre-determined asset allocation is implemented is often heavily influenced by taxation considerations.
Don’t rush out and buy shares
I don’t believe in investing in direct shares because there is overwhelming evidence that very few people or businesses (less than 1%) can pick which shares to buy and when to sell them consistently well to generate materially higher returns than the market.
Instead, I believe that investors are better off using a diversified portfolio of low-cost, rules-based, index funds that utilise various methodologies. Here are two blogs that explain this in more detail (here and here). Investors will still enjoy the tax benefits explained above if they adopt this approach. If you are interested in investing in the share markets and need help, don’t hesitate to reach out to us.