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The Joy of Franking - Eureka Report Article

April 30, 2007
The joy of franking
By Scott Francis

PORTFOLIO POINT: The tax advantages of holding stocks that pay fully franked dividends make them a must for investors.

I started investing in Australian shares about 15 years ago. In the following seven or eight years I built an investment portfolio primarily of Australian shares, with a sprinkling of listed property trusts. Many of my Australian shares paid franked dividends, and my understanding of franking credits was that:
  • Franking credits are usually attached to the dividends paid by Australian shares.
  • They reduce the amount of tax you have to pay.
  • Therefore they are a good thing.

And that's all true - but there is much more to know about this uniquely Australian invention. A full understanding of franking credits will create extra opportunities for any investor.

What are franking credits?

Franking (or imputation credits) became part of the Australian taxation landscape in 1987. Prior to that Australia had a "classical" taxation system, where profits a company made were first taxed at the company level and then, as the dividends were passed on to investors, taxed again at an individual level.

Let us look at a quick example to show how this worked, using the current company tax rate of 30% and a tax rate of 31.5% for the individual.

Company earnings: $100
Company tax (@30%) $30
Company earnings after tax: $70

Dividend paid to investors $70
Personal tax (@31.5%) $22
Dividend after tax $48

Under this system the company earns $100, pays $30 of tax, and declares a $70 dividend for the investor, who then pays $22 in tax (based on their tax rate of 31.5%). So just $48 of the original $100 in earnings ends up in the investors hands after tax.

The opposite of the classical tax system is the imputation tax system. The "imputation" tax system allows the tax paid at the company level to be imputed, or passed on to investors, in the form of franking or imputation credits. The following calculation shows the difference that franking credits make to the after-tax dividend for an investor.

The first stage of the calculation is exactly the same, with the company earning $100 and paying $30 in tax.

Company earnings: $100
Company tax (@30%) $30
Company earnings after tax: $70

The second stage of the calculation is different. Along with the $70 cash dividend, the investor also receives $30 in franking credits. The $30 represents the amount of tax already paid at the company level. When working out the amount of tax paid by the investor, this is calculated on the "gross" value of the dividend, which is the cash value of the dividend plus the value of the franking credits.

Dividend paid to investors $70 PLUS $30 in franking credits
Gross dividend (cash plus franking credits): $100
Personal tax (@31.5%) $31.50

The third stage of the calculation shows the franking credits at work. The investor has a tax liability of $31.50, however this is offset by the $30 of franking credits, leaving only $1.50 of tax to be paid.

Personal tax payable $31.50
less franking credits $30.00
Net tax payable $1.50

Dividend after tax $68.50

After receiving a cash dividend of $70, and offsetting the $31.50 of tax with the $30 of franking credits the investor ends up with $68.50 after tax. The investor is more than $20 (or 40%) better off under Australia's "imputation" tax system than a "classical tax system".

This demonstrates the benefit to investors of having the "double taxation" of dividends removed by the imputation tax system. Rather than having dividends taxed at both a company level and a personal level, the imputation system allows the tax at a company level to be claimed back by an investor at a personal level.

The next serious reform to affect the imputation tax system in Australian happened in 2000. The change allowed that surplus franking credits could be refunded to an investor.

For example, let us again do some calculations based on a $70 dividend with a $30 franking credit. This time let's assume that the shares are owned by a self-managed super fund that pays tax on income at a rate of 15%. The gross dividend is $100 ($70 cash dividend plus $30 franking credits) and the tax payable at 15% is $15. The $30 franking credit offsets the $15 tax liability with a $15 surplus, which is either used to offset other tax that needs to be paid by the super fund, or paid back to the superannuation fund in the form of a tax refund.

Franked dividends in funds

Once a superannuation fund starts to pay a pension, which is often referred to as the fund being in "pension phase", the tax rate of the fund is 0%. In this case, all of the franking credits are refunded by the tax office.

To provide a practical example of the tax effectiveness of refunded franking credits, take a look at the seven-year Vanguard Australian index share fund to September 30, 2006. The pre-tax fund return over this period was 12.36%. The after-tax return of the fund over the same period at a 15% tax rate (eg, super fund) was 12.86%, and the after-tax return of the fund over the same period at a 0% tax rate (eg, pension fund) was 13.70%. The after-tax returns are higher than the pre-tax return because of the refunding of excess franking credits.

Comparing franked and unfranked

At present the average dividend yield on the sharemarket is about 4%. (See Alan Kohler's lead story today CLICK HERE). The average income paid by a good online cash account is about 5.7%. How do we compare which is the more attractive income stream?

There is a very simple way to work out the value of franking credits on a fully franked dividend. You multiply the dividend by three and divide by seven. (Believe me, it works!)

For example, in the case of the $70 dividend we looked at earlier, the franking credits would be $70×3/7, or $30. In the case of the sharemarket average 4% yield, the level of franking credits would be 4%×3/7, or 1.71%. The gross dividend yield of the sharemarket is the cash dividend (4%) plus the franking credits (1.7%), a total of 5.7%. For simplicity, I have assumed that the dividends are 100% franked, whereas in reality the level of franking will be slightly lower than this. (Of course, as an independent investor you could choose to restrict your share portfolio strictly to stocks that pay 100% franked dividends).

Now we already know the "gross" yield of the sharemarket is 5.7%, which is basically the same as the yield from a good online bank account or 5.7%. This comparison allows a person to say that the yield from shares and bank accounts are about equal, therefore I will invest in shares as the income from shares is likely to grow over time.

The table below shows the calculations that compares a $1000 investment in a bank account that earns 5.7% ($57) with a $1000 investment in Australian shares that pays a 4% dividend ($40) with 1.7% ($17) in franking credits. The person in the example pays tax at a rate of 31.5%.

nThe bank vs the bourse
Bank Account
Sharemarket Investment
Cash Income
Franking Credits
Gross Income
Personal Tax (@31.5%)
Less Franking Credits
Net Tax Payable
Cash Income
Less Net Tax Payable
Income After Tax

As the calculation shows, where the gross income of the dividend is the same as the bank account interest rate, the income after tax from both investments is exactly the same. This is the key to comparing franked income with other income from sources such as bank accounts, rental property income and fixed-income investments: grossing up the franked income allows you to compare it directly with unfranked income.

In this case, at first glance the bank interest of 5.7% looked more attractive than the sharemarket yield of 4%. Once the impact of franking credits was taken into account the after-tax value of both income streams was identical for investors. Even though we only made this calculation for an investor on the 31.5% tax rate, the results will be exactly the same across other tax rates.

How are franking credits 'valued' by the market?

Cannavan, Finn & Grey, in a 2004 article entitled The Value of Dividend Imputation Tax Credits in Australia published in the Journal of Financial Economics, found that franking (or imputation) credits are not priced into the value of shares. They found that the cash value of the dividend was fully valued by investors, and the imputation credits were "effectively worthless to the marginal investor".

They make the case that the marginal investor, being the investor willing to pay the lowest price for the shares, will be an overseas investor who does not receive any benefits from franking credits, and therefore is not prepared to pay for them. The authors of this study used derivative contracts to support this theory by calculating that franking credits were not valued by the market.

This means that for an investor, franking credits are effectively an "unpriced bonus" of share ownership. This provides an extra layer of attractiveness for Australian shares, something that can be taken into account when considering the asset allocation of your portfoloio.

Asset allocation and franking credits

If you are building an investment portfolio then asset allocation is the number one driver of your investment returns. Does this research on franking credits effect how portfolios should be built?

The long-run return from all growth asset classes have been very similar. From July 1, 1980, to June 30, 2006, the average annual returns from the different growth asset classes have been:

Australian shares: 14.15% (measured by ASX All Ordinaries Accumulation)
International shares: 15.21% (measured by MSCI Word Index Accumulation ex-Aust)
Listed property trusts: 14.85% (measured by ASX Listed Property Trust Accumulation)

You can see that each of the returns from the growth asset classes have been very similar. Therefore investing in all three asset classes results in a portfolio with the same expected return, but with reduced volatility because asset classes that perform poorly in any period will be compensated for by the other asset classes that are performing better.

I use the "bonus" investment returns to justify a slightly higher asset allocation to Australian shares that to the other growth asset classes. A typical asset allocation within a client's growth assets might look like:

  • Australian shares 45%
  • International shares 30%
  • Listed property trusts 25%

The 45-day rule

An important rule associated with franking credits is the 45-day rule, which was introduced earlier this decade. This rule stipulates that shares have to be owned for 45 days for the investor to be able to claim the benefits of the franking credits.

At a practical level, the 45 day rule means that an investor can't just buy the shares the day before they pay a dividend, sell them the next day and receive the benefit of the franking credits.

Small shareholders who receive less than $5000 in franking credits are exempt from the 45 day rule.

The argument for abolition

In recent months there has been some debate in the media centered on the idea of abolishing franking credits completely and reducing the company (corporate) tax rate to 19%.

This discussion has been generated from a paper by CEDA (Committee for Economic Development of Australia). The paper, entitled Tax Cuts to Compete and authored by Dr Nicholas Gruen, argues that attracting international investors is a key factor in Australia's economic growth. (To read Gruen on the benefits on scrapping franked dividends click here). Gruen proposes that cutting the company tax rate to 19% and abolishing franking credits will make Australian investment more attractive to overseas investors, and therefore drive economic growth.

The flipside of this is that individual Australians who receive dividends from investments will be worse off if franking credits are abolished, even after the reduced amount of tax being paid at the company level. The following graph shows the value of $100 of company earnings to the investor under our current imputation system, compared with $100 of company earnings paid to investors under the proposed system that has a 19% company tax rate and no imputation credits. The current system leaves individual investors better off.


Franking credits have a big effect on the after-tax returns of your portfolio. Therefore having an understanding of franking credits is an important part of being an educated investor in the Australian environment. Taking the time to understand the calculations and research associated with franking credits will better equip you to deal with issues as important as tax management and asset allocation.