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REWARDS OF INVESTING IN SHARES

The rewards of investing in shares come in the form of dividends (income) and capital gains.

Dividends

When a company is profitable, the shareholders have a right to share in a portion of the profits. The payment commonly comes in the form of a cash dividend (scrip dividends do exist). The word ‘dividend’ means ‘that which is divided’. Dividends are a dividing up and distribution of a portion of a company’s earnings to shareholders.

The board of directors of the company decides how much of the profits will be paid out in dividends. Companies generally pay dividends twice each year; an interim dividend and a final dividend.

Dividends are paid either franked or unfranked. A franked dividend is a dividend on which company tax has already been paid by the company and the shareholder receives a tax credit for this amount (see ‘Dividend imputation’, below). Dividends can be partially or fully franked.

An unfranked dividend means the recipient is subject to tax at their normal marginal rate.

Dividend imputation

Dividend imputation was introduced in 1987. Basically, investors who receive franked dividends are entitled to a credit (known as a dividend imputation credit or franking credit) for the amount of tax already paid by the company. This credit reduces the amount of tax to be paid by the investor.

In simple terms, the shareholder is allowed to claim the imputation credit as a tax rebate. If National Australia Bank (NAB) pays a final 80c fully franked dividend. As the corporate rate in Australia is 30%, this means that NAB has already paid 30% tax and the 80c the investor receives is post tax. So how do we work out the pre tax amount? We simply say that if 30% tax has been paid, then 80c is equal to 70%. So what is 80c 70% of? 80 divided by 0.7 equals 114.3c. Therefore, we can work out the amount paid in tax by NAB (or franking credit) by subtracting 80c from 114.3c, which equals 34.3c. So if one owns 1000 NAB shares, this means that the dollar value of the franking credit is 1000 multiplied by 34.3c, which equals $343. This amount can be offset against one’s taxable income to effectively reduce tax payable. For more information, talk to an accountant or the Australian Tax Office.

45-day Rule

People get excited when they first hear about franking credits. They aren’t sure whether they can buy one day before the company goes ex dividend and then sell on the day the stock goes ex a dividend and still collect the franking credits. The answer is yes but there is a condition!

If you have less than $5000 per annum of franking credits, then you can hold the stock for one day if you choose and still receive the franking credits. However, should you have more than $5000 per annum in franking credits, you must hold the shares for at least 45 days in order to claim the franking credits on dividends received. That means you can’t buy shares the day before a company goes ex and then sell the next day and claim the franking credits on the paid dividend.

In summary, if a person claims less than $5000 worth of franking credits in a given year on their tax return, then they do not have to satisfy the 45-day rule. If they wish to claim $5000 or more of franking credits, then they must own all the shares that received dividends for at least 45 days.

For more information, talk to an accountant or the Australian Tax Office.

Dividend rewards

Consider an example of shares that reward investors with a regular income, in the form of dividends.

The following table demonstrates how $1000 invested in the Commonwealth Bank of Australia (CBA) from June 1996 to June 2006 would have performed.

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Why Invest in Shares?

Beyond shares being the best long-term investment and having tax benefits, they also offer other advantages, including flexibility and liquidity.

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