The 5 things you need to know about franking credits and dividends

Dividends and franking credits are the darling of many retiree portfolios, with good cause. But if you’re new to the game or could even just use a refresher, it’s worth understanding why they can be so useful for an income strategy, how they work, and where you can find them.

More than half of the companies listed on the S&P/ASX200 either fully pay or partially pay franked dividends – what this means is that you might be able to claim a tax deduction on any dividends you receive from investing in these companies. In a time where the cost of living is high and many of us are feeling the pinch, no one wants to miss out on any extra income they might be entitled to.

In short, here are the key things you need to know.

1. What are franking credits and dividends?

Dividends are a distribution that a company pays to its investors out of its corporate earnings and are typically paid in cash. The amount is set by a company’s board of directors.

Franked dividends are paid from after-tax earnings and include a tax credit (also called a franking credit or imputation credit).

“If a company makes $100 million pre-tax profit, they pay the 30% company tax rate which is $30 million, so there will be $70 million of after-tax profits left over. If that company pays a dividend of $70 million, equal to its profits, there will be a $30 million tax credit if it’s paid as a fully franked dividend – because the company has already paid $30 million in tax,” says Dr Don Hamson, managing director and Peter Gardner, senior portfolio manager for Plato Investment Management.

Franking credits or imputation credits are a tax rebate shareholders can use in their own tax returns. It reflects the portion of tax a company has already paid on that dividend. The shareholder only needs to pay tax on the dividend to the extent that their own marginal tax rate exceeds the rate of tax that the company has already paid on that dividend income.

Or as Paul Aliprandi, senior wealth adviser for Wilsons, explains:

“The franking credit arises from the company paying 30% tax on its income. Under the imputation system, recipients of franked dividends generally pay tax only where their marginal income tax rate exceeds 30%. The concept of the imputation system is to avoid the double taxation of company profits.”

2. How do franking credits work?

Companies can offer fully franked (100% franked) dividends – where the full company tax rate of 30% applies to the dividends, or partially-franked dividends – where only a portion of tax might apply.

In a fully franked dividend, that means 30c tax paid for every dollar.

An example of a partially franked dividend might be those paid by Macquarie Group (ASX: MQG) which has foreign earnings so will have varying tax rates applied (not just the Australian company tax rate of 30%). In Macquarie’s case, its final dividends for the 2023 financial year were 40% franked. So rather than 30c for every dollar, it would be 12c for every dollar.

Here’s an example from the ATO of how a franking credit can work. In this instance, the top marginal tax rate applies.

Source: ATO

3. Some investors may be able to receive a refund using franking credits

Franking credits can be very valuable to those investors who have tax-free incomes, like charities or retirees with pension phase superannuation balances of less than $1.7 million for 2022-2023 tax year, or less than $1.9 million for the 2023-24 tax year.

These investors can actually use the franking credits to receive a refund on the tax paid, thereby bolstering their income.

Australia is the only country to offer refunds of unused portions of franking credits, though it's not the only country to offer franking credits.

“For zero-tax investors, franking credits are (except for some discounting for the time value of money as franking credits are only refunded when an investor fills out their tax return) almost as valuable as cash dividends. Thus they should be a big part of a zero tax investor’s income and total return,” say Hamson and Gardner.

Using the previous ATO figures, what this might look like in practice for someone with a tax-free income follows:

Source: ATO

4. Which companies pay franked dividends – and how to find out whether they are fully or partially franked

You can typically find out whether a company pays franked dividends by looking at its previous earnings reports and dividend announcements.

There is a large number that pay fully-franked dividends. 

Some examples include the Big 4 banks, and miners like BHP (ASX: BHP) and Woodside Energy (ASX: WDS). Telstra (ASX: TLS) has also been a dividend darling for many years.

Some examples of companies that have paid partially-franked dividends in the past include Transurban (ASX: TCL) which offered 5% and QBE Insurance (ASX: QBE) which offered 10%.

Looking just at the top 10 ASX-listed companies by market cap:

Source: ASX, Market Index, 7 August 2023

5. How to select companies for income

Many investors might be tempted to simply look for a list of the highest yielding stocks, but Hamson points out this can be a trap.

“The easiest way for a stock to become a very high yield stock is for the current price to be depressed,” he says.

“If you look at just the dividend side you're going to say 'Great, it's fantastic.' But if you've been holding that stock and the stock price is halved, your total return is rubbish.”

If you want to use dividends and franking credits as part of your income strategy, there are a few things to keep in mind. The usual rules of stock selection still apply - you want to look for quality, strong balance sheets and management for example.

Some additional factors in the case of shares for income are the sustainability of company earnings and dividends.

That is, can a company continue to offer consistent earnings and pay consistent dividends across market cycles, and does it have a solid track record of doing so?

Andrew Fraser, portfolio manager for Merlon Capital suggests looking at free cash flow over the long term and how a company generates and spends its money can be valuable to identifying companies that will benefit your portfolio.

“We like to invest in companies that have a long-term track record of free cash flow generation. We like to understand how those companies generate those cashflows through different market cycles. 

We want to be careful not to overcapitalise on peak cycle conditions. We also have a focus on trying to understand what the sustainable level of capital expenditure is for those businesses,” he says.

Off the back of this, where could you look in 2024?

As always, there are a range of headwinds for companies in 2024. Some of the big payers of the past few years may find it harder in coming years.

Fraser points to insurers QBE Insurance (ASX: QBE) and IAG Insurance Group (ASX: IAG) as high conviction picks in Merlon’s portfolios.

“Those rising premiums and increased earnings on their investment books are key to them thriving and paying good dividends over the coming year or two,” he says.

He also points to Coles (ASX: COL) as being a beneficiary of tough times and therefore able to sustain earnings and dividend payments.

Similarly, Gardner sees an opportunity for insurers to strengthen dividends.

He still sees opportunities in financials, mining and consumer stocks, pointing to Macquarie Group (ASX: MQG), Woodside Energy (ASX: WDS) and Woolworths (ASX: WOW) as high conviction positions for Plato.

Bearing in mind the risk of dividend traps and the need to take a closer look at fundamentals, below are the 5 companies offering the highest dividend yield according to Market Index's scan.

Source: Market Index, 7 August 2023

This article was first published for Livewire Markets on Monday, 7 August 2023