Dividend season and your portfolio

We are currently in the throes of reporting and dividend season. We covered reporting last week and this week we shall look at dividends and their benefits and effect upon your portfolio.

Dividends are one of the fundamental reasons people buy shares, even if capital growth is not likely then a company can still make itself attractive by returning capital to its shareholders in the form of dividends. These are payments from profits that are made directly to shareholders - normally paid out twice a year they can be bolstered by special dividend payments. The level of dividend return is decided by the board of directors. For example, Telstra's share price was under pressure late last year but the prospect of a large dividend payment (coupled with some jawboning by the government with regards to T3) helped the price recover.

But it's not all about the dividend! - for the investor there is the magic ingredient called Franking. In 1987 the federal government introduced dividend imputation (known as “franking”) to encourage domestic share ownership. This countered the issue of double taxation where companies pay tax on their profits and shareholders who receive the dividends must still pay income tax upon their receipts. Therefore, an Australian-based investor who holds Australian shares (or share funds) is entitled to a franking credit equal to the amount of the company tax paid. Franked dividends are those paid by a company that has paid company tax.

The best way to understand how this can benefit you is to look at a practical example ;

In November 2006 we suggested buying Coca Cola Amatil (CCL), we subsequently included it in our hypothetical portfolio at $7.15, as you can see from the chart below, last night it closed at $8.29. You would assume that would be a $1.14 (15.9%) gain, however, it also went 18c ex-dividend yesterday, making the gain $1.32 (18.5%).

But there is more - as the 18c dividend payment had already been taxed at 30%, CCL has issued an 100% imputation credit for around 7.7c. Subsequently, when the shareholder submits their tax return, they add up the 18c dividend and 7.7c franking credit and declare 25.7c per share in pre-tax income. Then they apply whatever tax (from their personal tax bracket) is paid on this 25.7c.

So an investor on a 15% personal tax rate would normally have to pay 3.85c of tax, however as 7.7c company tax has been paid by the company to the Australian Tax Office, the share holder is 'owed' the difference of 3.85c by the ATO. Those on a rate of 48.5% rate would normally pay 12.47c. However, as thirty percent tax has already been pre-paid by the company, they only pay the difference between the 48.5 % and 30% tax already paid. In this case they only have to pay tax of 4.76c.

There are certain conditions; to be eligible; the company has to be registered for franking and that the holder of the relevant shares upon which the dividend has been paid has held the shares for 45 days (or 90 days in the case of preference shares). If not, the tax benefit of the franking credits will be denied. Additionally, this rule will not apply to individual shareholders who receive less than $2,000 in franking credits per annum on all shareholdings.

As always, before making any investment decisions we recommend that you discuss with your financial planner how franking credits affect your personal situation.