Dividends and Franking Credits

What are dividends

Majority of companies are designed to make profits. Dividends are an income distribution of the profits of a company. If you own shares in a public or private listed company, you may receive payments known as dividends.

Why and when companies pay dividends

When a company makes a profit, it has the option to either:

• pay out the profit to shareholders in the form of dividends;
• retain the profit to invest in the company’s growth; or
• a combination of both.

Dividends are usually distributed at least once a year, with some companies opting to pay dividends twice or more per year. However, as with company profits, dividends are not guaranteed with some very profitable companies opting not to pay dividends at all. One of the most well-known companies that has never paid dividends is Berkshire Hathaway (NYSE: BRK.A), owned and operated by one of the riches and most successful investors in the world, Warren Buffet.

How are dividends paid?

Companies generally pay dividends in cash to the bank account that you nominate or send you a cheque.

In some cases, rather than receive a cash payment, investors may be able to take advantage of a dividend reinvestment plan (DRP). The DRP involves the company offering investors the choice to use their dividends to purchase more shares in the company, instead of receiving the cash.

Investors wanting to increase their income (e.g. retirees) may prefer to receive their dividends as cash payments. However, investors who are more focused on growing their wealth (e.g. pre-retirees) may consider a DRP to grow their shares overtime.

What are franked dividends

In Australia, companies are required to pay tax on their profits, meaning the money they distribute via dividends has already been taxed.

To avoid double taxation of company earnings, to the company and then to the investor, these dividends come with a “franking credit”. The franking credit can be either fully franked, partially franked or unfranked.

• Fully franked dividend – the company pays 30% tax before paying the investor.
• Partially franked dividend – the company has paid part of the 30% company tax before paying the investor
• Unfranked dividend – No tax has been paid.

When you do your taxes for the year, you will receive a credit for any tax the company has already paid. If your top tax rate is lower than the company’s tax rate of 30%, you’ll receive a refund from the Australian Taxation Office (ATO) for the difference. That’s why franked dividends are considered tax-effective.