When we invest in the share market we like to see our shares increase in value – obviously – but when the market isn’t performing well instead of joining everyone in the doom and gloom, don't forget about dividend income.

In Australia, unlike many other countries, we are fortunate that most of our companies pay an excellent rate of dividend. These usually include credits for tax paid by the company, referred to as “imputation” or “franking” credits. As an example of the benefit, if you deposit your money in one of our major banks’ online savings accounts you will probably receive an interest rate of around 3% per annum. And these rates will follow the movement of interest rates.

If you buy shares in that bank you are likely to receive a dividend in the region of 5-7% per annum. It is even better if the dividend is fully franked, as this would be equivalent to a pre-tax rate of 7-9% per annum. And when a market downturn causes share market prices to fall, most companies continue to pay a steady dividend.

Not all Australian shares are fully franked or have as high a yield as the example above. However, if you look at the average dividend yield for the All Ordinaries Index it is in the region of 4% with an average franking rate of 80%. This can give you a pre-tax return of some 5%.

The moral to this story is when planning your share portfolio don’t focus entirely on the growth aspect – remember the dividends.

For more information, contact us at Leenane Tempelton on 02 4926 2300 or email success@leenanetempleton.com.au

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The importance of “dividend imputation” – for that’s what the system is called – is that it changed the post tax considerations of investing in favour of Australian shares, especially over cash.

Up until 1987, company earnings paid out as dividends were largely taxed twice. The first time was when companies paid tax on their gross profits (for dividends come from net profits). The second time was when the investors who received the dividends paid tax on this income.

Dividend imputation abolished the double tax whammy on dividends by allowing shareholders to claim a tax credit for some, or all, of the tax an Australian company has paid on its earnings. These tax credits are known as franking credits. Companies that pay all their tax in Australia often offer “fully franked” dividends.

So that low income earners could gain the full benefit of the new tax system for dividends, the Howard government made franking credits refundable in 2000. This means that low income earners can receive franking credits back in cash as part of their tax refund.

The tax law surrounding franking credits carries restrictions and exemptions that may change the tax benefits received for different people. But its mainstream application is significant because other asset classes generally don’t offer such tax effective income streams as Australian shares.

An Australian company, for instance, that offers a fully franked dividend of 5% (its expected dividend payment divided by its share price) is offering a more tax effective income stream than a bank term deposit offering a 5% return. In reality on a pre tax basis, this Australian company is offering a 7% yield for investors on the highest marginal tax rate, versus 5% still for the term deposit.

Dividend Yield

As Australian shares have fallen in recent times, the dividend yield on Australian shares has risen to about 5% overall, and many large stocks offer dividend yield far in excess of the average (see endnotes 1). This dividend yield would carry franking credits in excess of 90%, if the franking credits offered by the typical managed Australian share fund on their distributions is any guide. This means that the effective yield of Australian shares overall is closer to 7%. At the same time, term deposit rates are falling.

The drive behind the introduction of dividend imputation was to encourage investing in shares. It’s still working just as policy makers thought it would a quarter of a century or so ago.

To discuss your share portfolio speak with our Newcastle financial advisors

Endnotes
1 Bloomberg. As at 7 September 2011. Based on the S&P/ASX 200 Index.
Source: FIL Investment Management (Australia)
Limited, September 2011

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