If you are an Australian share investor, chances are you are familiar with or have at least heard about franking credits. Their popularity among Australian shareholders is no surprise given their tax implications on dividend income. So what are franking credits exactly and how do they work? Our latest article covers everything you need to know.
What are franking credits?
Franking credits, also known as dividend imputation credits, are a tax credit for the shareholder and is carried by a ‘franked dividend.’ In Australia, franking credits represent the amount in tax that a company has already paid on profits distributed as dividends.
This tax credit can then be used to offset the shareholder’s individual income tax return thereby, depending on their marginal tax rate, reduce their income tax or even give them a tax refund.
How do franking credits work?
In Australia, companies currently pay 30% tax on their profits. If these profits are then distributed to shareholders as a dividend, the government will recognise this amount as a credit for the shareholder to offset their individual income tax return.
Franked and Unfranked Dividends
Dividends can be either “franked” or “unfranked”. Franking is expressed as a percentage and refers to the amount of tax that has already been paid on the dividend by a company.
Franked dividends have a franking credit attached to them and can be fully franked, where the whole amount of the dividend carries a franking credit, or partly franked where the dividend has a franked and unfranked amount. Unfranked dividends have no franking credits attached to the dividend.
What is a fully franked dividend?
A fully-franked dividend means that a company has paid tax on the entire dividend at the company tax rate of 30%.
For example, XYZ Pty Ltd pays a 100% fully franked dividend.
How to calculate franking credits?
Franking credit = (Dividend amount/ (1 – company tax rate)) - dividend amount.
In Australia, franking credits can be calculated by first taking the dividend amount and dividing by one minus the company tax rate, then subtracting the dividend amount.
When did franking credits start?
Franking credits were first introduced in Australia in 1987 by the Hawke Government to prevent the government from double taxing company profits.
This system is known as the imputation system and recognizes the tax already paid on profits by a company and gives those who receive their dividends, a tax credit known as a franking credit. Prior to this, companies had to pay tax on their profits and, if they then paid a dividend, this dividend would be taxed again as income for the shareholder.
Can franking credits be carried forward?
Individuals and trusts will have excess franking credits refunded to them however, companies will not. Companies can still benefit by converting excess franking credits into carryforward losses – these are losses that are carried forward into a company's future years’ net income to reduce their tax liability.
What should income investors be focusing on?
Income investors should be wary of only focusing on dividend returns and forgetting about capital preservation. In isolation, if a stock pays a dividend yield of 6%, it is seen as an attractive income investment. However, if the investor receives 6% income return but the stock price falls 20%, the investor is losing out. Income should not be sought after at the expense of the investor’s hard-earned capital.
Investors should also look to avoid “dividend traps.” A lot of the time when you look up information about a company, there will be data on their trailing dividend yield. Trailing dividends are dividends that the company has paid out in the past 12 months. However, just because a company pays out a certain amount of dividends in the last year doesn’t mean they will be able to sustain this level in future years. It is more important to look at the forward dividend yield, which is the yield investors are expected to receive based on forecasted dividends in the next 12 months.
In the longer term, if the company invested in is facing a structural earnings decline, dividends will ultimately end up falling. Investors should look for companies that are growing their earnings, but not necessarily spending a lot to do so. If they invest a lot in their business to grow earnings, this may also come at the expense of paying out dividends to shareholders.
Should income investors be looking at franking credits right now?
Investors should always be looking for companies with fully franked dividends. That’s not to say that investors should avoid companies that pay unfranked dividends, particularly if they are solid companies who pay healthy dividends. However, you can usually add a few percent to the dividend yield for companies that pay fully franked dividends, depending on your tax situation.
As a general principle, to gross up a fully franked dividend yield you would simply divide the dividend yield by 70 and multiply it by 100. This is best illustrated with an example.
Say Company A has a dividend yield of 5% and their dividends are franked, whereas Company B has a dividend yield of 6%, but their dividends are unfranked. By applying this simplified formula, the actual grossed-up dividend yield investors of Company A receive is 7.14%. Company B’s dividend yield stays at 6% as there are no franking credits. This demonstrates the power of franking credits, in which a company offering a seemingly lower yield is actually higher when the dividends are grossed-up to account for franking. We re-emphasise the fact that this example only focuses on yield, and the investor would still need to consider future earnings potential and capital preservation when making an investment decision.
Companies with Fully Franked Dividends
In light of the uncertain market conditions, companies that pay a healthy dividend is a relatively attractive. However, income investors should be wary of only focusing on dividend returns and forgetting about capital preservation.
In more uncertain macroeconomic and market conditions, investors should be looking at companies that are resilient and have a defensive earnings profile. Tougher macroeconomic conditions will result in some companies being unable to sustain their earnings levels. Markets may react badly to some of these results, which will lead to a decrease in share price and result in investors losing capital. We suggest that investors look for companies with certain characteristics that will allow them to defend their earnings which will help sustain their share price.
This includes companies that aren’t overly exposed to the economic cycle, as well as companies that have pricing power or contracts that allows them to pass on higher costs. Other characteristics we look for are companies that have locked in lower costs through contracts, companies with a sticky earnings profile which includes those that sell goods or services with relatively inelastic demand from customers.
HALO Global offers investors a variety of features to help them identify better income opportunities including dividend monitors, forecasting tools, research and ready-to-invest thematic portfolios (known as Vues).
The Australian Equities Income Vue, from ASR Wealth Advisers, is a selection of high-quality companies that aims to generate the investor a solid dividend income as well as preserve capital. Along with healthy dividend yields, companies on this list offer strong cash flows, a defensive earnings profile that remains relatively stable throughout the economic cycle, a strong balance sheet, a good management team, the ability to pass on costs and a strong position within their industry.
Companies in this portfolio include:
Deterra Royalties (ASX: DRR)
Deterra operates a royalty business model that is involved in the management and growth of a portfolio of royalty assets. The company’s royalties are predominantly sourced from BHP’s Mining Area C (MAC) in Western Australia’s Pilbara region, which is expected to make up of around half of BHP’s iron ore production after the completion of the ramp-up of the South Flank mine.
Deterra has an attractive business model, with EBIT margins of approximately 97%. With no capital requirements, Deterra’s business model is to essentially collect royalty payments, with their small costs being employee expenses as well as a few other minor expenses. With little need to reinvest in the business, this allows Deterra to pay out most of their earnings to investors. Although royalties are tied to the price of iron ore, it is also dependent on the volume that MAC produces. With BHP currently ramping up MAC’s production capacity, earnings (and thus dividends) will be supported by this volume growth. This limits the downside of dividend payouts. The low-cost nature of BHP’s production practically ensures that the mines in MAC will continue to operate, which will support earnings and thus continued dividend distributions.
According to consensus forecasts, Deterra has a forward dividend yield of 7.83%. We do note that just as with the other companies paying fully franked dividends in our top 5, this figure is before it is grossed up to account for franking. Once grossed up, the actual dividend yield is higher.
Inghams (ASX: ING)
Inghams Group Limited is Australia's largest integrated poultry producer. The business is vertically integrated, with a network of feed mills, breeder farms, hatcheries, broiler farms, processing plants and distribution centres across Australia and New Zealand.
We are attracted to the structural tailwinds that poultry as a protein source is experiencing. We anticipate positive tailwinds associated with changes in eating habits, with more consumers choosing higher-protein and healthier white meats over more traditionally favoured red meats. Furthermore, we expect the prevailing macroeconomic conditions to accelerate this trend. As consumers are facing tighter hip pockets due to inflation and increased mortgage payments, they will be looking to shift away from higher cost red meats and towards lower cost meats such as poultry. We also like Inghams due to the cost advantage per kilo and versatility of chicken as a protein source, which is due to the size of the animal. We believe these tailwinds outweigh temporary headwinds including staffing issues and cost pressures.
We believe Inghams earnings will continue to be supported by the shift towards poultry as a protein source due to changing consumer preferences as well as current macroeconomic conditions. We expect this to underpin Inghams dividends moving forward. According to consensus forecasts, Inghams has a forward dividend yield of 4.80%.
Metcash (ASX: MTS)
Given that over 80% of revenue is generated from their food and liquor segments, this makes Metcash quite a defensive company, whilst retaining some cyclical exposure through their hardware segment. IGA is quite competitive in the Australian supermarket industry, holding about 10% of market share. Given that Woolworths, Coles and Aldi are vertically integrated, they own their own distribution networks which they do not share with independent retailers. This leaves Metcash in a leading position to supply independent retailers, who remain competitive by catering to the local demands of the community. We are also attracted to Metcash due to its business model as a distributor. It is a capital light business as the stores the company supplies to are owned by private enterprises. This allows Metcash to deliver strong returns on capital.
Given that non-discretionary food and liquor spending traditionally holds up throughout the cycle, we believe Metcash’s stable earnings profile will continue to underpin the company’s dividend payments. According to consensus forecasts, Metcash has a forward dividend yield of 5.42%.
Best & Less (ASX: BST)
Best & Less Group is an omni-channel retailer with a network of over 240 profitable stores across Australia and New Zealand, as well as a rapidly growing online presence. It operates under the Best & Less brand in Australia, and under the Postie brand in New Zealand, both of which are trusted ‘specialty value’ apparel retailers, strategically focussed on the baby and kids’ categories.
We are attracted to BST’s growth strategy aim which is centred around growing the retailer’s market share of the baby, kids, and womenswear categories. Its key focus is leveraging its current strength in the baby category to drive growth in lower penetration categories like womenswear. Due to the retailer’s core focus on relatively non-discretionary goods such as baby and kids wear, Best & Less has a relatively defensive earnings profile. This is particularly due to the company’s position as a value retailer. As prices rise across the board, we expect more households to switch to lower cost apparel retailers such as Best & Less in an effort to cut down on costs.
We therefore expect a combination of macroeconomic tailwinds and the execution of BST’s growth strategy to continue to underpin fully franked dividend distributions to shareholders moving forward. According to consensus forecasts, Best & Less has a forward dividend yield of 10.70%.
National Australia Bank (ASX: NAB)
Needing no introduction, NAB is one of the big four banks in Australia. NAB will see more of the benefits of interest rate increases in their FY23 earnings. Although higher interest rates increase credit quality risks, NAB has strong capital buffers to cover losses that the bank may potentially see during an economic downturn. We also expect the strong labour market to support a healthy credit environment. Even if it weakens, we believe it won’t reach a stage that will significantly affect NAB’s outlook, particularly given that the bank remains well capitalised.
We therefore believe that the rising interest rate cycle will underpin a strong dividend payment in FY23, and that NAB has effectively reduced its downside risk due its strong capital buffers. According to consensus forecasts, NAB has a forward dividend yield of 5.64%.
All information contained in this publication is provided on a factual or general advice basis only and is not intended or be construed as an offer, solicitation, or a recommendation for any financial product unless expressly stated. All investments carry risks and past performance is no indicator of future performance. Before making an investment decision, you should consider your personal circumstances, objectives and needs and seek a professional investment advice. Opinions, estimates and projections constitute the current judgement of the author as at the date of this publication. Any comments, suggestions or views presented in this communication are not necessarily those of HALO Technologies, Macrovue or any of their related entities (‘we’, ‘our’, ‘us’), nor do they warrant a complete or accurate statement.
The opinions and recommendations in this publication are based on a reasonable assessment by the author who wrote the report using information provided by industry resources and generally available in the market. Employees and/or associates of HALO Technologies or any of the other related entities may hold one or more of the investments reviewed in this report. Any personal holdings by HALO Technologies or any of the other related entities employees and/or associates should not be seen as an endorsement or recommendation in any way. HALO Technologies Pty Limited ACN 623 830 866 is a Corporate Authorised Representative CAR: 001261916 of Macrovue Pty Limited ACN:600 022 679 AFSL 484264. MacroVue Pty Limited is a wholly owned subsidiary of HALO Technologies Pty Ltd. These companies are related entities with Amalgamated Australian Investment Group Limited ABN 81 140 208 288 (AAIG)