Do dividends get taxed?
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A dividend is a payment that public companies distribute to their shareholders, either in the form of cash or additional stock. Companies that pay regular dividends may be attractive to investors who prefer to earn a steady stream of income without selling their shares. It is important to note that while shareholders can benefit from both dividends and, potentially, the capital gains from rising share prices, these are considered a form of income and investors must pay tax on these earnings. However, the tax treatment of dividends and capital gains differs, and this may become a factor in your investment strategy. Keep reading to learn more.
Both capital gains and dividend income are sources of profit for shareholders and create potential tax liabilities for investors. The primary difference is that capital is the initial sum invested, which means capital gains tax (CGT) only applies to the profit that occurs when an investment is sold for a higher price than the original purchase price. Investors do not make capital gains until they sell investments and take profits.
Dividend income is paid out of the profits of a corporation to its shareholders, with the frequency of payments ranging from annually to quarterly. It is generally considered income for that tax year rather than a capital gain in both Australia and New Zealand. In Australia, there are two types of dividends in terms of tax: franked dividends and unfranked dividends.
Dividends are taxed differently depending on whether the shareholder is a resident or non-resident of Australia and whether the dividend they receive is franked or unfranked. This imputation tax system is designed to ensure investors avoid double taxation on their dividend. For example, an investor could be taxed while receiving the dividend and again when reporting their dividend income in their individual tax returns. To ensure this doesn’t happen, the Australian Taxation Office (ATO) system allows a corporation to pass on the benefits or share of taxes already paid at the corporate level to the shareholders.
Franking credits (or imputation credits) are a type of tax credit that can be paid out by listed companies to their shareholders. This amount is attached to any franked dividend paid out and represents the amount of tax paid by the company. This mechanism prevents double taxation on the income derived by the company and is then paid on to investors as a dividend. By definition, a franked dividend has a tax credit attached to it while an unfranked dividend does not.
In Australia, when a company pays out profits to its investors in the form of franked dividend, it means the company has already paid tax on earnings at a corporate level. This is generally at the current Australian company tax rate of 30% but in some cases will be at the lower corporate rate of 25%.
Just as franked dividends include a tax credit called a franking or imputation credit, unfranked dividends carry no tax credit. Since the company has not paid tax on the amount you have received, you will have to pay income tax on the amount. Companies tend to pay an unfranked dividend when some portion of their net profit has not incurred a tax. Typically, some expense items such as depreciation or amortisation or sale of an asset may be exempt from tax. These often form the basis of dividends that are paid as unfranked dividends.
All investors are entitled to receive franking credits attached to the dividend of the listed company they hold shares in, but the final amount will depend on their marginal tax rate. If an investor’s marginal tax rate is below the corporate tax rate of 30% (or the lower rate, if applicable), they will generally receive a refund from the ATO for the difference. However, if an investor’s marginal tax rate is above the corporate tax rate, the investor will have to pay the difference between their marginal tax rate and the tax already paid by the company. Franking credits are therefore typically seen as more valuable to investors on lower tax rates, as they benefit the most.
If a company in Australia makes $100 profit and pays $30 of tax to the ATO (assuming a corporate tax rate of 30%), it has $70 of profit remaining after tax. Depending on the company’s dividend policy and other factors, the company could theoretically pay out the whole $70 to investors in the form of a fully franked dividend together with a $30 franking credit. An investor that is an Australian resident for tax purposes will include in their taxable income the “grossed up” amount of the dividend, ie. the dividend of $70 and the franking credit of $30. Where an investor has a tax rate of 0% – such as a pensioner – they will receive a full refund of the franking credits attached to the dividend.
On the other hand, an investor with a marginal tax rate of 47% would need to pay tax on the difference between their personal tax rate (47%) and the corporate tax already paid (30%), which would be 17% on the $70 fully franked dividend and $30 franking credit, a total of $17. This example underlines the value of fully franked dividends and franking credits to investors with a low marginal tax rate, especially retirees searching for additional income in today’s historically low interest rate environment.
Some companies offer investors the option to reinvest their dividends to acquire more shares, rather than receiving them as payments into their bank account. For tax purposes, investors who elect to reinvest dividends must treat these transactions as if they had received the dividend payments and used them to buy more shares. This means the dividends must be declared as income in an investor’s tax return, and the additional shares are subject to CGT. It should also be noted that the acquisition cost of the additional shares is equivalent to the amount of the dividends used to acquire them.
As an example, if you were invested in a stock which was paying you a $100 dividend payment, instead of receiving the payment directly into your bank account, the $100 would be used to buy an additional 20 shares in the company at a price of $5/share (or whatever the nominated share price is). In this case, you would declare the $100 as assessable dividend income in your income tax return. For CGT purposes, you would also be required to note that you acquired the 20 additional shares for $100.
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