The old saying goes there are two things certain in life – taxes and death.
Since you're reading this, we presume you're alive and breathing. But since you're alive and breathing, the taxman will also have his beady eye on you, looking to get his fair share of your income and capital gains.
It's natural to want to optimise your after-tax returns. For that reason, you should have a basic understanding of the tax treatment of different types of share investments. As ever, if you are unsure about anything tax related, seek advice from the tax office or your friendly accountant.
The Joy Of Dividends
We love dividend payments, whether they be in the form of a cheque in the post, a direct debit into you bank account, or are reinvested via a dividend reinvestment plan. To long-term investors, dividends in high quality companies are the gifts that just keep on giving.
On the flip side, resident individual taxpayers are liable to pay tax on their dividend receipts. Trust the taxman to spoil the party!
But there is some good news. Unlike most other countries, dividends from Australian listed companies are often paid with franking credits attached. Called dividend imputation, prior to their 1987 introduction a company would pay company tax on its profits and if it then paid a dividend, that dividend was taxed again as income for the shareholder, a form of double taxation.
As far as the taxman is concerned, you are entitled to a franking tax offset equal to the amounts included in your income. In essence, the franking tax offset will cover, or partly cover, the tax payable on the dividends. If the tax offset is more than the tax payable on the dividends, the excess tax offset will be applied to cover, or partly cover, any tax payable on other taxable income you received.
Here's an example of franking credits in action.
Cash Dividend Received (Franked amount) $700
Franking Credit (at the tax rate of 30%) $300
Gross Dividend $1,000
For a 45% taxpayer…
Tax payable (45% * $1,000) $450
Less Franking Credit Offset $300
Net tax payable $150
Net after-tax dividend received ($700 – $150) $550
So, instead of paying tax of $450, as you would in many other countries, Australians only pay tax of $150. Happy days.
The other thing to note is, when you take franking credits into consideration, the dividend yield on your investments is effectively higher. You might see the terms "gross yield" or "grossed-up yield" when quoting the dividend yield on a share.
Using the example above, if you owned $15,000 worth of shares in the company…
Cash dividend yield ($700/$$15,000) 4.67%
Gross yield ($1000/$15,000) 6.67%
Net after-tax yield ($550/$15,000) 3.67%
By way of comparison, if you'd received $700 interest from a $15,000 investment in a term deposit or savings account, the after-tax return would only be 2.57%.
Capital Gains Tax (CGT)
Investors are also liable for Capital Gains Tax (CGT) on any net capital gains realised by selling their investments.
If the shares were acquired on or after 20 September 1985, the capital gain is subject to CGT at the rate in the year in which you sold the shares.
For shares bought on or after 21 September 1999 and sold 12 months or more after the date of purchase, only half (50%) of any capital gain is included in your taxable income.
For example, 1,000 shares purchased in January 2008 for $5 each are sold in February 2009 $7 each, giving you a capital gain of $2,000. This gain is discounted by 50%, so only $1,000 is subject to CGT.
If you make a loss (and losses are an inevitable part of share market investing), there are rules regarding the treatment of capital losses. In short, in many cases, you should be able to offset at least some losses against any capital gains. Again, seek advice.
Summing Up
There is an old saying that you shouldn't let the tax tail wag the investment dog. In other words, make an investing decision based on it's own merits, and not on any tax advantages or disadvantages.
Believe it or not, paying taxes on your dividends and on any capital gains is a good thing. It means you're generating income and/or making a profit, which is a far better outcome than paying punitive rates of interest on your credit card debt!
