What are the Tax Implications?

Tax is the other side of the investing equation. Tax can change your investment decisions and understanding how this works is important because as this ensures you are acting in a way that optimises what goes into your pocket. As tax payers, all investors must pay tax on their earnings. The next section simply explains what you have to keep in mind when executing trades.

As previously detailed, the effect of Capital Gains Tax (CGT) can very easily change your decision to execute a sell trade. If you have high gains for the year and are wanting to exit a share you believe will be trading poorly, you may want to sell the share to receive a credit to your capital gains.

Franking credits
Franking credits, also known as imputation credits, are earned by investors who own shares that give out dividends. This is important, because unlike capital gains tax on shares (which are only applied upon sale), dividends must be declared as earnings to the ATO whether you decide to take the dividends as cash or to re-invest.

The whole idea behind franking credits is that, companies have already paid the tax (30%) on the dividends distributed, thus avoiding the need to double tax. Franking credits are then used to offset your taxable income.

Example:
To work out how much the franking credit is on your dividend, the following formula is used:

Franking Credit = (Total Cash Dividend ÷(100% - 30%)) x 30%
*assuming this is fully franked, meaning the company has paid tax on this profit.

Using a real life example, we will make the following assumptions:

Marginal tax rate of 47%
Cash Dividend fully franked = 56cents
Shares purchased for $10
Number of shares owned = 1000

So if we used the formula above we get the following:

Franking Credits

= ($560 ÷ (0.7)) x 0.3
= 800 x 0.3
= $240

What does this mean?
This means that you have a franking credit of $240. Now say your marginal tax rate is zero, you will receive both the dividend ($560) and the franking credits ($240).

Tax at top marginal rate (47%)
Using franking credits to your advantage at a higher tax rate (47%)

Cash dividend [A]	$560
Franking credit (non-cash)	$240
Total assessable income	$800 (0.56 X 1000)
Tax at 47% ($800 x 47%)	$376
Less franking credit offset	$240 (franking credits, as shown above)
Net tax payable [B]	$376 - $240 = $136
After-tax return [A - B]	$424

Compare this to term deposit or fixed interest
Cash dividend yield ($560 / $10,000) 5.60%
Grossed-up yield ($800 / $10,000) 8.00%
After-tax yield ($424 / $10,000) 4.24%

Comparing this to a term deposit or fixed interest deposit, $560 received in interest income is taxed at 47%, which means what you get in your pocket after taxes is 53% of the $560. This profit of $297, is equivalent to an after tax yield of 2.97% on your $10,000. This illustrates that what appeared to be a simple and attractive investment in a term deposit was not actually a good investment in terms of yield.

4.24% VS 2.97%

Winner: Shares Dividends