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Question of the week – Should you buy a stock that doesn’t pay franked dividends?

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by Paul Rickard

Q. Yield is high on the SMSF trustee’s agenda but does that mean they should forego companies that issue unfranked dividends?

A. There is absolutely no problem in buying a company that doesn’t pay a franked dividend. The only downside is that the company, arguably, starts a little way behind, because it can’t “tax advantage” the income return.

When investing, we consider both capital returns and income returns. Capital returns are usually demonstrated through an increase in the share price, the income return through the dividend. As our fund may have to pay tax on these returns, we consider both of these from an after tax point of view.

For an SMSF, a fund in the accumulation phase pays tax on income at 15 per cent and a fund in the pension phase pays tax at 0 per cent. As franked dividends carry imputation credits which act like a tax offset, the effective after tax returns from fully franked dividends for a fund in accumulation and a fund in pension are as outlined below.

So, a franked dividend yield of 5 per cent pa is effectively a return of 6.07 per cent (after tax) to a fund in accumulation, and 7.14 per cent (after tax) to a fund in pension. On the other hand, an unfranked dividend yield of 5.0 per cent will provide a return of 4.25 per cent to a fund in accumulation after tax at 15 per cent is paid, and 5.0 per cent to a fund in pension.

Coming back to the question, a stock that pays an unfranked dividend will need to produce a higher capital return than a stock that pays a franked dividend. Putting capital gains tax to one side (which is going to be fairly trivial or non-existent), if stock A pays an unfranked dividend of 5 per cent, and stock B pays a fully franked dividend of 5 per cent, a fund in pension will be better off investing in stock A if its share price outperforms stock B in the first year by 2.14 per cent – which is not that much!

While the system of imputation credits and franked dividends is a fabulous system, not all companies on the ASX can pay a franked dividend. The system is unique to Australia and only recognizes tax paid in Australia – there are many companies that are profitable and paying dividends, and either because they pay tax overseas or have carried forwarded tax losses, aren’t currently paying Australian company tax.

Don’t rule out companies that cannot frank their dividends.

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

Published on: Friday, March 01, 2013

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Question of the week – Should you buy a stock that doesn’t pay franked dividends?