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The term “dividend” refers to the amount paid out of a company’s profits to its shareholders. In Australia it is common practice to pay both an interim and a final dividend.

Earnings not distributed in the form of dividends are retained in the business and help it to grow. They still belong to the shareholders collectively.

Dividend announcements involve two dates: the “record date”, which determines who is entitled to the payment, namely, holders on the company’s register at that time, and a “dividend payable date” some weeks later, when the actual cheques are posted or equivalent electronic credits are put through.

For securities listed on the stock exchange a third date is also used. Five working days before and including the record date the stocks go “ex dividend” (xd), meaning that the sellers of shares rather than the purchasers become entitled to the payment. Before that the stock is traded on a “cum dividend” (cd) basis, meaning the reverse.

Theoretically, the market price at that time should drop to reflect the amount of the distribution. If it does not, and the “ex dividend” price is equal to the previous “cum dividend” price, then the shares are said to have “carried” their dividend.

Dividing the total earnings by the total ordinary dividend payout for the year (interim plus final distributions) gives the “dividend cover” – a yardstick which gives a rough indication as to how secure the continuation of the rate of dividend might be.

Dividend rates are best expressed in cents per share (often referred to as “dps”). The “dividend yield” is obtained by dividing this dps figure (in cents per share) by the market price of the share (also expressed in cents).

Dividing the dps by the eps (earnings per share) gives the “payout ratio”, the reciprocal of the dividend cover.

The apparent annual return from ordinary shares as measured by the dividend yield is not at all comparable with the return from fixed interest investments, as the true return from shares includes the capital growth element.

Imputation

Before 1 July 1987 corporate profits were subject to two lots of tax. Firstly, companies paid company tax on their earnings. Only the “after tax” earnings were then available for dividend declarations. Secondly, individual shareholders paid personal income tax on any dividends received by them, despite the fact that the companies paying them had already paid tax on the underlying profits. This unfair approach has now been replaced.

Under the current system, which is called “dividend imputation”, companies still pay tax on their earnings and then declare dividends, if they wish, out of their “after tax” incomes. However, these transactions no longer involve double taxation.

Such dividends are known as “franked” dividends. The company tax which was paid by the company on the portion of the gross profit relating to the dividend is called the “imputation credit”.

With a company tax rate of 30 per cent each $100 gross profit becomes $30 tax and $70 net profit. Each dollar of net profit thus has associated with it 30/70 dollars of imputation credits.

Individuals receiving a franked dividend are then treated, for tax purposes, as having received as assessable income both the dividend and the associated imputation credit, and as having already pre-paid as tax a sum equal to the imputation credit.

Individuals on marginal tax rates which are less than the company rate of tax thus become entitled to a refund of the amount overpaid. If not required as an offset to tax this refund is now available in the form of cash.

Some dividends are unfranked – for example, when the relevant company profits were earned overseas and did not result in tax payments to the Australian government.

Some dividends are only partly franked. The franked portion divided by the whole is known as the “franking ratio”.

Grossing-up

Before imputation was introduced the customary way of quoting dividend yields was to divide the full year dividend in cents per share by the market price in cents per share. The result, expressed as a percentage, was then perfectly comparable with the yields from other forms of investment.

This is no longer true in all cases. To make yields from shares paying fully franked dividends comparable on an “after tax” basis with returns from shares paying unfranked dividends, or from deposits or securities paying interest, or from property investments paying rent, it is necessary to multiply the yield as calculated in the previous paragraph by 100/70, to reflect the 30 per cent company tax rate.

The term “grossing-up” is often used in this context, when the face value of a franked dividend is multiplied by 100/70 (in other words, by 1.42857).