Talk to many an Aussie retiree and they will no doubt gush about the wonders of our tax system – more specifically, the wonders of franking credits and the joys of a fully franked dividend. Whilst our unique system of franking dividend payments is no doubt a very advantageous system in some aspects, there are also some significant issues that it creates in the process, many of which are rather hidden from plain sight.
So today we're going to have a frank… discussion around the pros and cons of this Aussie quirk.
What are franking credits?
A dividend is said to be 'franked' when it comes from a pool of profits that have already been taxed (at the corporate tax rate). In order to prevent the shareholders from paying tax again on the dividend income, the dividends will come with a franking credit one can use to offset other income (or get a refund if you don't pay tax), so in effect we only pay tax once.
In other countries (including the US), dividend income is typically taxed twice (once at the corporate level, once at the income level), so on the surface our system seems fair.
The disadvantages of franking
But this also creates an incentive for a company to pay a dividend, as shareholders love receiving fully-franked dividends, and even prefer it over other forms of income.
That's why almost every single company in the ASX 100 pays some kind of dividend. By comparison, if we take some of the biggest companies in the US (and the world) – names like Amazon.com, Alphabet (Google), Facebook, Netflix and Berkshire Hathaway – you'll find that none pay a dividend, even a small one.
These companies typically find better things to do with their cash than shovel it out the door – and their investors don't seem to mind too much. If a company can receive a high return on its invested capital, why would it give it away to shareholders rather than investing it back into the business?
If company's like Alphabet, Facebook or even Aussie-founded Atlassian don't pay a dividend, it seems strange to me that Aussie tech high-flyers like Appen Ltd (ASX: APX), WiseTech Global Ltd (ASX: WTC) and Altium Ltd (ASX: ALU) all do, especially when all of these companies are in full growth phase.
Foolish takeaway
I'm not convinced that our franking system encourages growth companies and in fact may inhibit future growth at the expense of present dividend payments. Good things rarely come without cost in investing, and I fear franking credits are no exception.
