As a private company, you’ll likely be faced with the choice of whether or not to pay dividends.
In this article we’ll explore the process and principle of paying dividends in Australia, and the complications and theory involved with these payments.
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What are dividends?
When a private company makes a profit, what it does with that money is their choice. This profit is also known as a distributable surplus.
They can choose to retain the money to reinvest into the business, or they can pay it out to their shareholders in return for their investment. This payment is known as a dividend.
Why do companies pay dividends?
Companies pay dividends as a way to extract the profits from the business.
When a company pays regular dividends at a stable value over a long period of time, owners and potential investors will take that as a sign of the company’s health and the quality of its management.
What are the main types of dividends?
There are three main types of dividends. The distinguishing characteristic between them is how often these dividends are paid.
Final dividend payments
Final dividends are paid at the end of the fiscal year, typically following a company’s annual general meeting when the company's financial success is disclosed.
Interim dividend payments
Interim dividends are paid quarterly or halfway through the fiscal year.
Special dividends
As the name may suggest, special dividends are paid on special occasions, such as a dramatic increase in profits over a given period.
Paying dividends from private companies
A corporate entity is a common structure that businesses operate under in Australia. While there are many benefits to this business structure, like a tax rate capped at between 25% - 30%, there is also the issue of how the company distributes its profits.
Who decides to pay a dividend?
Dividend payments will be decided upon by the company’s directors. The shareholders have no say in this matter, with the directors bearing full responsibility for this decision. Often the directors and shareholders are the same individuals, so it’s not a difficult choice — but this isn’t always the case.
How are dividends paid?
Companies pay dividends on each share of stock. For example, if you pay $1 dividends on your shares, then an investor with ten shares will be owed $10.
How are dividends paid out to investors?
There are several ways your company’s directors can choose to pay investors their dividends. The two most common ways are cash and stock dividends.
- Cash dividends are paid directly into investors’ nominated accounts.
- Stock dividends can be paid if you choose to award your investors with more shares of stock in your company
When are dividends paid?
Certain criteria need to be met before a dividend can be paid. ASIC governs these requirements as a way to protect a company’s stakeholders.
First, for a dividend to be paid, there must be profits. A general law principle states that dividends can only be paid out of retained profits. In itself, this is a rather simple test to apply.
A secondary run of tests is applied by ASIC, which restricts dividend payments unless:
- Immediately before the dividend payment, the company's assets are greater than its liabilities to the extent of the dividend declared. If your company passes the retained profits test, it’s highly likely you’ll pass the requirements for this test too.
- The dividend payment must be fair and reasonable to all shareholders. This issue typically arises more often when there are different classes of shareholders, and decisions need to be made about which classes of shareholders receive dividends. These decisions must be made on a fair and reasonable basis.
- The payment of the dividend does not prejudice the company's ability to pay its creditors. The company’s owners shouldn’t be taking profits unless they’re certain they can meet all obligations within the company. These obligations extend to staff wages, the ATO, financial institutions, and other creditors.
Once the decision has been made, the company’s directors will sign off on this declaration to confirm the dividend payment. The shareholders should then receive a dividend statement that shows the amount and date of the dividend declared, as well as any franking credits attached to the dividend.
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Do companies always pay dividends to shareholders?
Companies do not always pay dividends to their shareholders. A company doesn’t necessarily have to pay dividends to its shareholders. Whether they pay a dividend or reinvest into the company is up to the directors to decide.
But if it does, they must have sufficient net profits to do so. The company's directors must be satisfied that sufficient profits are available and that any additional requirements under the company’s constitution can also be met.
How franking rates affect dividend payments
The franking rate for dividends can have a big effect on a shareholder’s tax obligations. To understand this effect, let’s first define franked and unfranked dividends.
Your business’s income is, as you know, taxable in Australia. But dividends can also be taxable income for shareholders who receive them. The franking system exists as a way to avoid double taxation on these dividends.
Franking credits are essentially a rebate that your shareholders receive for the tax your company has already paid on its profits.
Let’s look at the types of franked and unfranked dividends you can pay your shareholders.
What is a fully franked dividend?
A fully franked dividend has been fully taxed as company income at the 25-30% tax rate. Your shareholders will receive franking credits that reflect this, and be reimbursed in full by the ATO.
What is an unfranked dividend?
An unfranked dividend has not been taxed as company income at all. Your shareholders will have to pay tax on it at their personal tax rate.
A company can choose to pay unfranked dividends as long as the ATO’s benchmark franking rule is not violated, and the recipient of the dividend is a shareholder.
What is a partially franked dividend?
In a partially franked dividend, only a portion of the dividend has been taxed at the 25-30% company tax rate. Shareholders will be assigned franking credits reflecting the size of the already-taxed portion of the dividend. The rest of the dividends will be taxed at their personal tax rate.
Without franking credits, your business would be required to pay tax on its profits, and then your shareholders, in turn, would pay tax on their received dividend payments.
So, is dividend tax applicable to private companies?
Let’s look at an example of how dividend tax works.
Company A makes an annual profit of $10,000. Their applicable tax rate is 25%. Their tax liability would be:
- A profit of $10,000, taxed at a 25% tax rate, resulting in $2,500 tax paid on this profit
- Their retained profits are $7,500
In the following year, the company’s directors can choose to pay the $7,500 in retained profits to their shareholders. For example’s sake, let’s say the shareholder is a single individual with $120,000 of other income in that year. The dividend would be taxed like this:
- They receive dividend income of $7,500
- The profit was taxed at a 25% tax rate, resulting in a franking credit of $2,500
- The individual’s total taxable income from the dividend is $10,000, and they are taxed at a marginal rate of 39% on that dividend — $3,900
- We then subtract the $2,500 franking credit offset from this amount, leaving the individual with a net tax of $1,400 payable on their dividend income.
What’s happening here is that the application of franking credits grosses the income back up to its original amount from the company. A credit for the tax the company has already paid is then applied to this amount.
Under this system, it’s far more beneficial for shareholders to receive dividend payments that are franked rather than receiving an unfranked dividend. So it’s important to review the franking credits a company has to apply against its dividends before any dividend is declared.
What type of dividends are not taxable?
This is a rare occurrence, but it does happen. For example, foreign tax residents aren’t required to declare fully-franked dividends in their Australian tax returns.
In other cases, a company can complete a share buy-back from its investors. This way, some of the money is paid as a dividend, and the other portion is completed as a return of capital.
But typically, the majority of dividends are considered taxable events.
How do you declare dividends on tax returns in Australia?
Investors receiving dividends from companies must declare these dividends on their tax returns. As a company issuing dividends, you will need to provide your investors with a shareholder dividend statement. This statement will need to declare:
- The type of the dividend paid (cash or otherwise)
- The value of the dividend
- The date the dividend was paid
The final word
Declaring a dividend will have varying degrees of tax implications for shareholders, depending on their personal circumstances. So if you’re both a company director and a shareholder, it’s important to consider this before making any such declarations.
