Franking Credits.

This discussion follows on from our earlier discussions about dividends.

The Company have previously stated that it is their intention to pay fully franked dividends. Now, we don't know if they will continue that policy into the future. There may come a time where the level of foreign profits are such that it is not practical to continue to limit the dividend to that which can be fully franked. However, just for the moment, maybe we can assume that this policy remains in place. We might even go further out on a limb and project that the Company sees no benefit in accumulating large amounts of franking credits and therefore may well pay a dividend that exactly matches that which can be fully franked.

Given the above, I thought it would be interesting to try to establish exactly what the franking credit situation may be at the moment. It actually turns out to be quite hard to do - not the least because franking credits are accumulated on a cash basis.

A couple of basic facts.

Franked Dividend. A franked dividend is simply a dividend that the company has already paid the Australian Income Tax on. A fully franked dividend will have had tax paid at the 30% Company tax rate. Companies do not have to pay fully franked dividends, they may pay unfranked or partially franked dividends. The Australian Taxation Office (ATO) will give us (the dividend recipient) a credit on our tax for the tax that has already been paid on the dividend. For simplicity, I will restrict this discussion to fully franked dividends. It is easiest to understand by an example. If we receive a $.70c fully franked dividend then we will receive a tax credit of 30c. That is because the company would have needed to earn and pay tax on $1.00 to produce a post tax amount of $.70. In essence, when we do our own tax, we record an income of the dividend plus the franking credit ($1.00) and then subtract 30c from our final tax amount to be paid. Thus, if our marginal tax rate is 30% then we will have effectively no tax to pay on the cash dividend received. If our marginal tax rate is higher than 30% then we end up paying the difference between our tax rate and the 30%. If our marginal tax rate is less than 30% then we end up with a credit that will be offset against any other income tax that we have to pay - or if there is none then we receive a nice cheque from the ATO. The best situation is that when we hold the shares in a Superannuation account that is in pension mode. There is no tax to pay and the entire franking credit (30c) is paid to us by the ATO.

Often, it is easiest to examine our dividends as a "grossed up" amount. In the example above (a fully franked dividend), the grossed up dividend is the cash dividend divided by 7 and multiplied by 10 (therefore a 70c ff dividend grosses up to $1.00). This is convenient as it allows us to compare the yield directly with the yield that we might get from alternate investments (eg Bank Deposit, Bond). It is very common to apply the same methodology to dividend yield %. That is, a dividend yield of 7% ff grosses up to 10%. The current Telstra dividend yield, for example, is 8.5% ff which grosses up to a touch over 12% (hint, hint).

Foreign Tax. For companies that earn some of their income through overseas subsidiaries there is another little complexity. Such subsidiaries will likely have to pay tax in the country in which the subsidiary operates. (Generally) Any tax paid overseas will be allowed as a credit by the ATO against the tax that would be paid in Australia. However, such tax will not provide any franking credits. In a "worst case" situation this means that a company that earns all of its income overseas may not earn any franking credits and will not be able to pay franked dividends. More usually, the Company will pay some tax overseas and some in Australia. This means that not all of the earnings of the company can be paid out as fully franked dividends. Either the company will pay only as much dividend as they have franking credits available to make the dividend fully franked, or they will pay unfranked or partially franked dividends.

Cellestis have expressed a desire to pay fully franked dividends. Whilst most of our sales are made overseas, we are in the fortunate situation of having an essential part of the manufacturing process in Australia. This means that a judicious setting of the price that we charge our overseas subsidiaries for the product enables a respectable amount of the profits to be booked in Australia where they will be taxed by the ATO and thereby attract franking credits. The fact that we have extensive expenses (Sales and Marketing) based overseas helps with this also.

I'm guessing that you knew all that.

Now, to specifics. It would be interesting if we can establish what the tax situation of Cellestis is, particularly how much tax they are paying in Australia to provide franking credits.

As I mentioned above, it is actually quite difficult to reconcile the franking credits account - largely due to the fact that it is run on a cash basis. However, if we look at the 2009 Annual Report we find this.

This tells us that in 2009, 93% of the company earnings were recorded in Australia. Consequently, we would have to presume that the vast majority of the income tax paid has been paid in Australia and will therefore have attracted franking credits. This would imply that there is absolutely no reason that the Company could not pay a very high percentage of earnings as fully franked credits, if the Company so wishes.

Now, the reason that such a high percentage of the profits were booked in Australia is due to two factors; firstly that a very high part of operating expenses are incurred overseas; and secondly that a large amount of the profit is recorded because of the price that the Australian operation is able to charge its foreign operations for the supply of product. It would follow that, whilst the second factor should remain reasonably constant in the future, the overseas expenses as a proportion of actual sales will reduce. Ultimately it will mean that the 93% will progressively reduce but not by enough to reduce the ability of the company to pay large fully franked dividends.

It is worthwhile noting that retaining franking credits in the Company provides no real benefit to anyone. I do note that it would appear that the 1.5c ff dividend paid for 2010H1 would not have used up all of the franking credits available. I can only guess as to why the Company might have decided to limit the dividend in that case. It may be that it was felt at that point that it was important to assure the stability of the company by retaining cash. That consideration, at that time, may have outweighed the desire to provide a higher immediate cash reward to shareholders. 

Ultimately, the upcoming financial results will go a long way towards clarifying this situation.