Question

Colin Green and his brother Nigel have always been interested in plants. Two years ago, in 2017, they established Green Brothers Horticulture Pty Ltd, with each brother owning half the shares on issue. Both Colin and Nigel have full-time jobs as engineers and earn good salaries: Colin's annual salary is about $200,000 and Nigel's is about $225,000. Their horticulture company is on a fairly small scale: annual turnover is about $150,000, so the company's tax rate is 27.5%. Its operations are really only a part-time interest for the brothers. Nevertheless, in the current financial year (2019-20), the company has been performing quite well and Colin and Nigel expect it will have a taxable income of about $44,000. Colin and Nigel have read press reports about the tax benefits associated with franking credits and are wondering whether the company should declare a dividend for tax reasons. They have asked you for advice. What is your advice? Why? (For simplicity, ignore the Medicare levy and assume that capital gains tax is payable at the end of the financial year.)

Answer 1

Dividends are a company's way to return surplus cash to its stockholders. When a company earns a profit, it has several choices. It can reinvest the money for future growth, pay down debt, buy back some of its own stock or distribute it to its stockholders.

A franking credit is a tax credit paid by corporations to their shareholders along with their dividend payments. It is a way to reduce or eliminate double taxation.

Depending on their tax bracket, investors who receive a franking credit may get a reduction in their income taxes (that is to pay only to make the difference in the marginal tax and the tax already paid by the company) or a tax refund.

In the given scenario, both the green brothers have full time job as engineers and earn good salaries. Colin’s annual salary is about $200000 assuming no other income and with a standard deduction of $12200, its taxable salary comes under the bracket of 32%. Similarly Nigel’s annual salary is about $225000 assuming no other income and with a standard deduction of $12200, its taxable salary comes under the bracket of 35%. Their horticulture company is fairly small scale so the company’s tax rate is 27.5%.

Since both Colin’s and Nigel marginal tax rate is higher than the company’s tax rate, they would have to pay an additional tax of 4.5% or 7.5%. Therefore it would be advisable to reinvest the money for future growth rather than paying dividends and additional tax along with it.