Summary
- Dividend stripping involves purchasing shares before a dividend is declared and then selling them when they go ex-dividend.
- The investors gain in case of income being more than the loss or if the tax treatment of the two offers an advantage.
- The Australian government introduced the 45-day rule to stop investors from manipulating the tax system through dividend stripping.
Have you ever heard about dividend stripping? The practice involves purchasing shares a short period before a dividend is declared or cum-dividend and then selling them when they go ex-dividend. Dividends are part of the profit given out by the companies to shareholders as a reward for investing in equity. The board of directors announces dividends after the consent of the shareholders.
The practice of dividend stripping helps investors to earn dividend income or a capital loss. The investors gain in case of the income being more than the loss or if the tax treatment of the two provides an advantage.
There have been cases of companies using dividend stripping to avoid tax. Dividend stripping or cum-ex trading helps a company to distribute profits to the owners in the form of a capital sum, as against dividend. The expectation is to receive the dividend, the franking credit and a capital gain at the same time, or a capital loss smaller than the dividend gain.
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To stop investors from manipulating the tax system through dividend stripping, the Australian government introduced the 45-day rule.
What is the 45-day rule?
Under the 45-day rule, the taxpayers are required to continuously hold shares "at-risk" for at least 45 days to be entitled to the franking credits. It includes 90 days for preference shares, not including the day of acquisition or disposal. The rule was originally set out in section 160APHC-E of the Income Tax Assessment Act 1936 (1936 Act).
This holding period rule generally applies to shares bought on or after 1 July 1997. It is not applicable where an individual’s total franking credits entitlement for the financial year are below AU$5,000.
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In Australia, ordinary external investors are free to purchase shares before the dividend is announced and sell them ex-dividend and treat the dividend income and capital loss the same as any other investment. However, anti-avoidance provisions of Part IVA of the Income Tax Assessment Act 1936 come into the picture in case of a deliberate arrangement by the company's owners to avoid tax.
Who is eligible for a franking credit?
A franking credit or an imputation credit is a kind of tax credit paid by corporations to their shareholders along with their dividend payments. Several countries, including Australia, allow franking credits to reduce double taxation.
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The franking credit allows companies to allocate a tax credit to their shareholders since they have already paid taxes on the dividends distributed to their shareholders. The shareholders might then get a reduction in their income taxes depending on their tax situation.
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To put it in simple words, the investor who gets the dividend receives a tax credit from the firm. This informs tax authorities that the company has already paid for the needed income tax on dividends.
As already explained, the taxpayers who continuously hold shares "at-risk" for at least 45 days are entitled to the franking credits as a franking tax offset.
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How to calculate franking credits?
Here is the standard formula for the calculation of franking credit:
Franking credit = (dividend amount / (1-company tax rate)) - dividend amount
If an investor receives a $60 dividend from a company paying a 30% tax rate, their full franking credit would be AU$40 for a grossed-up dividend of AU$100.
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