Paying dividends from private companies

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Taxation
By
Stewart Lane
Stewart Lane
Head of Tax
August 27, 2020
7
minute read

What you need to know before you decide to pay dividends in Australia

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.

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 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.

When are dividends paid?

There are certain criteria that need to be met before a dividend can be paid. These requirements are governed by ASIC, 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 restrict 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 around 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.

Does a company have to pay dividends to its 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 be decided by its directors.

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

Franking rates and franking percentage are terms that are often thrown around in relation to dividends. This refers to the portion of the dividend paid that has franking credits attached to it.

The franking rate for dividends can have a big effect on the tax consequences when paying a dividend to shareholders.

Dividends are considered taxable income in Australia, and the franking system exists as a way to avoid double taxation on these dividends. Franking credits are essentially a rebate that shareholders receive for the tax the company has already paid on their profits. Without this system, businesses would be required to pay tax on their profits, and then 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 30%. Their tax liability would be:

  • A profit of $10,000, taxed at a 30% tax rate, resulting in $3,000 tax paid on this profit
  • Their retained profits are $7,000

In the following year, the company’s directors can choose to pay the $7,000 in retained profits to their shareholders. For example’s sake, let’s say the shareholder is a single individual with $10,000 of other income in that year. The dividend would be taxed like this:

  • They receive a dividend income of $7,000
  • The profit was taxed at a 30% tax rate, resulting in a franking credit of $3,000
  • The individual’s total taxable income is $10,000, and they are taxed at a marginal rate of 39% — $3,900
  • We then subtract the $3,000 franking credit offset from this amount, leaving the individual with a net tax of $900 payable on their dividends.

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.

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.

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