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Last week we discussed the two ways that investments make you money: through capital growth and through an income return. This week, we thought we would do a bit of a deep dive into income return.

Income return is the return an investment gives you while you retain ownership of the investment. The simplest example is the rent that you receive if you are the landlord of a residential or commercial property. When you lease the property to a tenant, the tenant has the legal right to use the property. But you retain the ownership rights to the property.

Another simple example is the profit from a business. If you own a business, then the profit that the business makes is your income return from that business. If you own only a portion of a business that operates as a company – for example, if you own some shares in a publicly-listed company – then you may receive ‘dividends’ from that business. The rules for companies are that dividends can only be paid out of profits, although those profits may have been earned in previous years.

Businesses that operate through companies do not have to pay out all their profits as dividends. A company can retain some or all of its profits. Companies usually do this to finance activities such as acquiring more assets with which to continue operating. Theoretically, any profits that are retained within a company should increase the capital value of that company, because the assets of the company are higher than they would be if the profits were all paid out. For example, if a company makes $1 million in profit but only pays out $500,000 in dividends, then it has an extra $500,000 of cash sitting on its balance sheet. This should make the market capitalization of the business $500,000 more than it would be if the dividend was paid out. Of course, because market prices are not always rational, this may not be what actually happens!

The third category of investment is cash and cash-like investments. These can include things like savings accounts, term deposits and even debentures or bonds for the larger investor. The income return on these investments usually takes the form of interest. Interest is a simple concept: in return for the use of the investor’s money, the ‘borrower’ pays interest regularly over a period of time, at the end of which they return the amount borrowed.

A simple example: a 12-month term deposit paying 2% interest. The investor invests $50,000 into the term deposit. They receive $1,000 (2%) in interest and their original $50,000 back at the end of the 12 month period.

There are some variations in how interest is received, but they all have this basic element in common.

Taxation and Income Returns

(Please note that this article is not tax advice. The following is general information only and you should get individual advice from a registered tax adviser before making decisions about investments and tax).

The tax office knows a lot about psychology. One of the things they know is that it is much better to tax good things than it is to tax bad things. And making an income return is a good thing!

The tax treatment of income returns is also pretty simple. Generally, the investor simply adds the income return from their investment to their other income and then pays tax at their marginal rate. For example, an investor who receives a salary of $70,000 has a marginal tax rate of 32.5%. If that investor also receives $1,000 in interest on a term deposit, then their taxable income increases to $71,000. They will pay 32.5%, or $325, tax on the $1,000 interest.

Dividends from shares can be a little different. If an Australian company pays tax on its income before it pays out its dividends, then it would be problematic to also tax the dividends in the hands of the shareholder. This would essentially mean that the same profit was taxed twice. For example, say that a company earns $1,000 of profit per share. It pays company tax of 30%, or $300, on this profit. It then pays the remaining $700 to each shareholder. If the shareholder has a salary of $70,000 to which this dividend is added, then the additional $700 will be taxed at 32.5%. This would be an extra $227.50. So, the shareholder would only end up with $472.50 of the $1,000 that the company earned, and the ATO would get $527.50 ($300 from the company and $227.50 from the shareholder).

This is not really fair. The ATO gets more than half of the company’s profits. The answer is for the ATO to give the shareholder a ‘credit’ for tax paid by the company. This is usually known as a ‘franking credit.’ In the above example, the shareholder would get $700 in cash plus a credit for the $300 in tax paid. The shareholder’s marginal tax rate would then be applied to the whole amount of $1,000. This would give $325 in tax payable (32.5% of $1,000). But the ATO already has $300. So, the taxpayer only has to pay an extra $25.

In this way, the ATO ends up with the same amount of tax as if the shareholder had earned the money themselves. The company’s profits are effectively taxed at the marginal tax rate of each shareholder. If the shareholder had a marginal tax rate lower than 30%, the ATO would actually give them some money back. For example, if the same amounts ($700 plus a $300 tax credit) were paid to a shareholder whose marginal tax rate was only 19%, only $190 in tax would actually be payable. The ATO has already received $300, so the ATO would need to give the shareholder a refund of $110. Thus, of the initial $1,000 in company profit, the shareholder received $810.

In the next couple of weeks, we will write about capital return. When we do, you will see that, sometimes, capital returns are taxed more preferably than income returns. Much depends on (i) how much tax the investor is already paying; and (ii) how long they hold the investment. But that is for a future article. For now, please remember the simple logic that income returns are generally added to your other income and taxed at your marginal tax rate.