Investing can be intimidating especially with all the jargon thrown around. Capital gains! Efficient market hypothesis! Rate of return!
Thankfully, you don’t need a PhD to be a successful investor. But, there are a few terms you should familiarise yourself with on your journey to financial security. Two of the more confusing are dividends and distributions. Often these terms are used interchangeably, even though they have very different meanings.
What is a dividend?
A dividend is a payment made by a company to a class of shareholders out of profits earned, or from its retained earnings. While there can be many different classes of shares, the two most common ones are ordinary shares and preference shares.
The amount paid out as dividends to ordinary shareholders is determined by the paying company’s board at its discretion.
Some companies aim to pay a set percentage of their net profit after tax to ordinary shareholders, while others try to keep their dividends per share relatively constant irrespective of fluctuating profitability. Either way, as an ordinary shareholder you have no say in how much you will receive in dividends for each share you hold.
For preference shareholders the amount of dividends received will depend on the terms of preference class, but in general preference shareholders are entitled to receive dividends before ordinary shareholders (hence the “preference”).
Most listed companies tend to declare and pay dividends twice a year, once as an interim dividend and a second as the final one.
How are dividends taxed?
Depending on the source of the company’s profits and how it’s been taxed, dividends paid by Australian resident companies can be partially or fully ‘franked’, so that a tax benefit is received by Australian tax resident shareholders known as an imputation credit. These credits can be highly valuable to certain types of investors, particularly those on lower rates of tax.
Dividend imputation is a complex area of taxation, and if you’re not familiar with how it operates we’d strongly encourage you to read the ATO material on this topic, or to consult with a suitably qualified taxation professional.
What is a distribution?
Distributions are most commonly associated with trusts, so it’s worthwhile talking about them first.
A trust is a type of structure where legal ownership of trust assets reside with a Trustee, but those assets are held for the benefit of one or more other parties (beneficiaries). Trusts have been around for hundreds of years, and are a common alternative to forming a company. They are used extensively in the investing world, with managed funds being a form of trust where units are issued to investors in proportion to their share of ownership in the pool of trust assets.
The vast majority of Exchange-Traded Funds operate as trusts, the difference being their units are listed on an exchange and are thus tradeable like company shares. Superannuation is another common form of trust used for investing purposes.
When it comes to managed funds and ETFs, the Trustee is responsible for managing the assets of the trust, for collecting trust income and for administering, accounting for and paying out trust income to unitholders. The trust income amounts paid to unitholders are known as distributions.
Trusts must generally distribute the income they receive to their unitholders in full each financial year or face penalty rates of tax on undistributed trust income. So, at the end of each financial year you should receive a tax distribution statement outlining the amounts and types of income you’ve earned as a member of the trust.
The income might be in the form of dividends received by the Trust from shares it holds on your behalf, interest from cash and fixed interest investments, lease payments from properties held, or even distributions from investments in other trusts.
As a general rule most trusts will provide their year end tax statements to unitholders within 6 – 8 weeks of the end of the financial year. Most trusts provide some guidance on the various types and amounts of income that investors have to transcribe into their tax returns.
As with dividends, if you are unsure about how to read or understand your annual trust distribution tax statement, you should seek advice from a suitably qualified taxation professional.
So there you have it. Now you know the difference between dividends and distributions. You’ll be a hit at all your friends’ parties!
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Also published on Medium.