Dividends paid to Australian resident shareholders by Australian resident companies are taxed under a system known as “imputation.” The tax the company pays is attributed to shareholders in the company. The tax paid by the company is allocated to shareholders through “franking credits” attached to the dividends they receive. This is often referred to as “grossing up” a dividend.

Australian resident shareholders include an amount equal to the franking credit attached to the dividends they receive in the “assessable income” they report on their tax returns. Australian shareholders are also entitled to a “franking tax offset” equal to the amounts included in their income, subject to exceptions or “anti-avoidance” rules.

The franking tax offset will cover, or partly cover, the tax payable on the dividends. If the tax offset is more than the tax payable on the dividends, the excess tax offset will be applied to cover, or partly cover, any tax payable on other taxable income the Australian resident shareholder received.

Franking credits represent, in a real sense, additional income to Australian resident shareholders–a fact that many observers Down Under believe is lost on many investors. According one estimate, franking credits add more than 1 percent to the post-tax return from Australian shares for Australian investors. With Australia’s corporate tax rate at 30 percent, dividends are grossed up by AUD30 for each AUD70 of dividends received. This means that Australian companies that pay tax at the 30 percent company tax rate have AUD428.57 of attached franking credits for every AUD1,000 of dividends they pay out.

If any excess tax offset is left over after that, the Australian Taxation Office (ATO) will refund that amount.

Non-residents–including US-based investors–can also be paid or credited franked dividends or unfranked dividends by Australian companies, at least nominally. But we’re taxed differently from resident shareholders.

For us non-residents, the franked amount of dividends–the “grossed-up” dividends–you are paid or credited are exempt from Australian income and withholding taxes. At the same time, you aren’t entitled to any “franking tax offset” for franked dividends. You can’t use any franking credit attached to franked dividends to reduce the amount of tax payable on other Australian income, and you can’t get a refund of the franking credit.

The “gross-up-and-credit” effectively does not exist for non-resident investors.

The unfranked amount, on the other hand, which is effectively a “net” dividend in the context of this imputation system, will be subject to withholding tax.

If you do have income other than dividend income from Australia and you file with the Australian Tax Office, you should not include the amount of any franked dividend or any franking credit on your return.

Australian resident companies may also pay or credit an unfranked dividend, to which there is no franking credit attached. In general unfranked dividends paid or credited to a non-resident are subject to a final withholding tax, which is imposed on the full amount of the unfranked dividends–that is, no deductions may be made from the dividends.  A flat rate of withholding tax is applied whether or not you have other Australian taxable income. Withholding tax is also deducted from the unfranked amount of any partly franked dividends that you are paid or credited.

Withholding tax is deducted by the company before a dividend is paid, so you’ll be paid or credited only the reduced amount. The general rate of reduction is 30 percent. Australia has entered into a double-taxation agreement with the United States that limits the rate of withholding tax on dividends to 15 percent, at least through 2012.

The withholding tax on unfranked dividends is a “final tax,” so you’ll have no further Australian tax liability on the dividend income. If the only income you earned was dividend income that was a fully franked dividend or an unfranked amount of a dividend which was either subject to withholding tax or declared to be “conduit foreign income,” you don’t need to file an Australian tax return.

Dividend Watch List

Twenty of 107 companies tracked in the Australian Edge How They Rate coverage universe declared a dividend lower than the one declared for their prior corresponding period during the recently concluded earnings reporting season.

The business of AE is to identify businesses capable of paying sustainable and growing dividends over time. The corollary of this mandate is to identify those businesses that are not capable sustaining or growing dividends. With recent reductions the following companies have declared as well their worthiness for inclusion on the Dividend Watch List.

Basic Materials

Aditya Birla Minerals Ltd (ASX: ABY, OTC: ABWAF) announced in late 2011 that its board decided to not recommend the payment of a dividend in respect of fiscal 2012 first-half results. The company will report full 2012 (end Mar. 31, 2012) results in mid-June. Aditya Birla is a hold.

Alumina Ltd (ASX: AWC, NYSE: AWC) reduced its final dividend for 2011 by 25 percent, in step with guidance issued late in the year. Alcoa World Aluminum & Chemicals revenue rises 22 percent year over year from 2010 to 2011, but the uncertain economy ahead and its recent history recommend inclusion on the Watch List. It remains a buy under USD1.50.

Aquarius Platinum Ltd (ASX: AQP, OTC: AQPBF) will not pay an interim dividend on its fiscal 2012 first-half results, as sales and production both suffered during the period. Fourth-quarter production was threatened by supply problems in southern Africa that could prove persistent. Sell Aquarius Platinum.

BlueScope Steel Ltd (ASX: BSL, OTC: BLSFF) announced last October that it wouldn’t pay a dividend in respect of fiscal 2012 first-half results. The company is struggling to adjust to competitive pressures from steel producers in lower-cost Asian markets. Government aid will help, but this transition is not for dividend-focused investors to wait out. Sell BlueScope Steel.

Independence Group NL (ASX: IGO, OTC: IPGDF) reported a significant statutory loss on the writedown of a recently acquired asset. Production issues, which could be a continuing problem, and lower realized prices, which could turn, are the real questions following a 50 percent reduction in the company’s interim dividend. Independence Group is now a hold.

OneSteel Ltd (ASX: OST, OTC: OSTLF, ADR: OSTLY) is paying a AUD0.03 per share dividend, down 50 percent from the AUD0.06 it paid for the first half of fiscal 2011. But this is now a different company, one focused on its iron ore mining operations and away from its steelmaking past. Management is even considering a name change. Promising results from its mining operations for the recent period suggest management is on to something. Decision-makers expect “significant improvement” in fiscal 2012 second-half results. OneSteel is now a buy under USD0.80.

Panoramic Resources Ltd (ASX: PAN, OTC: PANRF) is paying 50 percent less with its fiscal 2012 interim dividend than it did a year ago, as lower realized prices for nickel offset double-digit production growth. Management lifted full-year production guidance, but policy required a lower investor payout. Panoramic Resources is a buy under USD1.60.

Western Areas NL’s (ASX: WSA, OTC: WNARF) 50 percent lower interim dividend is the result of lower sales. Realized prices for its nickel offset higher production, though costs trends were positive and management reiterated full-year guidance. Western Areas is a hold.

Consumer Goods

Billabong International Ltd (ASX: BBG, OTC: BLLAF) cut its interim distribution by 81 percent, but this is likely an interim step on the way to zero. The company is spinning a cash-generating unit into a joint venture with a third party to generate cash to pay down debt. But its ability to pay remaining liabilities will be impaired by the absence of the full cash flow from this asset. The company has also rejected a AUD3 per share cash buyout offer. Sell.

Goodman Fielder Ltd (ASX: GFF, OTC: GDFLF) isn’t paying an interim dividend. Prior-year comparisons make the decision obvious, as revenue was off 3.7 percent and statutory net profit after tax was down 77 percent. But sequential comparisons show a turnaround may be underway. Hold.

Consumer Services

APN News & Media Holdings Ltd (ASX: APN, OTC: APNDY) reduced its 2011 annual dividend by 28.6 percent from 2010 levels. Statutory net profit after tax (NPAT) slid by 24 percent, though revenue rose 1 percent to AUD1.07 billion. Trimming the dividend will provide more cash as the company undertakes a tough transition to outdoor advertising. Sell.

Harvey Norman Holdings Ltd (ASX: HVN, OTC: HNORY) trimmed its interim dividend by 16.7 percent, as fiscal 2012 first-half net profit after tax (NPAT) slid 2.1 percent on an 8.2 percent decline in sales. Harvey Norman is now a sell.

Southern Cross Media Group Ltd (ASX: SXL, OTC: SOUTF) management highlighted the fact that “like for like” revenue was off only 2.7 percent from the first half of fiscal 2012 compared to the prior corresponding period. Unequivocal good news can be found in the conclusion that cost-control efforts exceeded expectations; coupled with the cash saved from a 28.6 percent interim dividend reduction Southern Cross should be able to continue to ride out challenging advertising conditions. Southern Cross is a buy under USD1.25.

TABCORP Holdings Ltd (ASX: TAH, OTC: TABCF) reduced its interim dividend by 45.8 percent from AUD0.24 to AUD0.13 per share, a move management said was “in line with stated policy.” Hold.

Financials

QBE Insurance Ltd (ASX: QBE, OTC: QBEIF) reduced its 2011 dividend by 32 percent from the rate it paid in 2010; 2011 was a year marked by “unprecedented natural catastrophes and challenging investment markets,” which made hoarding cash a reasonable move. Internal metrics suggest QBE will do well once external conditions improve. For now, however, dividend investors are better off elsewhere. If you own it, hold.

Westfield Group Ltd (ASX: WRT, OTC: WEFIF, ADR: WFGPY) cut its full-year 2011 payout by 24 percent. Australia’s biggest REIT by market capitalization is a hold.

Oil & Gas

Caltex Australia Ltd (ASX: CTX, OTC: CTXAF) paid AUD0.45 per share in respect of 2011 results, down from AUD0.60 in 2010, as profit on a replacement-cost-of-operating-sales basis dropped to AUD264 million from AUD318 million, versus company forecast of AUD245 million to AUD265 million. The stock has run to well above AUD13, past our AUD11 buy-under target, and now rates a hold.

Santos Ltd (ASX: STO, OTC: STOSF) paid 18.9 percent less to shareholders in 2011 than it did in 2010, as it posted a 5 percent reduction in production. Santos remains a buy under USD13.50.

Utilities

DUET Group (ASX: DUE, OTC: DUETF) announced in mid-2011 that it would reduce its payout by 10 percent to reduce debt. The stock remains a hold.

Spark Infrastructure Group (ASX: SKI, OTC: SFDPF) reduced its 2011 payout by 25.1 percent, but management forecast 5 percent distribution growth for 2012. Spark Infrastructure is a buy under USD1.40.

The ADR List

Dividend Watch List member David Jones Ltd (ASX: DJS, ADR: DJNSY) now has an unsponsored American Depositary Receipt (ADR) trading stateside. It’s worth one underlying share traded on the Australian Securities Exchange (ASX). We’ll continue to track the How They Rate coverage universe and beyond for Australia-based companies that afford US investors the convenience of ADR investing, either on their initiative or via the effort of an interested financial institution.

Here again is our primer on Australian stocks, US over-the-counter (OTC) symbols and ADRs.

The great majority of the companies comprising How They Rate have US symbols, many because they actively seek to raise capital here on their own accord. That means they comply, to varying degrees, with US Securities and Exchange Commission filing requirements for foreign companies and with US accounting principles. Others trade here because a sponsoring institution has effectively created a secondary market for the shares, without the underlying company’s active participation.

Shares traded on US over-the-counter (OTC) markets bearing a final “F” in their five-letter symbols are basically home-listed shares trading in a market created by and for US institutions. Individuals can buy and sell here, too. Prices basically reflect Australian Securities Exchange (ASX) prices and also reflect changes in the relationship between the US dollar and the Australian dollar. One “F” share represents one ASX-listed share. The dividend you receive in respect of an “F” share is the dividend paid in respect of the ASX-listed share, adjusted for currency effects.

An American Depositary Receipt (ADR) is a certificate that represents stock of a foreign company. ADRs are listed on US stock exchanges or the OTC Bulletin Board or Pink Sheets. Those that trade OTC have five-letter symbols ending with the letter “Y.” All transactions, including dividend payments, are conducted in US dollars.

One ADR certificate may represent one or more shares of the foreign stock; it can also represent a fraction of a share. For example, one Telstra Corp Ltd (ASX: TLS, OTC: TTRAF, ADR: TLSYY) ADR, which trades under the symbol TLSYY, is worth five ordinary shares that trade on the Australian Securities Exchange under the symbol TLS. Australia & New Zealand Banking Group Ltd’s (ASX: ANZ, OTC: ANEWF, ADR: ANZBY) ADR, ANZBY, is worth one Australia-listed ANZ share.

Because many ADRs don’t have a one-to-one ratio between the depositary receipts and the shares of stock, financial ratios are often not included in stock listings. Data in Australian Edge Portfolio tables and How They Rate is derived based on Australian Securities Exchange symbols so is as complete as you’ll find anywhere.

Foreign companies themselves often “sponsor” the creation of their own ADRs. These are called “sponsored ADRs.” There are three levels of sponsorship.

A Level I sponsored ADR is created by a company because it wants to extend the market for its securities to the US. It does not, however, want to register with the Securities and Exchange Commission (SEC) or conform to generally accepted accounting principles (GAAP). Level I ADRs trade on the OTC Bulletin Board or Pink Sheets trading systems, usually but not exclusively by institutional investors. Australia & New Zealand Banking Group’s is a Level I ADR.

Level II and Level III sponsored ADRs must register with the SEC, and financial statements must be reconciled to generally accepted accounting principles. A Level II ADR requires partial compliance with GAAP, while a Level III ADR requires complete compliance. A Level III sponsorship is require if the ADR is a primary offering and is used to raise capital for the company. Only Level II and Level III sponsored ADRs can be listed on the New York Stock Exchange (NYSE), the American Stock Exchange or Nasdaq. Telstra Corp sponsors a Level III ADR in the US, meaning it’s actively seeking to raise capital here.

An unsponsored ADR is created by a US investment bank or brokerage that buys ordinary shares on the underlying company’s home market then deposits them in a local custodian bank. This depositary bank then issues shares that represent an interest in the stocks and handles most of the transactions with American investors, serving both as transfer agent and registrar for the ADR.

The shares of the foreign stock held in the custodian bank are called “American Depositary Shares,” although this term is sometimes used as a synonym for “American Depositary Receipts.” Unsponsored ADRs can’t be listed on the major American stock exchanges because they aren’t registered with the SEC and lack other necessary qualifications.

The price of an ADR is determined by supply and demand but will generally track the price of the underlying ordinary share. When dividends are paid, the custodian bank receives it and withholds any foreign taxes, exchanges it for US dollars and then sends it to the depositary bank, which then sends it to the investors.

The US depositary bank handles most of the interaction with US investors, including rights offerings, stock splits and stock dividends. Sponsored ADR investors may receive communications, including financial statements, directly from the company.