Explaining investor mumbo jumbo: What are franking credits?

Shareholders love them, politicians squabble over them, but what exactly are franking credits?

Franking credits, franked dividends, fully franked, imputation credits, dividend imputation – you could be forgiven if these terms have your head spinning.

Dividends, as you may know, are a portion of a company’s earnings issued to reward its shareholders. And since a dividend is a form of income, you’d normally pay tax on it as you would on your hard-earned salary.

However, the company paying the dividend has already paid tax on the money they are paying you.

That’s where franking credits come in.

Think of them as compensation from the Government for trying to take two lots of tax from the one pot of money.

No doubt the term is fresh in the minds of many Australians, as refundable franking credits became a key issue of debate during the 2019 federal election campaign. Labor wanted cash handouts to stop by reverting franking credits to how they were originally designed under the Hawke government in 1987, whereby excess credits could not be claimed as a cash refund as they can be today. The Liberals said changing the system would cut into the incomes of retirees.

But to understand what franking credits are, it’s first important to realise one important point. Having $200 worth of franking credits listed on your share statement doesn’t mean you will get that equivalent amount flowing into your bank account at the same time and in the same way a share dividend would arrive.

However, as the Australian Taxation Office (ATO) explains, franking credits do allow people to change what they put in the “taxable income” box on their tax return – which can then turn into very real cash.

Let’s dig a little deeper…

What are franking credits?

If you’ve dipped your toes into the world of share trading, you may have heard about ‘franked’ dividends. A franked dividend is one that carries a franking credit, also known as an imputation credit, which is essentially a small-scale tax offset. That’s why it’s called a “credit”.

According to the ATO, franking credits are a type of tax credit designed to prevent “double taxation”.

Double taxation is a bit like getting two pieces out of the one pie. As the name suggests, it usually occurs when the same income or asset is subject to taxation twice, typically when corporate and personal profits intersect, as is the case with dividends. This becomes particularly important when it comes to filing a tax return.

In Australia, we overcome double taxation through dividend imputation – a method used commonly across the globe. Under this imputation system, the ATO recognises that corporate tax has already been paid on a company’s profits which are distributed as dividends, and franking credits are used to avoid placing that tax burden on investors as well. In turn, this can allow an investor to reduce his or her tax liability (the amount of tax a person would otherwise have to pay).

One unique aspect of Australia’s dividend imputation arrangements is that following changes introduced by the Howard Government in 2001, if a person or self-managed super fund has franking credits that are worth more than the amount of tax they owe, they could receive a cheque from the government, paying them back the difference. But prior to these changes, any excess credits were effectively worthless because they couldn’t be claimed as a tax refund.

Let’s break it down with a working example…

How do franking credits work?

Here’s a hypothetical scenario: Company A pays 30% tax, or 30 cents of tax on every one dollar of profit it generates.

If Company A paid its shareholder Betty a fully franked dividend of 70 cents out of that dollar, she would also receive a franking credit of 30 cents, as detailed on her dividends statement, representing the tax Company A had already paid.

According to the ATO, when Betty fills out her tax return, instead of just putting down the 70-cent dividend as income, she could add the 30-cent franking credit to that income. The income from her shares would be written as $1.

ATO rules state that Betty was only required to pay tax on that $1 income at her marginal tax rate, as an individual. Now, here’s where franking credits do their work: Company A had already paid 30c of tax on that $1 of income. That means that 30c has been taxed twice.

The ATO states the dividend could affect shareholders differently, depending on their tax bracket.

For instance, if Betty’s marginal tax rate is below the company tax rate of 30%, she would likely benefit from the franking credits, because she would receive the excess tax she paid as a refund. The ATO states that rebate could be used to pay tax on other income, or otherwise Betty may receive a cheque at tax time if there’s no tax to pay.

On the flip side, if Betty’s marginal tax rate is higher than the company tax rate, she would likely not see the same level of benefit. Even so, the ATO states she could potentially expect to receive a tax offset equal to the franking credit, meaning she would only have to make up the difference between her marginal tax rate and the tax already paid by the company.

Other handy things to know about franking credits

  • Not every company listed on the ASX chooses to pay franked dividends.
  • Those companies that do don’t always have enough franking credits available to give them to shareholders.
  • There can be some eligibility requirements that must be met before franking credits are paid, such as that you must hold the shares ‘at risk’ for at least 45 days, according to the ATO.
  • There are also rules to consider that can apply to buying, holding and selling shares with franking credits attached.
  • Franking credits are commonly accrued through dividends by superannuation fund members, particularly for people with self-managed super funds (SMSFs), where withdrawals are not taxed for most people aged over 60.

It’s also worth keeping in mind the laws regarding the refund of excess franking credits are regularly being reviewed. To keep up to date with the latest rules regarding company tax rates and franking credits, it can be a good idea to check in with the ATO’s website.

Image Source: M. B. M. (Unsplash)

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