What are franking credits?

It’s no surprise many shareholders in Australia love franking credits – they can make dividends a very tax-friendly source of income. But what exactly are franking credits, and how do they work? Here’s what you need to know.

What are franking credits?

Franking credits are a type of tax credit sometimes issued to shareholders when eligible companies pay dividends from their after-tax profits. Shareholders can use franking credits to offset tax. The aim is to prevent income being taxed twice.

A key point about franking credits for shareholders is that they can make dividends on shares a tax-efficient source of investment income, but let’s delve a little deeper.

Dividends, as you may know, are a portion of a company’s profits paid to reward its shareholders. Since a dividend is a form of income, you would normally expect to pay tax on it, just as you would on your hard-earned salary or wages.

However, the company may have already paid tax on the profits that dividends are sourced from. And that’s where franking credits come in.

Franking credits prevent the government double-dipping, or taxing the same income twice.

How do franking credits work?

To understand how franking credits can work in a shareholder’s favour, let’s break things down a  little.

• Franked dividends have been paid from profits on which the company has paid tax.
• Franking credits act as a tax credit that shareholders can offset against tax on their dividend income.
• If your marginal tax rate is less than the 30% company tax rate, you may be entitled to a tax refund as a result of franking credits.
• The whole purpose of dividend imputation and franking credits is to avoid the problem of double taxation.

How do franking credits prevent double taxation?

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 Australian Taxation Office (ATO), the tax paid by the company is allocated to shareholders by way of franking credits attached to the dividends they receive. In this way, franking credits are designed to prevent ‘double taxation’.

Double taxation as the name suggests, can occur when the same income or asset is taxed twice. This can happen when corporate and personal profits intersect, as is the case with dividends.

Through our system of dividend imputation and franking credits, the ATO recognises that corporate tax has already been paid on a company’s profits which are distributed as dividends. So, the point of franking credits is to give you a personal tax credit for the company tax paid on profits.

Even better, 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 the excess back as a tax refund.

An example of franking credits in action

Here’s a hypothetical scenario to show how franking credits can work in practice. We’ll say Company A pays 30% tax, or 30 cents of tax on every 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. This will be shown on the dividend statement Betty receives. The 30-cent franking credit represents the tax Company A has 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 would add the 30-cent franking credit to that income. This would show her income from shares as $1.

ATO rules state that Betty is required to pay tax on that $1 income at her individual marginal tax rate. Now, here’s where franking credits do their work: Company A had already paid 30c of tax on that $1 of income. So Betty is entitled to a tax credit for the 30c of tax the company had already paid.

If Betty’s marginal tax rate is below the company tax rate of 30%, this tax credit means she would likely receive a refund. This would be equal to the difference between her marginal tax rate and the 30c tax paid.

On the flipside, if Betty’s marginal tax rate is higher than the company tax rate, she would likely have to pay tax on her dividend, though not at her full marginal tax rate. She would only have to make up the difference between her marginal tax rate and the tax already paid by the company.

To see how this works, let’s assume Betty is a high income earner with a marginal tax rate of 45% before the dividend is factored in. The benefit of the franking credit is that she won’t pay tax of 45% on her dividend. Rather, she’ll pay 15% tax on the dividend, being 45% less the 30% company tax already paid.

In this way, franking credits and dividend imputation can make dividends a very tax-friendly source of income.

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. However, under the small shareholder exemption, this rule does not apply if your total franking credit entitlement is below $5,000.

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.

For tailored information on how franking credits can benefit you or your SMSF,  it can be a good idea to check out the ATO’s website or seek professional tax advice.

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Original author: Ellie McLachlan. Image Source: M. B. M. (Unsplash)