Franking credits are unique to Australia. They are tax credits that may be applied to dividends on Australian investments, which may have the potential to offer significant tax savings to investors. But what should you know about them when you invest?
As you read through this explainer, remember that it shouldn’t be treated as financial or tax advice. Instead, please seek a professional to help you decide what is right for you. With that said, as a guide to a common investing concept, we hope you find it helpful!
What are franking credits?
Franking credits, often referred to as imputation credits, serve to eliminate double taxation on dividends . These credits represent the tax that a company has already paid on its profits before distributing dividends to its shareholders.
If franking credits didn't exist, then a company would pay tax on its profits, and the shareholder would also pay tax on the dividends they received. However, with franking credits, shareholders receive a rebate of the tax that was paid by the company. Essentially, franking credits allow shareholders to reduce the amount of personal income tax they owe on dividends by applying the tax the company has already paid. This system ensures that the same income isn't taxed twice, providing a financial boost to shareholders.
How do franking credits work?
Imagine a company making a profit. Before shareholders see a cent, the company pays its dues to the government, let's say at a corporate tax rate of 30%. What's left is then available for distribution among shareholders as dividends .
Here’s where franking credits come in. They ensure that the tax the company has already paid doesn’t disappear into the ether – it directly benefits the shareholders.
Each time a dividend is paid , shareholders receive not just the cash amount, but also a "franking credit." This credit represents their share of the tax the company already paid. It's like getting a coupon along with your dividend that you can use at tax time to reduce your own tax bill.
To keep track of all this, companies maintain a "franking account." This account is a bit like a ledger, recording the taxes paid and how much can be credited to shareholders when dividends are declared. For instance, let's say a company declares a dividend as a "fully franked" dividend. It's announcing that the dividends come with a full credit for the corporate tax paid on that income. If they're partially franked dividends, it means the company has only paid tax on part of its profits.
As an investor, when you receive a dividend, you will be notified whether it is franked and to what extent (i.e., fully franked or partially franked).
When you file your income tax return, you must include the total of the dividend, plus the franking credit, as your gross income. For example, if you receive a $700 dividend that is fully franked, the gross amount you report is the $700 plus the franking credit.
The franking credit can then be used to offset your income tax liability. If your marginal tax rate is less than the corporate tax rate of 30%, you may also be entitled to a refund of the excess franking credits.
However, if your tax rate is higher than the company's 30% rate, you may need to pay tax on top of the franking credit.
Like we mentioned earlier, this summary is general in nature. For an insight into how franking credits work in your specific situation, speak to a qualified tax accountant.
What are the benefits of franking credits?
Franking credits bring a number of potential benefits to shareholders, particularly in preventing the sting of double taxation on dividends. Here’s how they make a difference:
1. Double taxation dodged: The standout benefit of franking credits is their ability to stop income from being taxed twice. This system keeps your dividends from being nibbled away by additional taxes.
2. Boost your tax savings: Franking credits can potentially lead to substantial tax reductions. If your personal tax rate is lower than the corporate tax paid, you might even cheer at a tax refund!
3. Bigger dividends after taxes: With franking credits, the dividends that land in your pocket are effectively bulked up, as these credits help offset any personal tax dues. This can make shares of companies that issue franked dividends potentially attractive.
4. Invest locally, gain more: These credits encourage investors to focus on homegrown companies rather than looking abroad, where similar tax perks might not exist. This helps pump up the Aussie economy.
5. Fairness and clarity: Franking credits foster a transparent tax environment that aligns company interests with those of shareholders, ensuring everyone gets a fair slice of the pie based on the dividends they receive.
6. A financial boost for retirees: Many retirees, lower-income investors and SMSF holders benefit greatly from franking credits, often receiving cash refunds that provide a significant boost to their income.
Why do franking credits only apply to Australian shares?
Franking credits are uniquely tied to Australian shares due to the innovative design of Australia's tax system, which aims to preventing double taxation on dividends.
This system, known as the dividend imputation system, was introduced in 1987 and serves a pivotal role in tax fairness. It allows companies to pass on credits for the taxes they've paid on profits directly to their shareholders.
This approach is relatively unique to Australia, with only a few other countries adopting similar systems.
How are franking credits calculated?
Here’s how you can work out the value of your franking credits.
- Start with the corporate tax rate – 30% for large companies and 25% for small to medium ones. In this instance, we’ll use the rate of 30%.
- To determine the full dividend before taxes, divide the dividend you received by (1 minus the corporate tax rate). So, if you pocket $70 in dividends, the gross calculation at a 30% tax rate boosts it to $100.
- The franking credit is simply the difference between this grossed-up amount and the actual dividend you received. In our example, that’s $30.
Or, you can take a shortcut and use our handy Franking Credits Calculator !
What else do I need to know about franking credits?
While franking credits obviously have their advantages, they’re not without their limitations.
Franking credits are designed to prevent the double taxation of dividends, providing significant tax relief. However, they can introduce complexity to your tax filings.
While these credits are a boon for those in lower tax brackets, potentially slashing their tax liabilities, they can be less beneficial, or even problematic, for some. Specifically, non-resident shareholders or individuals in higher tax brackets may find that the credits don't fully cover their tax obligations.
Plus, eligibility for franking credits requires not just owning shares in a dividend-paying company that uses the franking system, but also meeting specific conditions.
For instance, there's a holding period of at least 45 days around the dividend period – excluding the purchase and sale dates – to qualify for the franking credit tax offset. (Unless your franking credit entitlement is less than $5,000.) This rule aims to prevent investors from simply buying shares before a dividend is declared and selling them shortly afterwards, a practice known as dividend stripping.
Additionally, you need to be a resident for tax purposes to maximise the benefits of franking credits, as non-residents may face different tax treatments that could dilute the advantages.
Because franking credits can be fairly complex, reaching out to a tax accountant can help you navigate some of the intricacies of your tax situation. You can also visit the Australian Taxation Office website's franking credits Q&A for more information on how to claim franking credits, receiving franking credits and dealing with unused franking credits.
A franking credits case study
This (entirely made-up) case study gives you an idea about the potential benefits of franking credits.
Meet Sarah, a retired teacher and seasoned investor, whose investment strategy boosts her retirement income. Among her diverse portfolio, she holds 5,000 shares in a leading Australian telecommunications company, which recently declared a $1.00 per share dividend, fully franked at the corporate tax rate of 30%.
When dividend day rolls around, Sarah receives $5,000. But there's a bonus. Thanks to franking credits, she also gets an additional $2,143. These credits are calculated based on the taxes the company has already paid (30% of the dividend amount). Now, Sarah's total income from this dividend becomes $7,143.
Given her modest tax rate of 19% due to her retirement status, her potential tax liability on these dividends would normally be $1,357. However, the franking credits cover this entirely, and she even gets a refund for the excess credits.
NOTE: this example is purely illustrative and doesn’t necessarily reflect a real-world outcome. This scenario would also be very different if Sarah was in a higher tax bracket.
The final word about franking credits
Franking credits can be incredibly advantageous if you’re receiving dividends from your share investments. But, as we’ve learned, they’re not without their complexities – particularly where taxes are concerned.
Chatting to a tax accountant or licensed financial adviser can help you understand your tax position in relation to franking credits, and simply just help you get a handle on your situation.
Happy investing!
