If you’ve ever invested in shares that pay dividends in Australia, you may have come across the term franking credits. For many investors, these credits provide a significant tax advantage and can help boost returns on investment. However, the concept of franking credits can be confusing, especially for those new to the world of dividends and taxes. In this blog post, we’ll break down what franking credits are, how they work, and how they can benefit you as an Australian investor.
What Are Franking Credits?
Franking credits, also known as imputation credits, are a tax credit that investors receive on dividends paid by Australian companies. These credits are designed to prevent the double taxation of company profits. Without franking credits, profits would be taxed twice—once at the company level when the company pays corporate tax and again at the shareholder level when dividends are paid out.
In simple terms, franking credits are a way of passing on the tax that a company has already paid on its profits to its shareholders. When a company pays dividends to its shareholders, it can attach a franking credit that represents the tax the company has already paid on those profits.
How Do Franking Credits Work?
Here’s how franking credits operate:
- Company Profits and Tax: When a company earns a profit, it pays corporate tax on that profit at the company tax rate, which is currently 30% (or 25% for base rate entities, which are companies with lower turnover).
- Dividends to Shareholders: After paying tax, the company can distribute the remaining profits to shareholders in the form of dividends. If the company has already paid tax on those profits, it can issue franked dividends, which come with franking credits attached.
- Shareholder Tax: When shareholders receive dividends, they must report them as part of their taxable income. However, the franking credit can be used to offset the shareholder’s own tax liability, as it represents the tax already paid by the company.
- Tax Offset or Refund: Depending on the shareholder’s tax situation, the franking credit can either reduce their tax bill or result in a tax refund. If the shareholder’s tax rate is lower than the corporate tax rate, they may be entitled to a refund of the difference between the two tax rates.
Example of How Franking Credits Work
Let’s take a look at an example to illustrate how franking credits benefit investors:
- Company A makes a profit of $100.
- The company pays 30% corporate tax on that profit, which equals $30, leaving $70 of post-tax profit.
- The company distributes the $70 as a fully franked dividend to its shareholders.
- The dividend comes with a franking credit of $30, representing the tax already paid by the company.
As a shareholder, you would declare the full $100 (the $70 dividend plus the $30 franking credit) as part of your taxable income. However, you can use the $30 franking credit to offset your personal tax liability.
- If your personal tax rate is 30%: You owe $30 in tax on the $100 income. The franking credit exactly offsets this amount, so you have no additional tax to pay.
- If your personal tax rate is 16%: You owe $16 in tax on the $100 income. Since the franking credit is $30, you’ve effectively overpaid $14 in tax, and you’ll receive a refund of $14.
- If your personal tax rate is 45%: You owe $45 in tax on the $100 income. After applying the $30 franking credit, you still need to pay an additional $15 in tax.
Types of Dividends: Fully Franked, Partially Franked, and Unfranked
Companies can pay dividends in different forms, and the level of franking affects how much tax credit is passed on to shareholders:
- Fully Franked Dividends: These dividends come with the maximum franking credit (based on the full 30% corporate tax rate), meaning the company has already paid tax on the entire dividend amount. Shareholders receive the full benefit of franking credits.
- Partially Franked Dividends: These dividends have been partially taxed by the company, so shareholders receive some franking credit, but not the full 30% benefit.
- Unfranked Dividends: These dividends are paid from profits on which the company hasn’t paid tax. As a result, no franking credit is attached, and the shareholder must pay tax on the entire dividend amount.
The Benefits of Franking Credits
Franking credits provide several benefits to Australian investors, particularly when it comes to managing tax liabilities:
- Tax Efficiency: Franking credits ensure that company profits are only taxed once, at either the corporate level or the individual level. This prevents the double taxation of income and ensures fairer taxation for shareholders.
- Tax Refunds for Low-Income Earners: If a shareholder’s income is below the tax-free threshold (currently $18,200 in Australia), or if their tax rate is lower than the company tax rate, they may receive a refund of the franking credit, providing a direct financial benefit.
- Ideal for Superannuation Funds: Superannuation funds in the pension phase pay no tax on earnings, which means they can fully benefit from franking credits and often receive refunds. This makes Australian shares with franked dividends an attractive option for superannuation portfolios.
Conclusion
Franking credits are an essential part of the Australian tax system, allowing investors to benefit from the tax already paid by companies on their profits. For many investors, franking credits can boost returns and improve the tax efficiency of their investments, particularly for those in lower tax brackets or those investing through superannuation funds.
If you’re looking to maximise the benefits of franking credits and enhance your investment strategy, speak with a Financial Advisor today.
