The word Franking Credits or Franked dividends might sound unfamiliar to you, but it caught many Australian eyes during the 2019 Federal election. Before we dive right into what Franking credits are and how do franking credits work, let’s brush up on some basics.
One of the few business methods to raise capital is by listing shares on the stock market. However, money always comes at a price. When individuals like yourself invest in these shares, the company cuts you a small slice in the ownership pie. Woohoo! You can now officially become a part-owner of Tesla Inc. After investing in those shares, you will be officially recognised as one of the many company’s shareholders. All companies reward their shareholders with a portion of their profit, and this is known as Dividends.
The profit a company makes is taxed, generally a flat 30%, and the left-over profit is shared amongst shareholders as Dividends. However, dividends are categorised under passive income, and you are required to pay tax on the income you make. This basically means that the money you receive from the company you invested in is double taxed, and this is where Franking Credits come into the picture.
Franking Credits and How do they Work?
A dividend paid by an Australian company from their after-tax profits is called a ‘fully franked’, and the tax paid by the company on your dividend is known as ‘Franking Credits.’ For instance, you have received a dividend worth $700, and this is the slice of the net profit after tax.
Assuming the corporate tax rate to be flat 30%, the tax for the dividend you just received is $300. This will be already paid by the company on the $1,000 in corporate profit derived.
Along with the $700 in cash, you also receive a notice that labels the $300 as ‘Franked Credits.’ The sum of the dividend and Franking Credit is known as the ‘Gross Dividend,’ which is worth $1000.
Continuing with the numbers from above, you are now required to pay tax on the gross dividend. Now, let’s assume that the tax rate for personal income is 19%, and this means that you have to pay $190 for the dividend you just received. This will result in $490 being paid as tax for the dividend you received in a traditional taxation system. This results from double taxation and the ‘Franking Credits’ or “imputation” system that exists solely to prevent this specific scenario.
The ‘Franking Credits’ in your gross dividend will act as a tax credit. The practice of using Franking Credits as tax credits is known as “claiming Franking Offsets.”
Assuming the company tax rate to be 30%, the dividend you received will be tax-free if the tax rate for your personal income is also 30%, as you can simply offset the income tax on your dividend using the tax credit from the Franking Credits.
Moreover, if your personal tax rate is 46%, you are only required to pay 16% “top up tax” on the dividend, as the remaining 30% is already paid in the form of the tax credit. This system was established in 1987.
If we continue with the earlier example, the income tax to be paid for the $700 dividend is $190, and now you can deduct this using the Franked Credits, which is $300, and you will still be left with $110 of excess credits. This extra credit can then be used to offset tax on other tax levied on taxable income, or the excess credits can be filed for refund with the ATO if there is no additional tax to be paid on the taxable income. Hence, with this system, the issue of double taxation is resolved.
Another Example for Dividend and Franking Credits
The Australian Tax Office decides the income tax rate for every individual based on their income. Australian residents with income less than $18,200, or students, or low-income retirees are exempt from income tax. Franking Credits will be beneficial for these individuals, as they can file for a 100% refund of the Franking Credit as they have no tax to offset, resulting in the government receiving no tax from the company or the individual.
Unfranked Dividends and Partly Franked Dividends
Unfranked Dividends are basically dividends with no tax credit attached to them, which arises when the company makes profits. There is no tax levied on it and therefore no credits in its franking account to impute on a distribution. Now, how can a company make a profit with no tax being imposed on it? This type of profit is gained from the sale of assets with no tax levied on them or overseas earnings as the company does not pay tax in Australia. Hence, the dividends being distributed without any tax credits attached.
When a company declares 30% company tax on a ‘part’ of the dividend, this is categorised as a partly franked dividend. For instance, the company declares 30% tax on only 75% of the dividend, but not 25% of the dividend. In this case, you will receive more dividends with a lesser tax credit compared to a fully franked dividend.
These three types of dividends might get your head spinning, and you might wonder which one of the three will be beneficial to you. In the end, the tax paid and the amount that ends in your pocket will be the same. However, it will affect your investment strategy.
Franking Credit Formula
Franking credits are calculated using the formula:
45 Day Rule
In order to be eligible for franking credits, you are required to hold the shares “at risk” for 45 days, and this excludes the purchase and sale date (effectively 47 days). The shares are to be:
- Purchased before the ex-dividend date.
- In your possession in the ex-dividend date.
In the end, the world of Franking Credits might sound complicated but is easy to comprehend and more beneficial for you as more money will be available to you for future investments. The Franking Credits system successfully eliminates double taxation and has the potential to be followed in other countries in the following years.