What are franking credits and why do they matter?
What are franking credits and why do they matter? We reveal their function and special features.
From the boomerang to the bionic ear implant, and the wine cask to wi-fi, Australians are an inventive breed.
This includes in the field of finance and investment, where polymer bank notes, negative gearing and the superannuation guarantee are Australian innovations. So too is the franking credit.
What are franking credits?
Franking credits are tax offsets distributed to shareholders with their dividends. They represent the tax a company has already paid on its profit, from which dividends are typically drawn.
Dividends that carry franking credits are franked dividends. Something 'franked' is pre-paid. In this case, tax.
Franking credits generally equate to the main corporate tax rate in Australia of 30%. If a shareholder receives a 'grossed-up' dividend of $1 from an Australian company that allocates franking credits, 70 cents will be the cash component and 30 cents (30% of $1) will be the franking credit for pre-paid tax. A grossed-up dividend is the sum of these two components.
What are imputation credits?
Franking credits are also known as dividend imputation credits because the tax paid by a company is 'imputed' or attributed to the shareholder by way of the credit.
Only Australian shareholders can use them.
When and why were franking credits introduced?
The franking credit or imputation system was introduced in Australia in 1987 to prevent the double taxing of company profits. Before then, profits were taxed first at the company level and then as dividend income when distributed to shareholders.
Franking credits have been refundable since 2000. If an eligible shareholder's tax liability is reduced to zero, any excess or unused franking credits can be refunded to the shareholder rather than lost.
What are the benefits of franking credits?
By eliminating the double taxing of company profits, franking credits allow a shareholder to reduce or offset their own tax liability. The shareholder pays the difference between the corporate tax rate (generally 30%) and their own marginal rate (somewhere between 0% and 45%, not including the Medicare levy).
This highlights the tax effectiveness of franking credits - you pay tax on the dividend at a lower rate than you do for other income.
Their allocation also increases the effective yield of an investment.
And for eligible shareholders, unused franking credits will be refunded to them by the Australian Tax Office. This in particular benefits retirees who may pay no tax and low-income earners whose marginal tax rate is below the corporate level.
The value shareholders place on this benefit was demonstrated at the 2019 Federal election. Labor leader Bill Shorten conceded that his proposal to unwind refundable franking credits "misread the mood" and cost Labor votes.
How prevalent are they around the world?
A variety of arrangements exist around the world to avoid the double taxing of company profits.
The UK, for example, provides shareholders with a tax-free dividend allowance. New Zealand companies can join the Australian imputation system and distribute franking credits for the use of shareholders who are Australian taxpayers.
What should you consider?
Not all Australian companies offer franking credits with their dividends.
Or, in some cases, offer only partly franked dividends.
Consider, for example, two of Australia's largest and most widely held companies. Banking giant Commonwealth Bank consistently pays fully franked dividends, whereas biotech leader CSL does not. This often reflects where a company generates its earnings and pays most of its tax.
While franking credits encourage Australians to invest locally, they can create a home bias and other opportunities, such as international shares, may be overlooked. And some companies might offer superior returns because of their capital growth despite not paying franked dividends.
Be aware too of the eligibility rules for the use of franking credits. One, for example, requires shares to be held for a minimum continuous period, generally 45 days. This aims to prevent rapid, short-term trading simply to obtain the franking credits attached to dividends.
And another thing - the value of franking credits is subject to changes in the corporate tax rate. If corporate tax rates decrease, the size of franking credits attached to dividends could decrease too, reducing the tax offset for the shareholder. That said, lower corporate taxes could mean more profit to distribute as dividends to shareholders. Paying more tax might not be so bad a problem to have.
Frankly, these credits are worth giving a damn. As ever, be informed and understand your own investment needs.
How do franking credits work?
- A company makes a profit of $1000. It pays $300 in tax at the corporate rate of 30% and receives a franking credit to the same value.
- The net profit of $700 is distributed as a dividend along with the $300 franking credit.
- The shareholder receives a grossed-up dividend of $1000 ($700 cash and $300 franking credit), which forms the shareholder's taxable income.
- If the shareholder's income tax rate is 37%, and ignoring any levies or deductions, the tax due is $370 (37% of $1000).
- Applying the $300 franking credit reduces the shareholder's tax liability to $70 ($370 less $300).
- If the shareholder's income tax rate is 16%, the tax due is $160 (16% of $1000).
- Applying the $300 franking credit results in a $140 refund to the shareholder of the unused portion of the franking credit ($300 less $160).
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