Franking credits represent a credit system that prevents the double taxation of company dividends. They are also called imputation credits in Australia.
Preventing Double Taxation
A company pays tax on the profit it makes annually, at the company tax rate of 30%. After the tax, the company may choose to pay dividends to its shareholders. When a dividend is paid, it represents a form of income for the shareholder. Thus, the dividend can also be taxed under income tax. Franking credits prevent a double taxation of the dividend. This is done by attaching a franking credit to the dividend.
The franking credit is a credit that is equivalent to the tax paid by the company on the dividend. A dividend with an attached franking credit is a ‘fully franked dividend’. When a shareholder files an income tax that includes a franked dividend, the Australian Tax Office (ATO) refunds the excess tax that has been paid on the dividend. The tax refund is equal to the franking credit minus the income tax on the fully franked dividend. Australia is one of the only few countries that calculates franking credits in this way, but it is the only country in the world that also refunds unused franking credits.
Example – Franking Credits
Person A is a shareholder in Company XYZ. Company XYZ pays Person A a dividend of $70.
The $70 dividend is fully franked because the company attached a franking credit of $30 to it. The $30 is the amount of tax that Company XYZ has already paid on the dividend in the form of company tax.
Person A’s taxable income is the fully franked dividend of $70 plus the attached franking credit of $30, which equals $100. If Person A’s income tax rate is 15%, then the tax he would pay on his taxable income is $15 (15% of 100). However, under the franking credit system, ATO notes that $30 has already been paid as tax on the dividend. ATO will then offer a tax refund to Person A for the overpaid tax. Here, $30 has been paid as tax instead of the $15 that Person A would have paid. So, ATO will offer Person A a tax refund of $15 ($30 – $15). You can find out how to apply lodge a tax return for franked dividends on ATO’s website.
However, if Person A’s income tax rate was greater than the company tax rate, then he would not receive a refund from the ATO. Person A would pay the difference between the income tax and the tax already paid by the company. If Person A’s marginal income tax rate was 45%, the taxed amount is $45. Since the company has already paid $30 in tax, Person A only has to pay $15.
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No Income Tax
An individual is not liable to pay any income tax, for example, if the individual is retired and relies on his super to offer him an income, or if the individual earns an income lower than the tax threshold. In this situation, ATO will refund the individual the whole amount of the franking credits.
For example, if Person A had no marginal income tax rate because he was over 65 and retired, ATO would refund the whole $30 (being the franking credit attached to the $70 dividend) to Person A. As a result, instead of paying any tax, Person A receives money from ATO.
Franked Dividends
Not all dividends are franked dividends. Sometimes a public company chooses not to pay franked dividends. Other times, a company might not be able to give a franked credit because the company’s profit may not be taxed due to some tax exemptions. Largely, franking credits are attached to dividends by self-managed super funds for retirees who do not pay income tax. There may also be requirements that need to be met before franking credits are paid. For example, ATO requires that the shares are held ‘at risk’ for at least 45 days before franking credits can be attached to a dividend. However this rule might not apply where a shareholders franking credits are below $5000.
