What are franking credits?
You probably know about dividends, but what are franking credits?
Investors receive franking credits in addition to the raw dividend amount paid by a company they’re invested in. Not all companies pay franked dividends, and we’ll explain why later on.
The franking credits represent the tax a company has already paid on its profits in Australia. Dividends are typically funded from profits, so the dollars paid to investors have already been taxed.
At tax time, investors declare these credits along with the dividend payment to prevent the income being taxed twice. This creates a level playing field for dividends with other types of investment income, like interest earnings paid on term deposits, which are only taxed once.
Why do we have franking credits in Australia?
Franking credits were introduced to solve the sticky problem of investors being taxed twice on dividends. This happens because companies pay tax on any profit they earn before paying dividends to investors. Investors need to declare this dividend as income, which then gets taxed again at the investor’s personal tax rate. This is known as double taxation.
Understandably, most shareholders don't like the idea of being taxed twice on the same income. It is also a big deterrent to companies paying out profits as dividends.
In his 2012 letter to shareholders, legendary investor Warren Buffett explained that double taxation was a big reason he elected not to pay dividends as chair of Berkshire Hathaway (NYSE: BRK.A, NYSE: BRK.B). Instead, Berkshire Hathaway returns cash to shareholders by buying back shares. This reduces the total number of shares outstanding and increases the value of each remaining share.
What are the tax benefits of franking credits?
When you receive a fully-franked dividend, you get a credit for the 30% tax the company has already paid on the dividend. This credit can reduce the amount you have to pay on your dividend income by bringing it in line with your personal tax rate. If your personal tax rate is less than 30%, you can claim back some of the tax as a refund.
For example, let's say a company earns a profit before tax of $1 per share. The company will pay 30 cents per share in tax to the government and send investors a cash dividend of 70 cents per share, plus a credit for the 30 cents of tax that has been paid to the government.
An investor needs to declare the combined $1 of income on their tax statement. If their marginal tax rate is less than 30%, for example 19%, they will be eligible for a rebate of the difference.
For the investor then, it is as if the dividend has been paid out of pre-tax profit and is then taxed at their marginal tax rate.
Why are franking credits popular with retirees?
After years of working, saving, and investing, retirees often have a nice nest egg of assets to their name. However, without full-time work, their taxable income in any given year can be relatively low. This is where owning a portfolio of income-generating, fully-franked dividends can be a big bonus.
We explained earlier how fully-franked dividends can provide a useful tax rebate if your marginal tax rate is below the 30% corporate tax rate. But for self-funded retirees with a low level of overall income (below $18,200), franking credits can be paid to them as tax refunds.
That's because the marginal tax rate on income below $18,200 per annum is 0%, meaning there is no income tax to pay. So, under the current system, all those franking credits can be refunded right back to the recipient in cash.
What is the difference between fully-franked and partially franked dividends?
A fully-franked dividend means the company's entire profit, from which dividends are paid, has been subject to corporate tax in Australia, so each dividend can include the maximum franking credit available.
Sometimes though, you'll notice that a dividend comes only partly-franked, or even unfranked. This happens when a company hasn't paid tax on the full amount being distributed to shareholders. A partially-franked dividend might be '50% franked', for example, which means the company has paid tax on 50% of the profit being distributed as dividends. Fully-franked dividends offer the highest 'grossed-up' value to investors.
How do you calculate a grossed up fully-franked dividend yield?
To work out the grossed-up yield of a fully-franked dividend, simply divide the dividend yield by 70 and multiply by 100. For example, a company paying a 4% dividend is the equivalent of a 5.7% grossed-up dividend (including franking credits).
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