An introduction to franking credits
You probably know about dividends, but what are franking credits?
In a nutshell, a franking credit (also known as an imputation credit) represents the tax a business has already paid on its profits in Australia. Dividends are typically funded from profits, so the dollars paid to investors have already been taxed.
Investors can receive franking credits in addition to the raw dividend amount paid by a company they're invested in.
At tax time, investors declare the tax credits and dividend payments on their individual tax return to prevent the income from 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.
Not all companies pay franked dividends, and later we'll explain why.
Why do we have franking credits in Australia?
Franking credits were introduced to solve the sticky problem of ASX investors being taxed twice on dividends. This happens because businesses pay company tax on profits before paying dividends to their shareholders.
Investors need to declare a dividend as income in their tax return, which then gets taxed again at the investor's personal tax rate. This is known as double taxation.
Understandably, most shareholders don't like being taxed twice on the same income. It is also a significant deterrent to companies paying out profits as dividends. A franking credit is a type of tax credit that allows the tax paid by the company to count towards tax payable by the individual.
In his 2012 letter to shareholders1, legendary investor Warren Buffett explained that double taxation was a big reason he elected not to pay dividends as chair of Berkshire Hathaway Inc. Instead, Berkshire Hathaway returns cash to shareholders through share buybacks. This reduces the total number of outstanding shares and increases the value of each remaining share.
What are the tax benefits?
When you receive a fully franked dividend, you get a credit for the 30% company tax already paid. This credit can reduce the tax you have to pay on your dividend income by bringing it in line with your personal tax rate. You can claim a tax refund if your personal tax rate is less than 30%.
For example, let's say a company earns a profit before tax of $1 per share. The company tax rate is 30 cents, so it 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 paid to the government.
An investor needs to declare the combined $1 of income on their individual tax return. The franking credit acts as a tax offset against tax that would otherwise be payable on that income by the investor.
If the investor's marginal tax rate is less than 30% — for example, 19% — they will be eligible for a rebate of the difference. If their marginal tax rate is higher than the company tax rate — for example, 37% — they will need to pay tax on the difference.
For the investor, it is as if the dividend has been paid out of pre-tax profits and is then taxed at their marginal tax rate.
Why are franking credits popular with retirees?
After years of working, saving, and investing, retirees in their pension phase often have a nice nest egg of assets to their names. However, their taxable income in any given year can be relatively low without full-time work. This is where a retirement portfolio of income-generating, fully franked dividends can be a big bonus.
We explained earlier how fully franked dividends could provide a helpful tax rebate if your marginal tax rate is below the 30% corporate tax rate. But for self-funded retirees with a low overall income (below $18,200), franking credits can be paid to them as cash 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 to the recipient. These credit refunds are in addition to the passive income generated from the underlying dividends.
What's the difference between fully 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 credits available.
Sometimes, 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.
An unfranked dividend is a distribution of profits upon which tax has not been paid. Partially franked dividends might be '50% franked', for example, which means the company has paid tax on 50% of the profit being distributed as dividends.
What do investors look for in franking credits?
Franked distributions are distributions upon which tax has already been paid. They come with refundable franking credits, reducing the tax payable on investors' net income. This is how Australia's dividend imputation policy prevents the double taxation of shareholders.
Investors like shares that pay franked income because of the associated tax benefits. A significant proportion of the return on a share investment can come from dividends. Therefore, it makes sense to be aware of the tax impact of dividend income and associated franking credits.