It is not a huge surprise that a lot of shareholders in Australia absolutely love franking credits. Why? Because they can make dividends an extremely tax-friendly source of income. However, a lot of people are unaware of what franking credits are and how they work.
So, in this guide, you will get to know everything needed about franking credits.
What are franking credits?
A franking credit or imputation credit stands for the tax a business or a company has already paid on the profits. Shareholders of the company may use franking credits to offset tax. The purpose of this is to prevent your income from being taxed two times.
Dividends are the portion of the profit of the company that is paid to reward the shareholders. Because the dividend income is still an income, so just like your wages or salary, you should pay tax on it, right?
But the dividends are usually funded from profits, and the company has already paid tax on these profits. So, the money paid to the investors has already been taxed.
This is where franking credits come in for your rescue and prevent the government from taxing the same income twice.
Need of franking credits
The need for franking credits arose because, previously, the investors were being taxed twice on the dividends. Declaring a dividend as an income in the tax return resulted in it getting taxed at both a company tax rate and a personal tax rate.
Getting taxed twice on the same income twice isn’t desired at all, which led to the need for franking credits. A franking credit is a kind of tax credit that lets the tax paid by the business be counted towards the tax payable by the investors or shareholders.
How do franking credits work?
Since franking credits work in favour of a shareholder, here’s what you need to know about how franking credits work:
- Franked dividends are paid from the profits the company has already paid tax on.
- Franking credits work as a tax credit with which the shareholders can offset the tax to be paid on their dividend income.
- In case your marginal tax rate is below the 30% company tax rate, you should be entitled to a tax refund because of franking credits.
Franking credits – preventing double taxation
For those familiar with the world of trading, franked dividends is not a new term. A frank dividend carries a franking credit, otherwise known as imputation credit, which is a small-scale tax offset (which is why it is named a ‘credit’).
The tax paid by an Australian company is distributed to the shareholders through the franking credits attached to the dividends issued to them, as per the Australian Taxation Office. As a result, franking credits prevent double taxation.
Double taxation is when the same income or an asset is taxed twice, hence the name. Usually, this happens when personal and corporate profits intersect, just like in the case of dividends.
Through the dividend imputation and franking credits system, the ATO gets to know that corporate tax has been paid on the profits made by the company, which are further distributed as dividends.
Surprisingly, when a person or self-managed super fund has franking credits worth more than the amount of tax owed, they could receive a tax refund to get the excess back.
Top benefits of franking credits
There’s no doubt that franking credits are really beneficial, so here are those benefits discussed thoroughly.
Cash refunds
What else could be better than being eligible for cash refunds from the government?
If your tax liability is less than franking credits or the franking credits exceed the tax liability, the government may provide you with a cash refund. In simpler terms, it means that you may receive money back, providing additional income from dividends.
This benefit is the reason why the shareholders, especially the ones in the lower tax brackets or in retirement, are attracted by the concept of franking credits.
Lower taxes
Franking credits are a tax offset, so naturally, they reduce the amount of income tax one has to pay.
As a result, you may receive an overall tax bill or an increased refund. So, you, as a taxpayer, get to keep more of your income, which is another reason for their popularity.
Increased returns on your investments
Having shares in Australian companies that give dividends with framing credits may boost your investment returns. Since the tax is already paid, you will get a higher after-tax dividend.
Importance for retirees
Franking credits are extremely popular with retirees, and here’s the reason behind it. After years of continuously working, investing and saving, a lot of retirees have a good number of assets to their name in their pension phase.
With the lack of full-time work, the taxable income of those retirees can be comparatively low. So at such times, a retirement portfolio of all the income-generating fully franked dividends may help a lot.
Franking dividends could help you get a tax rebate given that your marginal tax rate does not exceed 30% corporate tax rate. For self-funded retirees, on the other hand, who have a low overall income, i.e., less than $18,200, franking credits could be paid as cash refunds to them.
The reason behind this is that the marginal tax rate is 0% for an income below $18,200 per annum. Thus, no income tax has to be paid. Under the current system, the franking credits could be refunded to the recipient.
The credit refunds received are paired with the passive income from the underlying dividends.
Fully and partially franked dividends – what’s the difference?
Now, you also need to know that there are fully Franked dividends and partially-franked dividends. The difference between the two is based on the amount of franking credits attached to that dividend.
Fully franked dividends
If the company attaches franking credits equal to the complete amount of tax paid on the profits, such a dividend is what we call a fully franked dividend.
In simpler words, in this case, the company has paid the entire tax amount, and the franking credits attached represent their tax payment. Shareholders usually get to claim the complete franking credit to offset the personal tax liability.
Partially franked dividends
Partially franked dividends stand for when the attached franking credits by the company represent just a portion of the paid tax on the profits. In other words, it means that the company hasn’t paid taxes on the whole amount of profits allocated as dividends.
In such a case, the shareholders can still use the attached franking credits, but they might not be able to cover the whole tax amount they owe.
Unfranked dividends
Besides fully and partially franked dividends, there’s another type as well, namely, unfranked dividends. As the name suggests, the company hasn’t paid any tax on the profits it received, from which it distributes the dividends. Or, the company hasn’t elected to attach franking credits to the dividends.
In both cases, the shareholder will receive unfranked dividends, and when the dividend amount is added to the individual tax returns of the shareholders, there will be no tax offset to help them reduce their tax liability.
Am I eligible for franking credits?
For the eligibility criteria of claiming franking credits, certain rules and limitations may be applicable as per the individual’s circumstances, any changes in the tax laws and some other factors.
The eligibility depends mainly on three criteria, which are explained further.
Be an Australian resident for tax purposes
You have to be an Australian resident for tax purposes. Usually, the non-residents have limited to no access to franking credits, depending on certain tax treaties and specific rules applicable to their situation.
Be a Shareholder
This one is a no-brainer: you have to be a shareholder in an Australian company, and the company must pay dividends with attached franking credits.
In simpler terms, it means that you are entitled to receive dividends as you own shares in the company.
Satisfy the holding period
To be eligible to claim franking credits, one must hold the shares “at risk” for a specific period, which is generally called the holding period.
This period requires the person to hold their shares for a minimum of 45 days, excluding the purchase and sale date.
The reason behind this rule is the prevention of “dividend washing” and artificial transaction done only to claim the franking credits.
How are franking credits calculated?
The calculation of franking credits is not simple.
The company has to pay taxes on the profit it receives at the corporate tax rate. Then, the company determines the taxable profits by taking into account its expenses, revenue, deduction and a couple of other factors.
Now the taxable profits are multiplied by the corporate tax rate, which will result in an amount that it needs to pay the government. The amount paid to the government as tax is what becomes the franking credit once the company allocates dividends to the shareholders.
When can I claim franking credits?
You can claim franking credits at the end of a financial year by including dividends with attached franking credits in the income tax return (personal). To be extra sure of the eligibility and other conditions, it is always better to speak to a tax agent first.
The concept of franking credits is not too old, considering it was instituted in 1987. It is extremely beneficial for investors who are in lower tax brackets and who decide to invest in dividend-paying companies.
So if you wish to avail such benefits and are looking for some expert guidance, contact Clear Tax Accountants. At Clear Tax, we can help you analyse your situations much better and provide specifically tailored accounting and taxation advice to you.
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