Franking Credit

What is Franking Credit?

A franking credit, also known as an imputation credit, is a type of tax credit that allows the company's income tax to flow through to its shareholders. It is a system in place to avoid or eliminate doubling taxing dividends. 

Double taxing is when tax is paid twice on the same income or profit. Thus, when distributing dividends, the company and the shareholders pay tax on that money without any systems. 

This system works by passing along the said credits with dividends and considering shareholders' tax brackets, which depend on their taxable income. Depending on each shareholder's bracket, they receive either a reduction on their income taxes, a tax refund or pay no taxes on the dividend. 

Overall, the net effect reduces the taxes shareholders pay to their respective governments. 

The Hawke–Keating Labor Government first introduced the imputation system in 1987. It was one of the many tax reforms they introduced. Many countries use these credits to reduce double taxation, but it is most prominently used in the Australian tax system. 

It is important to note that not every company pays these credits, and there are certain eligibility requirements for shareholders to receive these credits. 

How does franking credit work?

Dividends are a form of income; thus, shareholders are taxed on the money they make from receiving dividends. 

The shareholders' percentage is taxed on their tax bracket, which relies on a specified income range. Therefore, higher-income individuals are part of higher tax brackets and get taxed more. 

While dividends add to a shareholder's total taxable income, companies are also taxed on the profit they earn. This means that dividends are double-taxed since they are just a company's after-tax profits. 

These credits were introduced to avoid this situation, so tax on the company's profit is paid only once. In addition, shareholders who receive company dividends are now not required to pay extra tax unless their tax rate exceeds the corporate tax rate. 

If an investor's tax rate exceeds the corporate tax rate, they must pay additional tax, equal to the difference between their tax rate and the corporate tax rate. In Australia, where this system is most prominent, the corporate tax rate is 30%. 

Thus, if an investor's tax rate exceeds 30%, they will be paying additional taxes. For instance, if their tax rate is 35%, they would have to pay the difference of 5% (35%-30%). On the other hand, if an investor's marginal rate equals 30%, they will have to pay no extra taxes. 

If their tax rate is less than 30%, they will get refunded the difference between the corporate tax rate and their tax rate. Finally, in the last scenario, if an investor's tax rate is 0%, they will receive all these credits as a refund. 

Essentially, these are tax credits that a company pays for and then gives to shareholders, who can claim them from the tax office. 

Example Of Franking Credit

For instance, if a company makes $200 and is taxed at 30%, the company's after-tax profit is $140 [200 - 200 (30%)]. 

If the company decided to give all its after-tax income as a dividend, shareholders could be taxed on the whole $140. However, with the imputation system, these credits are provided instead. The tax office recognizes the $60 in taxes the company has already paid on the shareholders' behalf. 

Thus, in the example, the shareholders' dividend would be considered $200 with a $60 tax credit held at the tax office. Shareholders can then claim this tax credit to offset the taxes paid on dividends. 

The following table will highlight the possible scenarios that shareholders can encounter in this example. In this case, the FC would be $60 as this is the tax the company has already paid to the tax office.  

The net tax shareholders have to pay can be calculated in one of 2 ways - (1) by finding the difference between the corporate and personal tax rate or (2) by calculating the income tax and subtracting the FC distributed. 

Or

Franked Vs. unfranked Vs. partially franked dividends

Not all companies distribute franking credits. Dividends are fully franked when companies pay all the tax on their profits before distributing dividends. This means that the company has already paid the 30% tax rate on all its earnings.

If a company does not pay the tax before a dividend is distributed, then that dividend is unfranked and carries no tax credit. This means that the shareholder is responsible for paying the full taxable amount on that dividend income. 

A company can also distribute dividends that are partially franked. This means the company has paid some taxes on its earnings but not the full amount. In this case, the tax office does not hold the full credit amount, and shareholders will be required to pay more taxes or receive a smaller refund. 

The following charts highlight the difference between a fully franked, unfranked, and partially franked dividend. For example, let's say that a company has made a profit of $100. 

Unfranked

In this case, the company has paid no taxes on the $100. 

 

Partially Franked  

The company could have paid tax on a percentage of its earnings in a partially franked dividend. For this example, let's say the company paid 30% corporate tax on 70% of its earnings. Thus, the company paid a partially franked dividend, which is franked at 70%. 

 

Fully Franked 

In a fully franked dividend, the company has paid the 30% corporate tax rate on the total amount of earnings.

Holding period rule and eligibility

These credits benefit investors by reducing their taxable payable to the tax office. However, to ensure investors do not wrongfully take advantage of this system, the Australian Tax Office (ATO) has some eligibility requirements before investors can claim their credits.

In cases where the system has been manipulated or used unfairly, the tax offset and refund, if applicable, will be denied.

The main rules the ATO and most countries enforce to be eligible for franking credits are the holding period rule, and the related payments rule. So, for example, in Australia, if you have more than $5000 in FC, both requirements need to be met, but if it's less than $5000, only the related payment rule needs to be met.  

A related payment is when a taxpayer has, will, or is under obligation to pass on the benefits of the franked dividend to someone else. If this rule applies, you can not receive a tax offset for the franking credits if you do not hold the shares at risk for 45 days (90 days for preference shares). 

Similarly, the holding period rule, which applies to franking credits of more than $5000, states that one must hold the shares for 45 days (90 days for preference shares). 

If you do not meet this requirement, you are not entitled to the franking benefits. Furthermore, you have to abide by this rule for the total amount of franking credits, not just limited to $5000.

Calculation Of Franking Credit

Calculating franking credits is simple and involves only two variables - the tax rate on a company's profits and the dividend amount. 

Franking Credit (FC) = [Amount of dividend / (1 - company tax rate)] - amount of dividend 

Let's explore an example of how much an investor can expect in FC depending on the tax rate and dividend amount. 

A shareholder in ABC Inc. receives a $60 dividend from a company that incurs a 20% corporate tax. The shareholder, who is a doctor, falls within the tax bracket that pays 35% in taxes annually.

FC = $601 - 20% - $60

= $600.8 - $60

= $75 - $60 = $15  

Therefore, from this example, this shareholder would receive their $60 dividend with the $15 in franking credits. 

With income taxable at 35%, this shareholder will need to pay additional taxes as they exceed the corporate tax rate. The total dividend income is $75. In this case, the shareholder will pay an extra $11.25 to the tax office.

Net Effect = Tax payable= (Dividend income personal tax rate) - FC

= ($75 X 35%) - $15 

= $26.25 - $15 = $11.25 

Researched and authored by Pooja Patel | LinkedIn

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