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Franking and the bountiful story of tax credits

Franking credits are generated when a company pays tax. They are a tax credit that can be passed on to shareholders to help avoid company profits being taxed twice – firstly, when the company pays tax on profits and secondly, when shareholders add the dividend income to their taxable income.

They can cause immense confusion – as the calculations are not straightforward – and the system is unique in global markets and considered a bit of a quirk.

The most important thing to know from the perspective of a shareholder is that they work like a pre-paid tax. When you hold shares in companies that issue franked dividends, you’ll receive a credit at tax time for the franked income you have received.

This credit will either reduce the amount of tax you pay, or – depending on your situation – can even mean you’ll receive a refund cheque in the mail from the ATO.

It’s worth mentioning that foreign investors receive no benefit from franking credits – they expire worthlessly – because the benefits are only for those of us who interact with the ATO.

 

Why do they exist?

Franking credits exist so that company profits are not taxed twice. Essentially, when an Australian company announces its profits, it will (in theory) hand over 30% of this profit in tax and distribute the remaining 70% among its shareholders as dividends.

When you receive this dividend, you include it to your tax return, adding the full dollar value of the dividends plus the franking credit you received to your assessable income.

If franking credits didn’t exist and we stopped the calculations here, you can see that the company’s profit would be taxed twice. Firstly, when the company declares it, and then when you pay tax on your dividends.

The calculations can become confusing because of the way the franking credits are included in the calculation. At the first instance, the tax-payer must declare the value of the dividend plus the value of the franking credit to the investor or fund’s taxable income. Later in the calculations, the franking credit amount is subtracted in full, from the tax payable by that individual or fund. This is more easily understood with examples, which we’ve set out below.

 

Franking credits for investors and funds on different tax rates

Let’s imagine ACE Ltd, announces $10million profit, hands over $3million in tax and then distributes the remaining $7million to its 100 shareholders.

We’ll look at what happens at tax time for three ACE shareholders or superannuation funds that each receive $70,000 from ACE in fully franked dividends, with a franking credit worth $30,000 each (because that’s how much ACE has already paid to the ATO).

John Smith – his only income this year is from his share investments.

 

Dividends received $70,000
Franking credits $30,000
Taxable income $100,000
Tax payable ($26,117)*
Franking credits $30,000
Net Tax Payable (Refund) ($3,883)**

* Based on the marginal tax rates for 2018/19

** Calculated as Tax payable minus franking credits: $26,117 – $30,000

 

SMSF Clarke Superannuation Fund – this fund has two members and is 100% in pension phase and neither member receives the aged pension. Each member has a balance of $750,000, giving the fund a total balance of $1.5million.

 

Dividends received $70,000
Franking credits $30,000
Taxable income $100,000
Tax payable ($0)*
Franking credits $30,000
Net Tax Payable (Refund) ($30,000)**

* All income is exempt current pension income

** Calculated as Tax payable minus franking credits: $0 – $30,000

 

SMSF Russo Superannuation Fund – this fund also has two members with $750,000 each, totalling $1.5million, however this fund is in accumulation mode (taxed at 15%) as both members are still workings.

 

Dividends received $70,000
Franking credits $30,000
Taxable income $100,000
Tax payable ($15,000)*
Franking credits $30,000
Net Tax Payable (Refund) ($15,000)**

* Based on 15% taxation for accumulation mode on superannuation fund

** Calculated as Tax payable minus franking credits: $15,000 – $30,000

You can see in all three examples, for the investor and two funds, they will receive a net refund on their tax paid because of their franking credits bonus.

*The ability to receive surplus franking credits as a refund may change under the proposed ALP policy. That’s a whole other complication and we’ll save that analysis for another day.

 

Why are some dividends partially franked or unfranked?

A conversation about franking wouldn’t be complete without explaining why some dividends are partially franked, and some have no credits at all, known as unfranked.

The primary reason is because the company earns a large portion of its income overseas, so is therefore not paying much or any tax in Australia it will not generate as many (or any) franking credits. Examples of Australian companies with a large portion of overseas income include QBE, which has only 30% franked dividends, and MQG with 45.5% franked.

Another key reason for partially franked or unfranked dividends is for a company that pays minimal or no tax because of a unique corporate structure. For example, Sydney Airport is unfranked as its unique structure means it pays no tax at a company level and is a stapled security (which means shareholders receive income as ‘interest’ on debt, rather than a dividend).

 

What does this mean for me?

Franking credits are an important factor to consider as you build your share portfolio and they can reap significant rewards for a savvy investor. As you can see for the examples above, the benefits will vary depending on your unique financial position, and will also be different if you hold your shares directly or through a trust or a self-managed superannuation fund. For this reason, we recommend you speak with your adviser directly to assess your financial position and receive frank advice (if you’ll pardon our pun) on the best strategy for you.

This information is a statement of personal opinion only and is not intended to constitute general or personal advice to any person or entity.

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