Franking Credits – An IOU From The Tax Office

Written and accurate as at: 10 June 2014

One of the benefits of being a shareholder of Australian shares is that many Australian companies reward their shareholders by paying out a dividend. Dividends are essentially a portion of the profit that the company has made during the year, paid to their investors.   

Often attached to these dividends are franking credits. Put very simply, franking credits form part of the income an investor receives, which isn’t received in cash, but as a kind of IOU from the tax office.

Franking credits are tax credits, which represents the amount of tax that the company has already paid on the profit. These tax credits, can be used by the shareholder to reduce their taxable income, or receive as a refund from the Australian Taxation Office (ATO).

To make things a little complicated, franking credits are also called imputation credits. Australia’s imputation system was introduced in 1987. Prior to this, when a company made a profit and distributed it to shareholders the amount was essentially double-taxed with both the company paying tax at the company rate of 30%, and the investor paying tax at their marginal tax rate on the same profit.

To rectify this the imputation system was introduced and works as follows:

  • A company makes a profit. Let’s use an example of $100 profit.
  • The company has to pay tax on their profit at the company tax rate of 30%. So on $100 profit, tax would be $30. The $30 is paid to the ATO and the company makes a record of this payment in their franking account.
  • The company then pays the net (after-tax) dividend to investors of $70 either in the same year or later. When the company pays the dividend it may attach a franking credit from its franking account, in proportion to the tax rate. So each $70 of dividend may have $30 of franking credit attached. This type of dividend is referred to as a Franked Dividend.
  • The shareholder receiving a Franked Dividend declares the income amount of $70 plus the franking credit of $30, and depending on their marginal tax rate can either use the franking credit to reduce their final tax bill or receive the franking credits back in cash, at the end of the financial year.

It’s worthwhile noting that franking credits are designed to benefit long-term investors, not short-term traders: as a 45 day holding rule states that a shareholder must have owned the shares for at least 45 days, in order to be eligible for franking credits over $5,000.

The example we’ve used above outlines the treatment of Fully Franked Dividends, but dividends can also be unfranked or partially franked. A company can still pay a dividend to shareholders even if there is no balance in the franking account (perhaps because it has been making tax losses). In this instance the cash dividend is just paid without any franking credit attached and this is referred to as an Unfranked Dividend.

If the company only has a small balance in the franked account, they can choose to pay a portion of the dividend as a Franked Dividend and a portion as an Unfranked Dividend. When this occurs, the company is said to have issued a partially franked dividend.

The portion of dividend which is unfranked will be treated as ordinary income and taxable at the shareholder’s marginal tax rate (i.e. no tax credit is attached).

Investing in shares that pay a fully franked dividend can sometimes be an attractive tax effective investment strategy particularly for those investors on a lower marginal tax rate, who are in the pension-phase of superannuation or who have their own Self Managed Super Fund.

However, it pays to seek professional advice as it’s never advisable to purchase an investment for tax benefits alone, and the fundamentals of the company and appropriateness in relation to your overall investment strategy should always be taken into consideration. We discuss more about shares in our Investments module.