To those unfamiliar with the world of investments and shares, franking credits (or imputation credits as they’re also known) was a term that seemed to appear out of nowhere during the lead up to the 2019 Australian federal election. Ultimately proving to be a key political issue at the time, since then, it’s faded back into the investment shadows.
However, with the ASX Australian Investor Study 2020 finding ‘close to 9 million adult Australians holding investments outside their super and primary dwelling’, understanding franking credits and how they can affect your taxable income is essential.
Before we talk about franking credits, it’s good to understand the Australian Tax Imputation system. The Australian Taxation Office (ATO) tells us:
‘When corporate tax entities distribute, to their members, profits on which income tax has already been paid – such as when a company pays a dividend to its shareholders – they have the option of passing on, or 'imputing', credits for the tax.
This is called ‘franking’ the distribution. The franking credits are attached to the distribution and can be used by the recipients as tax offsets.
The imputation system also applies to a non-share dividend paid to a non-share equity interest holder in the same way as it applies to a membership interest.
Although the recipients are taxed on the full amount of the profit represented by the distribution and the attached franking credits, they are allowed a credit for the tax already paid by the corporate tax entity.
This prevents double taxation – that is, the taxation of profits when earned by a corporate tax entity, and again when a recipient receives a distribution.’
What are franking credits?
In other words, a franking credit, or imputation credit, is the tax credit attached to a franked dividend. When the company pays a dividend to a shareholder, the franking credit is attached to the payment. When the shareholder lodges their tax return, while they’re taxed on the full amount, the franking credits are applied. This in turn, reduces their actual tax payable amount.
If the shareholder is an individual with other income, when they lodge their tax return, the franking credit is applied to their taxable income. If the shareholder doesn’t earn enough taxable income or isn’t required to lodge a tax return, the credits are paid to the individual as cash.
These amounts will vary depending on the individual’s taxable income and their marginal tax rate.
A franking credit case study
Susie Shareholder receives a cash dividend of $700. A franking (imputation) tax credit of $300 is attached because this $300 has already been paid by the company as tax. This brings the total taxable income to $1000 ($700 + $300).
When Susie lodges her tax return, she declares the $1000 as part of her taxable income. Her marginal tax rate is 19 percent, meaning she should be paying $190 tax on the dividend. However, as the company has already paid tax of $300, Susie can claim the difference of $110.
Can franking credits really be paid in cash?
Yes! That’s why it was such a big issue during the 2019 federal election because the then Shorten led Opposition wanted to do away with it. Especially with retirees who relied on these credits as part of their regular income stream.
The Tax Imputation System was first introduced by the Hawke Government in 1987. The idea was to incentivise investors in lower tax brackets to invest, to buy shares.
However, in 2001, the Howard Government made some changes. These changes allowed for any individual or Self-Managed Superannuation Fund (SMSF) with franking credits worth more than any payable taxes, the option to receive the monies owed in cash.
Basically, the government would ‘pay them back’ whereas previously, excess franking credits were worthless as they couldn’t be claimed back as part of a tax refund.
This is what the ATO says about refunding excess franking credits for individuals:
‘If you receive franking credits on your dividends, you need to let us know your:
- franked amount
- franking credit.
If you are an Australian resident, we will use this information to:
- reduce your tax liability from all forms of income (not just dividends) and from your taxable net capital gain
- refund any excess franking to you after any income tax and Medicare levy liabilities have been met.’
Are all dividends franked?
Not all companies want to pay franked dividends meaning, dividends aren’t always paid on taxed profits. Therefore, unfranked dividends aren’t issued with a franking credit. What this means is, if you’re issued with an unfranked dividend, it’s considered taxable income and you’re required to pay tax on it.