Most of you would have heard of Franking Credits.  You might know that it is something to do with tax, company shares, and important enough to significantly impact the Australian election results in 2019 when Labor’s policy pledged changes to their tax treatment.  Do you really understand what they are?

I am going to try to explain this as simply as I can which is not going to be easy.  Stick with me to the end and you will hopefully understand them a little better.

Franking Credits relate to companies.  While you may hear of franking credits in trusts and superannuation funds, ultimately they are the result of an investment in a company.  We will just stick to companies for this article.

A company has shares.  The owners of the shares collectively are the owners of the company.  This means that the shareholders have a right to share the profits of the company that they own. The way that shareholders share in the profits of the company is by way of a dividend. A dividend can be franked or unfranked, but we will talk about that difference later.

Let’s consider a very basic company that has one shareholder.  It trades for the year and makes a profit of $1,000.  Let’s also assume for the purposes of this exercise that the company is taxed at a rate of 27.5%.  There are other factors to consider but we are keeping this very simple.

Profit:                                $1,000

Tax on Profit                    $275

Profit after tax                 $725

If the shareholder wants to draw a dividend on this profit, they have $725 that they can physically take out of the business because that is all that is left after the tax has been paid.

A franked dividend is drawn for $725 and this will be taxable income to the shareholder in the year that the dividend is paid.

When the shareholder prepares their tax return they report that they have been paid a franked dividend of $725.  The franked dividend has a franking credit for the tax paid by the company, so the franking credit is $275.  In the tax return both the dividend and the franking credit are added together and become taxable income to the shareholder.  The shareholder would have $1,000 in taxable income even though they only physically received $725.

Tax is then calculated on the shareholders total taxable income, including the dividend.  The shareholder then gets a credit for the franking credit against the tax calculated.

As an example, the shareholder’s other income is $130,000 so they have a marginal tax rate of 37%.  We need to add a 2% Medicare levy to this, so their true marginal rate is 39%.

$1000 x 39% = $390. This is the additional tax that will be payable due to the dividend.

A credit of $275 will be applied due to the franking credit.

$390 – $275 = $115 which is the additional tax that will be paid on the dividend.  It is not as much as the shareholder’s marginal tax rate, but it is not “tax free” either.  Many people think a franked dividend is tax free and that is not true.

Now assume the shareholder had very little income so that their total income (including the dividend) is below the tax free threshold.  Tax on the $1,000 dividend is nil, but the $275 credit will still apply.  The shareholder would get back the full franking credit of $275.  Happy days.

The two biggest groups on a low a tax rate are retirees and superannuation funds.  A self-managed superannuation fund with its members in pension mode has a 0% tax rate.  Franking credits are gold to retirees who have structured their investments effectively. Any wonder taking them away was an election issue.  The Labor party have now released a statement that they will not be suggesting any policy changes to franking credits in the future.

There is a lot more to this, particularly as income tax rates are changing and to draw a dividend a company needs to have paid tax and have a distributable surplus (in other words have retained earnings in the business – or more assets than liabilities), but that is for your accountant to help you determine.

If tax has not been paid on the profits a franking credit cannot be applied to the dividend.  In this case a dividend is unfranked, and it is taxed as normal without any credits.

The rules are pretty much the same whether your shares are in a listed company (such as Telstra) or your own Pty Ltd company.  The tax rates may be different as listed companies will have a 30% tax rate, but the principles on how the dividend is taxed in the hands of the shareholder at the same.

Important to remember:

·       A franked dividend is grossed up (the physical amount received plus the franking credit) so you are paying tax on the full amount of profit that the company would have earned before tax, and effectively getting a credit for the tax the company paid on that profit.

·       The company needs to have paid tax to the ATO before it can draw a franked dividend.

·       A company needs to have sufficient retained earnings to draw a dividend.

·       A dividend is taxable in the year that it is paid, not when it is declared.

It is a difficult concept but hopefully this has helped you to understand franking credits a little more.

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