What are franking credits?

An introduction to franking credits

You may already know about income-based investing and the thrill of earning passive income when your ASX shares pay dividends. But what are franking credits? 

Investors can receive franking credits in addition to the raw dividend amount paid by a company they're invested in. Not all companies pay franked dividends, and later, we'll explain why.  

A franking credit (also known as an imputation credit) represents the tax a business has already paid on its profits in Australia. Dividends are typically funded from profits, so the dollars spent on investors have already been taxed. 

At tax time, investors declare both the dividends and franking credits on their individual tax returns. The franking credits are credited towards the tax payable by the investor, preventing the dividend income from being taxed twice. 

This creates a level playing field for dividend income with other types of investment income, like interest earnings paid on term deposits, which are only taxed once.

Why do we have franking credits in Australia?

Australia introduced franking credits in 1987 to solve the sticky problem of ASX investors being taxed twice on dividends. 

Businesses typically pay company tax on profits before paying dividends to their shareholders. Before franking credits, corporate profits distributed as dividends were taxed at the corporate level and again as income of individual investors. 

Understandably, most investors don't like the idea of being taxed twice on the same income. It is also a significant deterrent to companies paying out profits as dividends.

The introduction of franking credits meant that taxes paid at the company level could count towards taxes payable by the individual.

In his 2012 letter to shareholders¹, legendary American investor Warren Buffett explained that double taxation was a big reason he elected not to pay dividends as chair of Berkshire Hathaway Inc (NYSE: BRK.A, NYSE: BRK.B). 

Instead, Berkshire Hathaway returns cash to shareholders through share buybacks. This reduces the total number of outstanding shares and increases the value of each remaining share.

What are the tax benefits of franking credits?

When you receive a fully franked dividend, you get a credit for the 30% company tax already paid. Investors' dividend income is taxed at their personal marginal tax rate. Any tax payable, however, is reduced by the amount of the franking credit. You may even be eligible for a tax refund if your personal tax rate is less than 30%.

For example, let's say a company earns a profit before tax of $1 per share. The company tax rate is 30 cents, so it will pay 30 cents per share in tax to the government. And it will send investors a cash dividend of 70 cents per share plus a credit for the 30 cents of tax paid.

An investor must declare the combined dividend and franking credit ($1) as income on their individual tax return. Tax is payable on this amount at the investor's marginal tax rate. The franking credit acts as a tax offset against the tax payable on that income by the investor. 

If the investor's marginal tax rate is less than 30% (for example, 19%), they will be eligible for a rebate of the difference. If their marginal tax rate is higher than the company tax rate (eg, 37%) they must pay tax on the difference. 

For the investor, it is as if the dividend has been paid out of pre-tax profits and is then taxed at their marginal tax rate.

Why are franking credits popular with retirees?

After years of working, saving, and investing, retirees in their pension phase often have a nice nest egg of assets. However, their taxable income in any given year can be relatively low without full-time work. This is where a retirement portfolio of income-generating stocks paying fully franked dividends can be a big bonus.

We explained earlier how fully franked dividends could provide a helpful tax rebate if your marginal tax rate is below the 30% corporate tax rate. But self-funded retirees with a low overall income² (below $45,000) can receive franking credits as cash refunds. 

That's because the marginal tax rate on income below $45,000 is 19% (below the corporate tax rate of 30%), while the marginal tax rate on income below $18,200 per annum is 0%. Under the current system, franking credits in excess of personal tax payable can be refunded to the recipient. These credit refunds are in addition to the passive income generated from the underlying dividends. 

What's the difference between fully and partially franked dividends?

A fully franked dividend means the company's entire profit, from which dividends are paid, has been subject to corporate tax in Australia. This means each dividend can include the maximum franking credits available.

Sometimes, you'll notice that a dividend comes only partly franked or even unfranked. This happens when a company hasn't paid the total 30% tax rate on all its profits. A company might not always pay the total rate on all its profits due to factors like tax deductions, exemptions, or income earned in other tax jurisdictions.

An unfranked dividend is a distribution of profits upon which the company has not paid tax. Partially franked dividends might be '50% franked', for example. This means the company has paid tax on 50% of the profit being distributed as dividends. 

The level of franking on dividends results from the amount of Australian tax the company has paid on its profits, which can vary from one fiscal period to another based on the company's financial performance and tax planning strategies.

Why do investors look for franking credits?  

Franked distributions are distributions upon which tax has already been paid. They come with refundable franking credits, which reduce the tax payable on investors' net income. This is how Australia's dividend imputation policy prevents the double taxation of shareholders. 

Investors like shares that pay franked dividends because of the associated tax benefits. A significant proportion of the return on a share investment can come from dividends. Therefore, it makes sense to be aware of the tax impact of dividend income and associated franking credits.