What is a Franking Credit? You have probably seen this phrase on tax statements provided to you by a company you invest in but what does it actually mean?
Franking Credits are the means whereby Australian companies can give credit for tax paid at the company level to their shareholders, which can then be used by the shareholder to avoid double taxation of the profits paid out as dividends.
A company is required to pay tax to the Australian Taxation Office (ATO). It is left with its profit and may distribute some of that profit to its shareholders. Profit distributed by way of dividends has already been subject to tax at the 30% company tax level, so franking credits are attached to those dividends in order to prevent double taxation. Shareholders tax liability is calculated as if they had received the before-tax profit (dividend plus franking credit) but the franking credit, available as a tax offset, ensures that they are only required to pay the difference between the corporate tax rate and their own marginal tax rate on those dividends.
To calculate your assessable income, you include both the dividend and the franking credits as income (grossed up dividend) on which tax is calculated at your marginal tax rate, and then you can use the franking credits to reduce the resultant tax liability, or even generate a tax refund under current rules.
For example, Jill receives a fully franked dividend of $350 with a franking credit (representing tax the company has already paid) of $150. Grossed up, the profits paid out as that dividend would have been $500. On her tax return, Jill must declare $500 as her taxable income even though she only received $350. If her marginal tax rate is 20% then she would have to pay $100 tax on the grossed-up dividend; however, because the company has already paid $150 in tax (the franking credit amount on her statement), under current rules she is entitled to a refund of the $50 difference. Alternatively, the $50 unused offset can be used to reduce tax payable on Jill’s other sources of income.
Investments with attached franking credits are therefore very appealing to non-taxpayers, low-income earners or pensioners. If a taxpayer has a marginal tax rate higher than 30%, this would result in them owing more money to the ATO. For example, if your marginal tax rate is 37% (+ 2% Medicare levy) and you receive a fully franked dividend of $350 with a franking credit of $150. Grossed up, the dividend would be $500 which is the amount you would declare. The company has already paid $150 tax on the dividend but, at your marginal tax rate of 37% (+ 2% Medicare levy), the total tax and levy payable would be $195. Therefore you would owe an additional $45 to the ATO. Owing additional tax may seem problematic but remember that you received a $350 dividend.