What are Franking credits?

posted on November 23rd, 2015 by Bellmont Research Team

In this post we answer the questions, what are franking credits and how do they work.

Every year, most profitable Australian companies distribute a portion of their earnings to shareholders in the form of dividends. In order to avoid the double taxation of these dividends (where the company pays tax on their profits, and then the investor also pays tax on the dividends) Australia operates what is known as an ‘imputation system’. Under this imputation system, investors receive ‘franking credits’, representing the amount of tax that the company has already paid on its profits. These franking credits are able to be offset against the tax that the investor would ordinarily have to pay on the dividend income.

Calculation

Franking credit

The tax payable on the dividend is calculated by a simple three step process:
1. Adding back the franking credits to the dividend amount to get the ‘grossed up dividend’
2. Multiplying the ‘grossed up dividend’ by the investor’s tax rate to determine the total tax payable
3. Subtracting the franking credits (tax already paid by the company) from the total tax payable, to determine the net tax payable (refundable) for the investor

In practice, what this means is that in a company that pays fully franked dividends, investors on a marginal tax rate of greater than 30% will need to pay a small additional amount of tax, while investors with a marginal tax rate of less than 30% will in fact receive a tax refund for the difference between the company tax rate, and their own.

Note – it’s important to be aware that in order to be eligible to receive franking credits you need to hold your shares at risk for a period of at least 45 days.

Example

Let’s look at an example. Pierre owns 5,000 shares in ABC Limited, for which he paid $5 per share for a total of $25,000. ABC Limited had earnings per share of $0.40, pays the full 30% company tax rate, and decides to distribute a fully franked dividend of $0.30 per share.

Pierre’s Tax rate 0% 32.5% 45%
Dividend
(Div/Share = $0.3)
$1,500 $1,500 $1,500
Franking Credit $642.85 $642.85 $642.85
Taxable income $2,142.85 $2,142.85 $2,142.85
Gross tax payable
(Income * Tax rate)
$0 $696.43 $964.28
Refundable or (Tax payable) $642.85 $(53.58) $(321.43)
After tax income $2,142.85 $1,446.46 $1,178.57

This post was written by Bellmont Securities intern Enzo Angelo.



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