What Are Franking Credits?

• Franking credits reduce double taxation: These credits represent tax already paid by a company on profits before distributing dividends.
• Tax benefits for investors: Franking credits offset tax liabilities and can result in tax refunds for low-income earners.
• Retiree-friendly income stream: Self-funded retirees can receive franking credits as cash refunds, boosting their passive income.

How Do Franking Credits Work?

Franking credits, also known as imputation credits, are a mechanism that allows shareholders to receive credit for tax paid by companies on their profits. This ensures dividend income is not taxed twice—once at the corporate level and again at the individual level.

When companies generate profits, they typically pay a corporate tax of 30% in Australia before distributing dividends. Investors who receive these dividends also receive franking credits, which can be used to reduce their personal tax liabilities. If an investor's marginal tax rate is lower than 30%, the excess credit can be refunded, making fully franked dividends particularly attractive.

Why Does Australia Have Franking Credits?

Australia introduced the dividend imputation system in 1987 to prevent double taxation on corporate profits. Before this, investors were taxed on dividends even though the company had already paid tax on the profits used for those dividends. The introduction of franking credits meant that shareholders could claim a credit for the tax already paid at the corporate level.

This system encourages companies to distribute profits as dividends rather than retaining earnings. Without franking credits, companies might favor share buybacks or alternative profit distribution strategies to avoid double taxation.

Tax Benefits of Franking Credits

A fully franked dividend includes a credit for the tax already paid by the company. Investors are taxed at their marginal tax rate, but the franking credit offsets their tax payable. This structure provides tax relief and, in many cases, results in refunds.

For example, if a company earns $1 per share in profit, it pays 30 cents in tax and distributes a dividend of 70 cents per share. The investor must declare $1 in taxable income but receives a 30-cent franking credit to offset their tax liability. If the investor's tax rate is lower than 30%, they receive a refund for the difference. Conversely, if their tax rate is higher, they pay tax only on the difference.

Why Are Franking Credits Popular With Retirees?

Retirees often rely on dividend income to supplement their retirement funds. Since retirees in pension phases generally have lower taxable incomes, fully franked dividends provide an additional advantage. Those earning below $45,000 annually can receive franking credits as cash refunds, further enhancing their investment income.

For example:

• Income below $18,200: Tax rate is 0%, meaning all franking credits are refunded.
• Income between $18,200 and $45,000: Tax rate is 19%, so franking credits in excess of payable tax are refunded.
• Income above $45,000: Tax rate increases, meaning the investor may need to pay additional tax beyond the credit received.

This structure makes franked dividends highly attractive for retirees managing tax-efficient portfolios.

Fully vs. Partially Franked Dividends

A fully franked dividend means the company has paid the full 30% corporate tax on its profits before distributing dividends. Investors receive the full benefit of franking credits.

A partially franked dividend means only a portion of the dividend has tax paid on it. For example, a 50% franked dividend indicates that half of the distributed profits were taxed at 30%, while the rest remains unfranked.

An unfranked dividend means the company has not paid tax on the distributed profits. This typically occurs when businesses operate in jurisdictions with lower tax rates or receive tax exemptions.

The level of franking on a dividend depends on the company’s tax obligations and financial strategy.

Why Do Investors Seek Franking Credits?

Investors favor franked dividends due to the associated tax benefits, particularly in Australia’s imputation system. With dividend income being a major component of stock market returns, understanding the impact of franking credits on after-tax earnings is essential.

Companies that consistently pay franked dividends often attract income-focused investors, particularly those in lower tax brackets or retirement phases. By leveraging franking credits, investors can optimize their tax positions and enhance long-term returns.

Conclusion

Franking credits play a crucial role in Australia’s tax system, providing shareholders with a fairer taxation structure and encouraging dividend payments. Fully franked dividends offer significant advantages, particularly for retirees and income investors seeking tax-effective investment strategies. Understanding how these credits work can help investors maximize their after-tax returns and build a stable income portfolio.