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Franking Credits Explained
If you’re in Australia (or invest in Australian companies), you might be eligible to receive franking credits.
These credits are part of a system that helps reduce double taxation on dividend payments to shareholders of Australian companies. Depending on your income tax bracket, this can result in significant savings.
In this article, we’ll explain everything you need to know about franking credits, including who qualifies, how credits get calculated, and benefits for recipients – particularly for retirees. Let’s get started.
What Are Franking Credits?
Franking credits are a type of tax credit that companies attach to dividends to avoid double taxation.
The premise is that the company profits have already been taxed once, so you shouldn’t be taxed again on your dividend income.
The franking credit informs the tax office that these profits have already paid taxes at the corporate rate. This process is called dividend imputation.
Franking credits also help bring transparency to the taxation process. The government, companies, and shareholders can all clearly see how much tax has been paid and by whom. That helps increase trust between all parties involved.
Note: Dividend imputation systems are available in a handful of countries, but the rules vary. For simplicity, we’ll focus on Australia in this article. Check local tax laws in your area to learn if franking credits are available and how you might benefit.
Varying Credit Levels
Dividends can get fully or partially franked.
- A dividend is fully franked if the company has paid the entire corporate tax owed.
- If the dividend has been taxed less than the full amount, it is considered partially franked.
- A dividend is unfranked if no corporate taxes have been paid.
Franking credits can even be attached to dividend-paying stocks, dividend-paying mutual funds, and ETFs. These instruments pass the franking credits through to the shareholder.
How to Calculate Franking Credits
Franking credits are derived from a simple formula using the dividend payout and the corporate tax rate.
Franking Credit = (Dividend / (1 – Tax Rate)) – Dividend
For example, suppose a company pays a dividend of $7, and we know the Australian corporate tax rate is 30%. In that case, we can calculate the franking credit to be $3. That means the company will send you a $7 dividend plus a $3 tax credit.
How much of the tax credit you get to keep will depend on your income tax rate.
Who Qualifies for Franking Credits?
In Australia, qualifying for franking credits depends on your tax situation, annual total credits claimed, and how long you have owned the stock. Here are the requirements:
- Franking credits are available to resident and non-resident shareholders of companies that pay tax in Australia.
- You must own shares for at least 45 days, excluding the buy and sell date. The purpose of this threshold is to prevent quick in-and-out trades by those looking to score the tax credit. This rule encourages long-term investment.
- You must be in the 0% – 30% income tax bracket range. You won’t be eligible to utilize franking credits if you’re in a higher tax bracket.
- Your total yearly tax credit from franked dividends can’t exceed a limit of $5000.
You can receive credits if you meet these qualifications, but that doesn’t necessarily mean you get the total amount. We’ll look at that next.
How Much of the Franking Credit Can I Keep?
The role of the franking credit is to inform the tax office how much tax has been paid on a dividend. However, this doesn’t necessarily mean you will receive a full refund on that amount. The size of your refund will depend on your income tax bracket.
The Australian corporate tax rate is 30%. So comparing that number to your tax bracket can show you how much you’ll get:
- 0% income tax bracket – you can receive the entire refund.
- 15% income tax bracket – you can get half the refund.
- 30% income tax bracket – you won’t get any refund.
- A bracket higher than 30% – you might have to pay tax on the difference.
In any case, franking credits are an excellent feature of the Australian system.
Why Are Franking Credits Popular for Retirees?
Companies that give out franking credits are a popular investment for anyone, but especially for retirees.
Generally, retirees have a low taxable income, which puts them at or near the 0% bracket. That means they can usually maximize the return on franking credits and get a full refund.
Plus, the tax office will pay the difference if the franking credit is more than what you owe in taxes. For these reasons, they often fit nicely into a sound retirement investing strategy for Australians.
Using Them as a Source of Income
If you’re retired with a tiny tax bill, you could get a tax refund if you hold shares of a company giving out dividends with franking credits. It can be a great way to supplement income during retirement.
Not only are you getting paid a cash dividend, but you’re also getting a tax credit that may function as cash if your taxable income is low enough. It is definitely something to remember if you are planning for retirement as an Australian investor.
Say No to Double Taxation with Franking Credits
As a shareholder, you own part of the company, which means you already pay corporate taxes on profits. Franking credits help make sure you don’t get taxed twice. It is a powerful feature of the Australian system – especially for those planning for retirement.
Fun fact: The investor Warren Buffet has pointed to America’s lack of dividend imputation as a key reason why he doesn’t pay dividends to his shareholders. He doesn’t think it’s fair to tax dividend income twice. Instead, he uses other methods to deliver value to long-term investors.
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