What is Franking Credit?

What is Franking Credit?

A franking credit, also known as an imputation credit, is a type of tax credit paid by corporations to their shareholders along with their dividend payments. Australia and several other countries allow franking credits as a way to reduce or eliminate double taxation.

Since corporations have already paid taxes on the dividends they distribute to their shareholders, the franking credit allows them to allocate a tax credit to their shareholders. Depending on their tax situation, shareholders might then get a reduction in their income taxes or a tax refund.

How Franking Credits Work

In most countries, dividends are treated as a form of income. This means that they are usually grouped with other types of incomes to determine total taxable income. Whenever a company earns profits, it must pay tax on this profit. In Australia, the corporate tax is set at 30%.

Before the introduction of franking credits by the Hawke/Keating government, the country’s tax authority used to impose a tax on the company profits, as well as on the dividends paid out to investors. Since dividends are simply the profits left after the corporate tax has been paid, it meant that dividend income was double-taxed.

However, since the introduction of franking credits, the tax authority imposes a tax on just one front. Therefore, investors who receive dividends are not required to pay additional tax except when their marginal tax rate is higher than the corporate tax rate paid on the dividends. Even then, an investor only needs to pay the difference between his marginal tax rate and the 30% corporate tax rate.

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Consider an investor whose marginal tax rate is 30%. Since the company already paid a 30% tax on the profits earned, the investor would not incur more tax on his dividends. However, if his marginal rate is 45%, he will pay the difference, which is 15% (45% – 30%).

Alternatively, if the investor’s tax rate is 0%, they will receive all the franking credits as a refund. In 2000, franking credits were made fully refundable, making them a factor in an individual’s investment strategy.

Calculating Franking Credits

This is the standard calculation for calculating franking credits:

Franking credit = (dividend amount / (1-company tax rate)) – dividend amount

If an investor receives a $70 dividend from a company paying a 30% tax rate, their full franking credit would be $30 for a grossed-up dividend of $100.

To determine an adjusted franking credit, an investor would adjust the franking credit according to their tax rate. In the previous example, if an investor is only entitled to a 50% franking credit, their franking credit payout would be $15.

The Bottom Line

The concept of franking credits was instituted in 1987 and therefore is relatively new. It provides additional incentive for investors in lower tax brackets to invest in dividend-paying companies.

Potentially, other countries could consider integrating franking credits to reduce or eliminate double taxation. Therefore, people who would like to see a similar system in the United States and other nations watch the effects of franking credits closely.