If it weren’t for franking credits, you’d be taxed twice on the dividends you receive from investments. To prevent this, the Australian tax system uses franking credits.
Sounds simple, but navigating franking credits can be daunting. In this article, we’ll break down how franking credits work, their benefits, eligibility criteria, and recent developments surrounding them.
Table of Contents
What is a franking credit?
Franking credits represent a credit system that prevents the double taxation of company dividends. They are also called dividend imputation credits in Australia.
A company pays tax on the profit it makes annually, typically at the company tax rate of 30%. After the tax, the company may choose to pay dividends to you, its shareholder. The paid dividend represents a form of income for you. Thus, the dividend can also be taxed under income tax for the recipient.
Franking credits prevent double taxation of the dividend. This is done by attaching a franking credit to the dividend.
There are two types of franked dividends: fully franked and partially franked.
Fully franked dividends have franking credits equal to the company tax rate, while partially franked dividends have credits below the full tax rate. This distinction is crucial because it affects how much tax relief shareholders can claim.
How do franking credits work for shareholders?
You receive franking credits along with your dividend payments. The franking credit equals the amount of tax paid by the company on the dividend.
When you file an income tax return that includes a franked dividend, the Australian Tax Office (ATO) compares the tax already paid on that franked dividend by the company with your individual tax rates.
If your rate is higher than the franked dividend rate you will pay top-up tax of the difference – likewise, if your rate is lower, you will be refunded the difference.
Need Financial or Legal Advice for your small business?
Example calculation
The calculation for franking credits is straightforward:
Franking Credit = (Dividend Amount / 1 – Company Tax Rate) – Dividend Amount
Let’s say Person A is a shareholder in Company XYZ. Company XYZ pays Person A a dividend of $70.
The $70 dividend is fully franked because the company attached a franking credit of $30 to it. The $30 is the amount of tax that Company XYZ has already paid on the dividend in the form of company tax.
Person A’s taxable income is the fully franked dividend of $70 plus the attached franking credit of $30, which equals $100. If Person A’s top marginal income tax rate is 15%, then the tax they would pay is $15 (15% of 100).
However, under the franking credit system, ATO notes that $30 has already been paid as tax on the dividend. The ATO will then offer a tax refund to Person A for the overpaid tax.
Here, $30 has been paid as tax instead of the $15 that Person A would have paid. So, ATO will offer Person A a tax refund of $15 ($30 – $15).
Note that if Person A’s income tax rate were greater than the company tax rate, then they would not receive a refund from the ATO. Person A would pay the difference between the income tax and the tax already paid by the company.
Eligibility criteria for claiming franking credits
To claim franking credits, you must meet certain criteria.
- Australian residency: You must be an Australian resident for tax purposes.
- Holding period: You must hold shares for at least 45 days (including the purchase and sale dates) to qualify for franking credits.
- Small shareholder exemption: This exemption applies to small shareholders who receive less than $5,000 in franking credits per year. If you qualify, you can claim credits without meeting the holding period requirement.
Get a fixed-fee quote from Australia's largest lawyer marketplace.
Franking credits and tax refunds
Franking credits are refundable when they exceed your tax liability. This would happen if your marginal tax rate is below the company tax rate of 30%.
For instance, if a retiree receives a fully franked dividend of $70 with a $30 franking credit and has a 0% tax rate, they would receive a full refund of the $30 franking credit.
Eligibility for tax refunds
Similar to claiming franking credits, related tax refunds are also subject to specific eligibility criteria:
- Residency requirement: You must be an Australian resident for tax purposes for the entire financial year.
- Tax liability: Your basic tax liability must be lower than the total franking credits received.
- Anti-avoidance rules: You must comply with anti-avoidance rules to ensure fair tax practices.
Types of tax refunds
Depending on your eligibility, you may get a full, partial, or no refund.
- Full refund: If you have no tax liability, you can receive a full refund of the franking credits. This scenario is common among retirees who rely on dividend income from their investments.
- Partial refund: If your marginal tax rate is below 30% but not zero, you will receive a partial refund. For example, if your tax rate is 20%, you would receive a refund of the excess franking credits beyond the 20% tax liability.
- No refund: If your marginal tax rate is 30% or higher, you do not receive a refund. Instead, the franking credits offset your overall tax liability, so you don’t pay additional tax on the dividend income.
Beneficiaries of franking credit refunds
Certain groups particularly benefit from franking credits.
- Self-funded retirees: Retirees often have low or no taxable income, making them eligible for full refunds on franking credits. This option can significantly boost their retirement income.
- Low-income investors: Individuals in lower tax brackets can also receive refunds, which reduce their tax liability or provide additional income.
- Superannuation funds: SMSFs and other super funds in the pension phase can receive full refunds of franking credits due to their 0% tax rate.
Applying for a refund
You’ll need to use a designated ATO form to claim a refund for excess franking credits. This process is straightforward and can be completed even if you do not lodge a tax return.
Recent developments and controversies surrounding franking credits
Franking credits have been at the centre of political and public debate in Australia. One of the most significant controversies arose when the Labor Party proposed ending cash refunds for excess franking credits in the lead-up to the 2019 election.
This policy aimed to reduce the financial burden on the government, but it was met with strong opposition.
Recently, the Australian government has passed legislation to address concerns about the misuse of franking credits. This legislation, enacted in November 2023, prevents companies from attaching franking credits to dividends funded by capital raisings. This essentially aims to prevent artificial arrangements that exploit the system.
These changes reflect ongoing efforts to balance the benefits of franking credits with the need for fiscal responsibility and fairness in the tax system. Despite these reforms, franking credits remain a contentious issue, with ongoing discussions about their impact on different demographics and the broader economy.
Want more?
Sign up for our newsletter and be the first to find hand-picked articles on topics that we believe are crucial to successfully scale your unique small business.
By clicking on 'Sign up to our newsletter' you are agreeing to the Lawpath Terms & Conditions
FAQ
What is the difference between a franked and an unfranked dividend?
A franked dividend includes a franking credit, which represents tax already paid by the company, while an unfranked dividend does not.
How can I determine if a dividend is fully franked or partially franked?
Check the dividend notice from the company to see if it specifies the dividend as fully franked or partially franked.
What is the small shareholder exemption?
The small shareholder exemption allows shareholders receiving less than $5,000 in franking credits annually to claim these credits without meeting the holding period requirement (45 days).
Making franking credits work for you
Franking credits are a valuable tool if you are an investor in Australia. They help significantly lower your tax obligations and encourage investment in domestic companies. But to have favourable returns, it’s important that you understand how these credits work and stay updated on recent developments.
Need help navigating the complexities of Australia’s business tax compliance? Look no further than Lawpath. Our professional services will make sure that you’re making the most of your investments. Get in touch today.
Don't know where to start?
Contact us on 1800 529 728 to learn more about customising legal documents, obtaining a fixed-fee quote from our network of 600+ expert lawyers or to get answers to your legal questions.
