In Australia, ‘franking credits’ are a unique aspect of the tax system and are basically designed to prevent double taxation on dividends paid by an Australian company to their shareholders.
ATO franking credits explained
A franking credit ensures that company profits do not fall foul of double taxation by the Australian Taxation Office (ATO)—once at the corporate level and again at the individual shareholder level.
As the distributor or receiver of dividends, you can often deal with ‘fully franked’ and ‘partially franked’ credits, which we’ll explain further in the article.
If you run a company that offers shareholder equity, you need to become savvy in this area. In fact, anybody holding shares and looking for a tax refund or tax credit should also pay close attention to more fully grasp how shares and taxation work through the application of franking credits.
What’s a franking credit in simple terms?
Put simply, franking credits essentially represent the tax that’s already paid by a company on its profits.
For example, when a company makes a profit and pays corporate tax on that profit, it has the option to pass on the tax paid to its shareholders.
This is done through the mechanism of franking credits and occurs when distributing dividends.
So basically, franking credits are a way for the ATO to give individual shareholders credit for the tax already paid by the company.
Tax benefits of franking credits
The primary benefit or function of a franking credit lies in the reduction of double taxation.
Without a franking credit, dividends would be subject to taxation yet again at the individual shareholder level, effectively taxing the same income twice. You can think of them as a type of tax credit.
However, by attaching franking credits to dividends, shareholders can offset or reduce their personal tax liability when they pay tax. This could then mean that the taxpayer who receives franking credits could pay less tax or receive a tax refund.
How franking credits work
When a company pays dividends to its shareholders, it may attach franking credits based on the tax it has already paid on its profits.
Shareholders receiving franked dividend income include both the cash amount of the dividend and the attached franking credits in their assessable income for tax purposes. The ATO then allows shareholders to use these franking credits to offset tax payable on other income.
What does fully franked, 100% franked and partially franked mean?
There are indeed different types of franking credits and they can be split into two main categories:
Franking credits from a fully franked dividend
Fully franked dividends (or 100% franked) are dividends for which the company has already paid tax at the full corporate tax rate.
This means that when a shareholder receives fully franked dividends, they’re entitled to claim the full amount of the attached franking credits to offset their tax liabilities.
Franking credits from a partially franked dividend
On the other hand, partially franked dividends are dividends for which the company has paid tax at a rate lower than the full corporate tax rate. In such cases, the franking credit attached to these dividends is adjusted accordingly.
Shareholders receiving partially franked dividends can still use the franking credits to reduce their tax liability, but the amount they can claim is proportional to the tax paid by the company.
Do managed funds and ETFs pay franking credits?
Yes, both ETFs and managed funds essentially use franking credits as well, but in a more complex way depending on whether they’re distributing funds or accumulating funds.
For clarity, a managed fund, taken care of by a professional fund manager, will pool money from multiple investors to invest in a diversified portfolio of assets such as stocks, bonds, and other securities.
ETFs, on the other hand, are investment funds traded on stock exchanges, similar to individual stocks. They aim to track the performance of a specific index, sector, commodity, or other asset.
Let’s see how franking credits are handled in both distributing funds and accumulating funds.
Distributing funds and ETFs
• Distributing managed funds and ETFs pass on franking credits to investors when distributing dividends.
• Investors can claim these credits on their tax returns, reducing their tax liability.
Accumulating funds and ETFs
• Accumulating managed funds and ETFs reinvest dividends back into the fund, including any franking credits.
• While investors do not directly receive these credits, they contribute to potential growth within the fund.
