Who Is This Frank Guy Anyway? Dividends and Franking Credits

In any discussion around taxation, particularly in the politically charged lead up to a Federal election, you might hear the term 'franking credit' brought up. There's been a lot of talk about whether they're good or bad, so let's take a look at how they work.

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Firstly, what are dividends?

When any company makes a profit it can invest back into the business, perhaps by upgrading equipment or hiring more staff, or it can pass on some or all of those profits to the owners of the company. When a company has been listed on a stock exchange, such as the ASX, the people who own the shares are the owners of the company, and when profit is distributed among them this is called a 'dividend'.

There are often a lot of shares, and therefore a lot of shareholders, so dividends are expressed as an amount per share. If the dividend is $0.10 then for each share you own, you'll be paid ten cents. The more shares you own, the greater the total of dividends paid.

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Profit after tax

If the profit of the company is $100,000, and the company's tax rate is 30%, then it will have $70,000 to distribute among shareholders. However, for the recipient of those dividends, if the amount is added to their pre-tax income, then they will be taxed on it twice. Firstly when the company was taxed on the profit at the company tax rate, and then at the individual's marginal tax rate. Thankfully the Australian Tax Office doesn't double-dip.

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So how does it work?

Let's say I have 10% ownership in “Widgets R Us”, a company which made a $100,000 before tax profit last year. The company decides to distribute the full amount of profit to the shareholders, and pays tax then issues the dividend.

$100,000 profit minus $30,000 tax = $70,000 in fully franked dividends of which my share is 10% = $7,000.

At tax time this will affect me in different ways depending on my marginal tax rate.

When I report my income to the ATO, I add the dividends and the franking credits together, to get the full amount of profit I should have received. Technically the tax paid to the ATO was on my behalf, so it gets added back in.

Dividend of $7,000 plus franking credits of $3,000 puts us back at the $10,000 profit.

If my marginal tax rate is 32.5% ($45,001-$120,000 bracket) then I owe $3,250 on that $10,000 but I get a credit for the tax already paid of $3,000 so I only owe $250 in additional taxation.

If my marginal tax rate was 19% ($18,201 to $45,000 bracket) then I would only need to pay $1,900 on that $10,000 profit, so I would get a tax return of $1,100 for the additional tax the company paid on my behalf.

Taxable Income from shares = dividends + franking credits
Taxation owed = (marginal tax rate x taxable income from shares) – franking credits

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What about partially franked shares?

These work exactly the same as fully franked shares, but the proportion of tax paid will be less than the company's tax rate. The way it gets applied to your income and tax is exactly the same, though the actual amount of tax you're credited with will be lower than if the shares were fully franked.

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Conclusion

So why are franking credits so contentious?

Some of that conversation has been framed around people receiving a tax return from the government when they had paid no income tax. Whether or not the rules change in the future, for now, franking credits remain a useful means of ensuring that we're not paying taxation twice on our dividends.

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* The information provided in this article is general information only and does not take into account your objectives, financial situation or needs. Before making a financial decision, please assess the appropriateness of the information to your individual circumstances and consider seeking professional advice.

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