7 December 2023
Let’s dive into the fascinating world of franking credits, a unique feature of the Australian tax system that can have a significant impact on your investment returns.
If you are new to the game , understanding franking credits is essential for maximizing your tax benefits and making informed investment decisions.
So, let’s demystify this concept together. Don’t worry if you are thinking , what is this ? I’ve never heard about this before!.
Years ago, when my first boss asked me if I knew what they were, I was clueless. All I knew, was there was something called a franking machine where you had an arrangement with the post office to make your postage seals. I thought it was something related to that !!
How do franking credits work?
Imagine you’re a shareholder of a large company that just made a profit and paid corporate tax on it. Now, when the company distributes the remaining profit as dividends to you, the ATO(Australian Tax Office) ensures that you don’t get taxed twice on the same income.
This is where the magic of franking credits step in.
Franking credits, also known as imputation credits, are tax credits attached to dividends. These credits represent the tax the company has already paid on its profits.
Dividends can be fully franked or partially franked. If the company earns some of its income overseas it does not have to pay tax in Australia on those earnings. In such cases you may receive a partially franked dividend. These details will be provided on your dividend statement.
By attaching franking credits to dividends, the company allows shareholders to offset their own personal income tax liability.
Let’s break it down with a simple example
Suppose you own shares in XYZ Ltd. The company generates a profit of $10,000 and pays a corporate tax of $3,000, leaving an after-tax profit of $7,000.
XYZ Ltd. decides to distribute this $7,000 to its shareholders as dividends, along with franking credits of $3,000, representing the tax already paid.
Now, as a shareholder, you receive a dividend of $80 with the attached franking credits of $34.29.
The simple formula to calculate franking credits on fully franked dividend is as follows:
Dividend X 30/70 or in this case $80 X 30/70 = $34.29
When you do your tax, you need to include this dividend and franking credits in your taxable income. If you earn less than $21,000 or don’t earn any income you will get this amount back as cash refund.
However, the good news is that you also get to claim the $34.29 franking credits, which can offset your tax liability.
Now depending on your marginal tax rate, you will either receive cash back , pay less tax, or have to pay additional tax than what has been already collected.
As the tax rate for large companies is 30%, if your tax rate is below that, you will pay less tax, if it is the same you will pay no tax and if you are high earner on the 45% + 2 % ( Medicare Levy) rate, you will have cough up the difference.
Definitions
Go here to see all the definitions on the ATO website –https://www.ato.gov.au/forms-and-instructions/refund-of-franking-credits-for-individuals-2023-application-and-instructions/definitions#ato-Frankingcredit
Benefits of Franking Credits
Franking credits offer several advantages to shareholders and encourage investment in Australian companies. Let’s explore their benefits:
- Reduces Tax : Franking credits reduce the amount of tax you owe on dividend income, putting more money back in your pocket. This tax-saving feature can significantly enhance your after-tax returns on investments.
- Encouragement for investing in Australian companies: Because of franking credits, individuals are incentivized to hold shares for the long term, fostering stability and growth in the Australian stock market.
- Boosting Dividend Yield: Franking credits increase the effective dividend yield of shares. When a dividend carries franking credits, the dividend yield becomes higher, reflecting the tax benefit received from those credits. This can make certain stocks more attractive to income-focused investors.
- Cash Refund: If you have an income lower than $21,000 in a year, you actually get the franking credits back as a full cash refund.
- Super funds: All super funds stand to benefit from franking credits if they invest in Australian shares as their tax rate is only 15 %. Similarly if you have an account based pension your tax rate is 0% and you will get the full cash back.
Will the government meddle with franking credits ?
For some years now, the government has been thinking of tinkering with this system to boost their own income. In fact many say that Labours loss in 2019 was because they wanted their share in this enticing pie.
Scores of retirees bandied together and spoke with their local members to prevent this from happening. Since Superannuation as a retirement vehicle commenced only in 1992, most older people don’t have one. And so to create their own retirement fund, a lot of them bought good quality shares and were able to boost their returns via a full cash refund in the form of franking credits.
If you are a retiree, the bigger your Australian share portfolio, the higher your franking credits. Portfolios in the vicinity of $1,000,000 are know to earn approximately $15,000 in franking credits.
And this has worked to an extent as no government wants an additional burden on the Age Pension if more pensioners were able to claim a part pension because the franking credit portion was denied to them.
Recently the Labour government has announced that they will go after capital raisings and off market share buy backs where companies use their franking credits to reduce their costs.
So far the retail investor, super funds and retirees have been spared.
Conclusion:
If you found all of the above too confusing, just remember this.
Dividends are like the icing on the cake and the Franking Credit is the cherry on top and of course the cake is the share you own!
Franking credits play a crucial role for investors and encouraging investment in Australian companies.
They provide an avenue for reducing personal income tax liability on dividend income, potentially boosting after-tax returns on investments.
Understanding how franking credits work and how to utilize them effectively can enhance your investment strategy. By considering your personal tax rate, you can make informed decisions that optimize your tax savings.
This unique feature encourages investment in Australian businesses and provides shareholders with a tax benefit. This approach stands out internationally as it aligns with the principle of ensuring that dividends are not double taxed.
So, as you navigate the world of investing in Australia, keep franking credits in mind. However, if it is growth that you are after, you may want to look at other asset classes like International Shares as well. If you are on the road to F.I.R.E, then this article could help-https://primedforprosperity.com.au/what-is-passive-income/