Franking Credits: What Should Know

“Franking Credits explained” is a common search phrase in Australia. Franking credits play a key part in how companies pay taxes in Australia. They help in the ‘dividend imputation’ system. Therefore, it’s prudent for any investor in the country to understand what they are and how they work. So, consider this article as an explainer. It details how the franking credits work in the income tax system and how to exploit them.

What Are Franking Credits?

When you invest in ASX companies, your shares earn passive income in dividends. That’s where franking credits come in. As an investor, you’ll receive franking credits besides the raw dividend amount paid by the company. But not all companies will pay you franked dividends.  

A Franking credit, or imputation credit, is a tax refund for paying more than needed. 

When you file taxes, you declare dividends and franking credits. The credits count towards your tax, so dividend income isn’t taxed twice. Dividend income is treated the same as other investment income, like interest from term deposits, which is only taxed once.

How Franking Credits Work

Franking credits, introduced in 1987, solve the problem of double taxation for ASX investors. It ensures you only pay taxes at the shareholder level. So, it spares you the headache of paying taxes on the same income at the company and individual levels. 

The franking credits system idea is simple. When a company files for returns, it pays corporate income tax on its profits. Afterwards, it shares the after-tax profits to its shareholders as dividends. These dividends may carry franking credits—representing the tax the company has already paid. So, in a way, franking credit informs the taxman that you have already paid taxes on these dividends.

Here’s the process:

Eligibility for Franking Credits

You need to understand eligibility for franking credits to alleviate any confusion. These credits help you retain more capital and manage your tax obligations. They reduce your overall tax liability. But to be eligible for franking credits, you must meet certain conditions. These conditions include:

1. Shareholder Requirements – Franking Credits are for Locals

Individuals must be Australian Tax Residents. If a minor holds shares through family trusts, the minor’s parent or guardian takes charge. A trust fund can utilise the franking credits subject to specific conditions.

Some companies may also hold shares. In such cases, only Australian-resident companies receive franked dividends. Just like individuals, companies can generally use them to offset their own corporate tax liabilities. Also, qualifying Australian resident Trusts, such as the one we discussed above, can enjoy franking credits.

Non-resident shareholders are not eligible to receive franking credits. But, foreign nationals may receive certain withholding tax exemptions depending on tax treaties between Australia and their country of origin.

2. Dividend Requirements – Only Franked Dividends Qualify

The dividend must be franked, meaning the company has attached it to franking credits. Not all dividends come with franking credits. Some may be unfranked or partially franked.

Only dividends from Australian resident companies that have paid corporate tax qualify.

3. Holding Period and Entitlement – Ex-Dividend Date

Shareholders must be on the company’s register before the ex-dividend date. Shareholders must be registered as of the record date specified to receive the dividend and associated franking credits.

4. No Double Benefits – No Double Dipping

Shareholders cannot claim franking credits more than once. The credits are intended to represent the tax already paid, so they must be appropriately accounted for in the shareholder’s tax return.

You can still receive franking credits if you reinvest dividends to buy more shares using a Dividend Reinvestment Plan (DRP). But this is only so if you meet the eligibility criteria and transitional rules.

Changes in legislation or company structures may affect eligibility. It’s important to stay updated with the Australian Taxation Office (ATO) guidelines.

Australian companies receiving franked dividends are eligible to utilize franking credits. Like shareholders, they use the credits to reduce their own corporate tax liabilities. But they must meet specific conditions. Read here for more.

To check your eligibility for franking credits, review your dividend statements. They show whether dividends are franked, unfranked, or partially franked. And they also declare the associated franking credits. With this information, you can effectively use franking credits to manage your tax obligations. 

Refunds of Franking Credits

Dividends from Australian resident companies are taxed under an imputation system. The company pays tax and then passes this benefit to you as its shareholders. As we have said, the benefit comes as franking credits attached to your dividends. So, any Australian shareholder may be eligible for a refund of excess franking credits.

Shareholders must declare both the franked amount and the franking credit. Australian residents can use this information to lower their overall tax liability. They may receive a refund if the credits exceed their tax and Medicare levy.

Eligibility for a Refund

Eligibility for a refund of excess franking credits requires the following:

• Receipt of franked dividends directly or through a trust/partnership after 1 July 2000.
• A basic tax liability is lower than the franking credits received after considering any other tax offsets.
• You comply with anti-avoidance rules designed to ensure fair taxation.

There have been ongoing discussions and occasional legislative changes affecting franking credits. For up-to-date information, consult the latest ATO guidelines or a tax professional.

Advantages and Disadvantages of Franking Credits

You can use franking credits to offset your tax liabilities as an eligible shareholder. Franking credits act as tax offsets, allowing you to reduce the tax payable on other income. But as always, there’s always also a negative side. So, here are the advantages and disadvantages of franking credits.

Advantages

• They help reduce double taxation
• Those eligible get higher after-tax returns
• Tax refund opportunities
• Encourages locals to invest in Australian companies

Disadvantages

• It excludes non-residents
• There are some limitations on tax refunds
• Lower dividend payouts. Franked dividends mean the issuing company retains more profits to meet tax obligations

Common Misconceptions About Franking Credits

Franking credits can be a valuable tax benefit for shareholders but are often misunderstood. Many investors are confused about how they work, leading to several common misconceptions. We’ll clarify some of these misunderstandings and help you better understand the value and function of franking credits.

1. Franking credits are only beneficial for large corporations

Franking credits aren’t just for large corporations. Regardless of the size of their investment, any shareholder can enjoy franking credits if they receive franked dividends.

2. Only high-income earners enjoy franking credits

Franking credits can reduce anyone’s tax liability. Nevertheless, income level may determine how much you save in taxes. High-income earners may see greater benefits compared to low-income earners. But all receive a reprieve on the tax amount they could have paid.

3. Franking credits are too complicated to understand

Though they may seem difficult, the concept is simple. It goes like this: companies pay taxes on profits, and shareholders are exempted from paying taxes on that income. Franking credits prevent double taxation by ensuring shareholders only pay tax once.

4. Franking credits will always lead to a refund

Not always. Whether you receive a refund or not depends on your tax position. If your tax liability is lower than the credits, you might carry them forward instead of receiving an immediate refund.

5. Franking credits lead to double taxation

Franking credits are designed to prevent double taxation. They ensure that the company’s tax is passed on to shareholders, who can offset it against their own tax obligations.

Conclusion

Franking credits create fairness across tax brackets. It ensures that low-income earners may get a refund while higher earners pay lower than usual taxes. It’s a more equitable and competitive tax framework, particularly benefiting domestic investors. But they are only available to Australian residents, and only dividends with franking credits are eligible. To benefit, you must have accurate documentation of dividends and these credits. To stay informed and maximise your benefits, regularly check updates from the ATO or consult a tax professional.

With the proper knowledge, you can get the most out of your investments. Visit BrokerRaters.com for more financial tips and expert advice!