Unpacking the Importance of Franking Credits

Franking credits, also known as imputation credits, are a unique feature of the tax system in some countries, notably Australia. They are associated with dividend payments made by companies to their shareholders.

In Australia, when a company earns profits, it is required to pay corporate tax on those profits. If the company distributes a portion of its profits as dividends to its shareholders, the dividends are also subject to personal income tax in the hands of the shareholders.

To avoid double taxation of company profits, Australia introduced the concept of franking credits. A franking credit represents the amount of tax that the company has already paid on its profits. It is attached to the dividend payment and is passed on to the shareholder along with the dividend.

Shareholders receiving dividends can use franking credits to offset their personal income tax liability. If a shareholder’s marginal tax rate is lower than the corporate tax rate paid by the company, the franking credits can result in a reduction or even elimination of the shareholder’s tax liability. In some cases, shareholders may be eligible for a cash refund if the franking credits exceed their tax liability.

Franking credits effectively ensure that company profits are only taxed once, either at the corporate level or the individual shareholder level, depending on the shareholder’s tax rate. This system aims to encourage investment in Australian companies by providing tax incentives to shareholders.

It’s important to note that the rules and regulations regarding franking credits may vary between countries. The explanation provided here specifically applies to Australia. If you are referring to a different country, the concept and rules surrounding franking credits might be different.

Franking credits exist to address the issue of double taxation and promote fairness in the taxation of company profits and dividends. The concept was introduced to ensure that corporate profits are not taxed twice—once at the corporate level and again at the individual shareholder level.

Without franking credits, when a company pays corporate tax on its profits and distributes the remaining amount as dividends to shareholders, those dividends would be subject to personal income tax in the hands of the shareholders. This would effectively result in the same income being taxed twice—once at the corporate level and again at the individual level.

By introducing franking credits, the tax system allows shareholders to offset their personal income tax liability with the tax already paid by the company. If the company has paid tax at a higher rate than the shareholder’s personal tax rate, the franking credits can result in a reduction or elimination of the shareholder’s tax liability. In some cases, shareholders may even be eligible for a cash refund if the franking credits exceed their tax liability.

The purpose of franking credits is to ensure that profits earned by companies are not overly taxed, thereby encouraging investment in companies and stimulating economic growth. By reducing the tax burden on dividends, franking credits aim to make investing in companies more attractive to shareholders, who can then allocate their capital toward productive investments.

It’s worth noting that the specific reasons for the existence of franking credits may vary between countries, as different tax systems have different objectives and considerations when it comes to the taxation of company profits and dividends.

Franking credits are associated with the dividend payments made by companies to their shareholders. The taxation of franking credits involves two key components: the franking credit itself and the dividend income.

•  Franking Credit: The franking credit represents the amount of tax that the company has already paid on its profits. It is attached to the dividend payment and is effectively a credit that the shareholder can use to offset their personal income tax liability.
•  Dividend Income: The dividend income received by the shareholder is included in their assessable income and subject to personal income tax at the shareholder’s marginal tax rate.

When it comes to the taxation of franking credits, there are two main scenarios:

•  Franking Credit Offset: If the shareholder’s personal tax rate is equal to or higher than the company’s tax rate, the franking credits can be used to offset the tax liability on the dividend income. The franking credits are applied as a tax offset, reducing the amount of tax payable by the shareholder. This ensures that the dividend income is effectively taxed at the shareholder’s personal tax rate.
•  Franking Credit Refund: If the franking credits exceed the shareholder’s tax liability on the dividend income, the excess credits may be eligible for a refund. This typically occurs when the shareholder’s personal tax rate is lower than the company’s tax rate. In such cases, the shareholder can claim a refund for the excess franking credits, effectively receiving a cash refund from the government.

Let’s go through how wages are taxed to set the scene.

The money you receive in your bank from wages/salary isn’t the amount that you’re taxed on – you’re taxing on the “gross” wage that you’ve received which is the net banked amount plus the taxes your employer has paid on you.

Someone who is on $65,000 a year will only receive $50,000~ of actual cash – the rest is tax paid on their behalf to the ATO.

Franking credits work very similar to this, however, the tax paid to the ATO is based on the company size instead of the taxable income of the recipient. The rates in the 2020 financial year are either 27.5% or 30%.

For someone who has received a $1,000 dividend into their bank, the actual income is $1,428 – with the $428 difference being a potentially refundable income tax credit.

It’s important to note that the rules and calculations surrounding the taxation of franking credits can be complex, and individual circumstances can vary. It’s advisable to consult with a qualified tax professional or refer to the specific tax laws and guidelines of the country in question to understand the precise details and requirements related to the taxation of franking credits in that jurisdiction.

Franking credits are often considered important to older Australians because they can have a significant impact on their retirement income and financial well-being. Here are a few reasons why franking credits are particularly relevant to older Australians:

•  Retirement Income: Many older Australians rely on investment income, including dividends, to fund their retirement. Franking credits can play a crucial role in enhancing the after-tax return on their investments. The ability to receive franking credits as a tax offset or refund can increase the overall income generated from their investments, making a meaningful difference in their retirement income.
•  Lower Marginal Tax Rates: In retirement, individuals often have lower marginal tax rates compared to their working years. Franking credits allow retirees to potentially reduce or eliminate their tax liability on dividend income by offsetting it with the attached franking credits. This can be particularly advantageous for older Australians who have lower income levels and are in lower tax brackets.
•  Dividend-Focused Investments: Older Australians may have a higher proportion of their investment portfolio allocated to dividend-paying stocks or managed funds that distribute franked dividends. By investing in companies that pay franked dividends, retirees can benefit from the imputation credits associated with those dividends, thereby maximizing their investment returns.
•  Stability and Predictability: Retirees often seek stability and predictability in their income streams. Franked dividends and the associated franking credits can provide a more consistent and reliable source of income compared to other investment options. The ability to receive regular dividend payments, along with franking credits, can provide older Australians with a steady income stream to support their living expenses in retirement.
•  Wealth Accumulation: Many older Australians have been investing in companies and accumulating shares over their working years. As a result, they may have built up significant portfolios with a substantial number of franking credits attached to their dividend income. The value of these franking credits can be substantial and can make a considerable difference to their overall wealth and financial position.

It’s important to note that the impact and significance of franking credits can vary depending on an individual’s personal circumstances, including their investment portfolio, tax position, and retirement goals. Some individuals may benefit more from franking credits than others, depending on their specific situation.

Franking credits play a crucial role in the taxation of company profits and dividends in certain countries, such as Australia. They aim to prevent double taxation, promote fairness, and provide tax incentives for shareholders, particularly older Australians who rely on investment income in retirement.

By allowing shareholders to offset their personal income tax liability with the tax already paid by the company, franking credits can enhance retirement income, provide stability, and potentially reduce or eliminate tax liabilities on dividend income. For older Australians, who often have lower marginal tax rates and rely on dividend-focused investments, franking credits can be particularly important in maximizing investment returns and maintaining financial security.

It’s worth noting that the importance of franking credits may differ depending on individual circumstances and the specific tax laws of different countries. Understanding how franking credits work and consulting with financial advisors or tax professionals can help individuals make informed decisions regarding their investments and retirement planning.

Overall, franking credits serve as a mechanism to balance the taxation of company profits and dividends, benefiting both companies and shareholders, while supporting the financial well-being of older Australians and promoting investment in the economy.