A See-Through The Franking Credits!

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Australian Economy, Macro Economics

Australia’s dividend imputation system was introduced in late 1980s by Hawke/Keating Government as part of a broad range of income tax reforms and this touched upon the nesting of ‘Franking credit’, which is a type of tax credit representing taxes paid on profits by companies being passed to investors. The franking credit is thus interchangeably referred to as ‘Imputation credit’. The core significance of this is built on the aspect to avert any double taxation of company profit as the tax paid at the company level and when passed on to the shareholders. Mathematically, the franking credits are evaluated using the below formula:

Franking Credits = (Dividend Amount / (1-Company Tax Rate)) – Dividend Amount

It is now clear that companies can either retain their profits for business expansion or pay a portion of the profit as a dividend to shareholders; and when they intend to pay dividends with franking credits, the shareholders’ total assessable income or grossed up dividend soars up. The shareholders’ marginal tax rate will determine if they receive franking credits refund from the Australian Taxation Office otherwise they have to pay additional tax on this dividend based on their taxable bracket. On the other hand, dividends without franking credits are alluded to as unfranked dividends. These cannot be grossed up and subsequently, the tax payable in the shareholders’ hands is calculated by applying the marginal tax rate to the dividend they receive without any adjustment.

To get a better idea of franking credit or imputation system, let’s look at the below hypothetical example: Company A decides to pay fully franked dividend of about $350 to a shareholder, then the franking credit comes to about $150, which is the tax already paid by the company with the company tax rate in Australia as 30%. In such a case, the shareholder will declare the income as $500 and with a marginal tax rate of 15%, would pay tax of $75 and subtracting this from $150 tax paid by the company, the shareholder will receive a refund of $75.

Remember, the refund will be applicable when the total imputation credits surpass basic income tax liability for the year. If investors want to lodge an income tax return, then they can claim refund of excess imputation credits.

The below table shows comparison of S&P/ASX Accumulation Index performance before and after franking. Over time, franking credits have led to significant impact on returns especially for tax-exempted investors i.e., pensioners.

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Australian Shares Performance before and after franking (Source: S&P Dow Jones)

It is to be thus understood that a shareholder who does not pay any tax, an individual or a pension fund, makes money by refunding the excess franking credits and government in return does not receive any tax revenue from the earnings. However, the shareholder benefits from the scenario. Looking at this only, the Labor party has now flagged to ban the dividend rebate, if it comes into force through the next federal election. Though the development is debatable and yet to find grounds, the franking credits do benefit shareholders in terms of good income stream.


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