Most investors have heard the term ‘franking credits’ (sometimes known as ‘imputation credits’). But you know what the term means?

A franking credit is sometimes attached to dividends that shareholders receive from companies. The credit exists where the company issuing the dividend has already paid tax on the income used to fund the dividend.

Franking credits are part of Australia’s dividend imputation system. This system is designed to prevent company profits from effectively being taxed twice: once at the company level and then again in the hands of the individual shareholder when they receive a dividend. The simplest way to understand is often to use an example.

Let’s assume a company has made profit of $100,000. We will assume that the company is large enough such that its tax rate is 30%. This means that the company must pay $30,000 of tax on its profit.Once the tax is paid, the company has $70,000 left. For simplicity, we will assume that the company has 1000 equal shareholders and has not retained profits from previous years. It decides to distribute the $70,000 cash that its holding to its shareholders.

Each shareholder receives $70 in cash. They also receive a franking credit of $30.

When the shareholder comes to complete their own tax return, they add both the $70 in cash and the $30 franking credit to their taxable income. Thus, their taxable income increases by $100. This $100 is then taxed at the shareholders marginal tax rate.

Shareholder A is a super fund. It has a flat marginal tax rate of 15%. Therefore, the $100 gives rise to $15 in tax payable by the fund.

Shareholder B is an individual with a high employment income. She has marginal tax rate of 47%. In her case, the $100 gives rise to $47 of tax payable.

Shareholder A owes the tax office $15. However, Shareholder A is also holding a $30 franking credit for tax that has all ready been paid to the tax office by the company. So, what actually happens is that the tax office refunds $15 to Shareholder A. This is the $30 in tax paid by the company minus the $15 in tax payable by shareholder A.

Shareholder B owes the tax office $47. Shareholder B is also holding a $30 franking credit for tax that has already been paid to the tax office by the company. In this case, Shareholder B must pay an additional $17 to the tax office.

Hopefully, from these examples, you can see that the actual amount of tax payable on a company dividend depends on the marginal tax rate of the shareholder. If the shareholders marginal tax rate is 15%, then the portion of company profits that flow to that shareholder is taxed at just 15%. If the shareholders marginal tax rate is 47%, then the portion of company profits that flow to that shareholder is taxed at 47%.

In this way, profits are not taxed twice. They are only taxed once – but the tax rate that applies is the tax rate of the shareholder, not the company.

Because of this, we often see people with relatively low taxable incomes, such as self-funded retirees, prefer to invest in shares that pay franked dividends (the term used when a dividend comes with franking credits attached). Their investment income is basically supplemented by the return of tax that was paid at the company level before dividends were paid out.

Franking credits can be complicated beasts. We urge you to seek professional tax advice for any issue to do with Australia’s franking credit system.