After a fierce and ultimately fruitless battle over franking credits three years ago, the Labor government earlier this year announced a new, albeit small, change to the controversial taxation system.
The news sparked conversation from both detractors and supporters of franking credits. But for such a fiercely debated topic, there are many Australians who don’t understand how they work at all.
What are franking credits, and who benefits from them?Credit:Dominic Lorrimer
So what are franking credits, and who benefits from them? In short, the credits represent tax that has already been paid by a company on your investment. They relate only to Australian shares, and then only to the portion of profits Australian companies have generated within Australia and paid Australian company tax on.
You use these credits to reduce the tax that you would otherwise be required to pay. Let’s break it down further with an example:
Imagine you own shares in Telstra. Telstra generates all of its profits in Australia and so it pays Australian company tax on anything that it has earned. As a shareholder, you are entitled to a portion of those profits, paid out to you as dividends.
Attached to these dividends will be a franking credit. This is not a cash payment to you, but is a credit used when you do your tax. It reflects the fact that a 30 per cent tax has already been paid on the company profit that is being shared with you via this dividend. Were it not for the franking credit, this income would effectively be taxed twice: once when the company makes the profit, and then again in your hands when it’s received as a dividend.
If your personal tax rate is less than 30 per cent you can actually receive any excess franking credit as a refund.
From this perspective, franking credits appear an obvious and necessary invention, yet Australia is one of the very few countries that have this provision.
Franking credits effectively boost the return you receive from your Australian shares. If you received $1,000 income from your investment property or interest on a term deposit, then you will need to pay your full rate of tax on this income. However, where you receive this same amount of income as a franked dividend, then it will have already had $430 worth of tax paid on it, so you only need to make up the difference between that and your personal tax rate.
In fact, if your personal tax rate is less than 30 per cent you can actually receive any excess franking credit as a refund, something that is quite attractive to retirees in particular, who are often on a zero per cent tax rate. For someone who pays no tax, $1 of a fully franked dividend is equivalent to $1.43 in the hand, once they receive the refund on their franking credit.
Super funds are another big winner from franking credits, given they pay 15 per cent tax in the accumulation phase, and no tax at all in the pension phase. The excess credits they receive beyond their tax rate are effectively an extra dividend.
Interestingly though, for those on the highest marginal tax rate, there’s a slightly better outcome for them if they generate their returns through capital gains due to the 50 per cent capital gains tax discount where you have held the asset for more than a year.
A consequence of franking credits is that Australian companies tend to be quite generous in their dividend payments relative to companies overseas where this provision does not exist. If you contrast Australia with the United States, U.S. companies pay far fewer dividends, averaging about 2 per cent compared to 4 per cent here in Australia. Instead, listed companies in the United States tend to use profits to buy back shares, which means greater returns for those remaining shareholders while avoiding the issue of double taxation.
- Advice given in this article is general in nature and is not intended to influence readers’ decisions about investing or financial products. Investors should always seek their own professional advice that takes into account their own personal circumstances before making any financial decisions.
Paul Benson is a Financial Planner, author, and host of the Financial Autonomy podcast.
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