Question: What’s the deal with franking credits?
Kyle’s answer:
Australian dividends are often “franked” which means they come attached with a “franking credit”. This comes about as the company has already paid tax on the profit they’ve earned to pay the dividend so the Government recognises this and is a way to avoid you paying tax twice.
Let’s say you own a share of a company that has a profit of $100 and it plans to pay out all of its profit after tax. As companies are taxed at 30%, the company pays tax of $30 so now has $70 to pay as a dividend.
Now let’s assume you have a “marginal tax rate” of 34.5%. If franking didn’t exist, you would now pay tax of 34.5% on this $70 ($24.15) meaning the Government has essentially received $54.15 on the $100 and you only have $45.85 left.
That doesn’t seem fair!
Luckily franking does exist, and the Government essentially ignores that the company paid tax and taxes the profit at the individual investor’s tax rate. So the Government should receive tax of $34.50 (34.5%) and the investor be left with $65.50.
So how does this work in practice?
Dividend received = $70
Grossed up dividend/taxable income = $100 ($70 / .7) – the 0.7 comes about from 100% minus the company tax rate of 30%
Franking credit/tax offset = $30 – grossed up dividend minus dividend received
Marginal tax rate – 34.5%
The $100 is added to the investor’s income and taxed at 34.5% meaning they have $34.50 tax payable however due to the franking credit they have a tax offset of $30 which reduces their tax payable so they only owe tax of $4.50 ($34.50 – $30).
So the investor has received $70 in cash from the dividend and only owes $4.50 in tax, leaving him or her with $65.50. Nice!
Franking credits are in the news all of the time at the moment as Labor is proposing to ban franking credit refunds. I summarised all of Labor’s proposed changes here.
Refunds will only come about if your marginal tax rate is less than 30%, for example, a retiree with lower income or super fund. I’ll cover this in detail on another day however the proposal effectively puts a minimum 30% tax (received by the Government) on all company profits.
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