Franking Credits & Do you really benefit from it?
By The Accrual World on The Capital
You probably have heard or read about franking credits especially during election times, and perhaps find it complicating and think it is probably just another boring tax policy. As an investor, it is vital for you to understand what it is and if it works in favour for you.
The introduction of franking credit itself traces back to the late 80s under the implementation of imputation tax system, built to avoid double taxation on the same amount of income. Franking credits essentially is the tax paid by a company on its profit which is distributed back to shareholders as a dividend.
The full corporate tax rate in Australia is set at 30%, and let’s use an example of a company with a profit before tax of $ 100. The tax payable on this $ 100 will be $ 30 (100*0.3 = 30). So the net profit after tax will be $ 70. And say the company has 10 shareholders and decides to distribute a fully franked (meaning taxes has been paid on this distribution) dividend to each shareholder at $ 7 per share.
Now to avoid double taxation, this $7 distribution has actually been taxed and should not be taxed at your individual level again. What you will receive in your bank account upon payment date from this company will be $7. However, on this $7 received, it includes a $3 tax credit, which has been paid from the company to the Australian Taxation Office (ATO). And thus, you have a $3 franking credit in your tax account. When you lodge your tax return, you will have to report a taxable income of $10 (grossed up of 7+3), even though you only received $7 in your bank account.
Now depending on your situation and marginal tax rates, I have three different scenarios to play out.
From the table above, we have three individuals with three different tax rates. Note that row B and C remain the same, which is the fully franked dividend paid from the company to the shareholders. Now depending on your income tax rates, franking credits might not necessarily be beneficial from the point of taxation. In the above scenarios, Individual 1 would have an additional $ 3 refund for the dividend income received from the ATO upon lodging his/her tax return. Whereas Individual 2 and 3 will have to fork out additional tax payable on the dividend income, as their marginal tax rates are higher than 30%.
So now if you’ve been following on Australian Labor Party’s 2019 proposed franking credit changes you might have a little clue on what is finally going on. ALP’s proposal is to deny Individual 1 from claiming the $ 3 franking credit refund, on the grounds that the individual has essentially not paid any taxes. Do you think this is fair to Individual 1? Because the proposed tax changes will still allow Individual 2 and 3 to continue claiming the $ 3 franking credits.
Well with the ALP losing its election in 2019 resulting with the Liberals being in charge, we can temporarily have this discussion set aside and revise in future. Taxation should not be the sole reason of your investment decision, but it should be a point of consideration in terms of stock selection.
Now knowing how franking credits work, would you prefer high yield dividend stocks or capital growth stocks?
Some other worthy notes on dividends and franking credits:
- Not all listed companies pay a dividend
- Not all dividends are fully franked
- Some dividends may be partially franked
- Some dividends may be unfranked (no taxes has been paid hence no franking credit)