Franking credits are a tax credit system used primarily in Australia that prevents profits made by companies from being taxed twice: once at the company level and again when those profits are distributed to shareholders as dividends. These credits represent the tax a company has already paid on its profits before distributing dividends. When shareholders receive dividends with franking credits attached, they can use these credits to reduce their personal income tax liability. If the credits exceed the tax owed, shareholders might even receive a refund. This system enhances the value of dividend income, especially for lower-income investors and retirees, by avoiding double taxation and potentially increasing after-tax income from dividend-paying shares.
How Franking Credits Work
- A company earns a profit and pays company tax (usually 30% in Australia).
- It distributes the remaining profit as dividends to shareholders.
- Dividends come with franking credits that reflect the tax already paid by the company.
- Shareholders include the total of dividends plus franking credits in their income tax returns and use the credits to offset their tax liability.
- If the shareholder’s tax rate is lower than the company tax rate, excess credits could result in a refund.
Example
If a company makes a profit of $2.14 per share and pays 30% tax ($0.64), the net profit of $1.50 is paid to shareholders as a dividend. The $0.64 tax paid becomes the franking credit attached to that dividend. Shareholders add both the dividend and the credit to their taxable income but subtract the franking credit when calculating the tax they owe, thus preventing double taxation.
Benefits
- Prevents double taxation on company profits.
- Can reduce or eliminate personal income tax on dividends.
- Potentially provides tax refunds if franking credits exceed tax payable.
- Makes dividend income more valuable for shareholders, especially retirees and low-income earners.
Franking credits represent a key feature of Australia's dividend imputation tax system, ensuring fairness in how company profits are taxed when distributed to investors.
