Franked Dividends, Franking Credits and the Dividend Imputation System Explained
Companies reward shareholders by paying dividends out of after tax profit. In Australia, prior to 1987, dividends were also taxable in the hands of shareholders. In effect share dividends were taxed twice. Firstly, when the profit was earned by the company and secondly, when the dividend was distributed to the shareholders. This represented a disincentive to share ownership and was a barrier to national savings.
What is the dividend imputation system?
The dividend imputation system was introduced by the Hawke/Keating government in 1987 as one of a number of major economic initiatives to increase national savings.
With the introduction of the dividend imputation system, investors are credited for tax already paid on the dividends they recieve. Dividends are now only be taxed the difference between the companies tax rate (ususally 30%) and their own marginal tax rate. So if an individual’s tax rate is 30% then they will not have to pay tax on the dividends, i.e. the dividend is tax free. If the marginal tax rate is above 30%, say 46.5%, then they will pay the difference, 16.5%. Since 2000, franking credits have become fully refundable. For example let’s assume the individual didn’t earn any taxable income for a particular year, if they received a franked dividend of $700, then not only is the dividend tax free, they will also receive a franking credit refund of $300 from the Australian Tax Office which represents the tax that the dividend issuing company has paid on profits that fund the dividend. Hence the value of a franked dividend to the share holder can be upto $1000 if the shareholder is on a zero marginal tax rate.
Franking Credits Explained
The dividend imputation system allows investors who have been paid a dividend to receive a personal tax credit (franking credit) for the tax that the company has already paid in earning the profit behind on this dividend. The corporate tax rate for companies with revenue greater than A$50 million is 30%. Small companies have a lower tax rate of 26% in 2020/21 (falling to 25% in 2021/22).
As an example, lets say company XYZ makes $1.00 profit. Company XYZ is required to pay corporate tax at the rate of 30% on this $1 profit. So if a company is paying franked dividends then the 30% that has already been taxed ($0.30) can be used to offset an individuals taxable income in the form of a franking credit.
How does the franking credit system work?
To explain with an example, assume again that company XYZ makes $1.00 profit and is required to pay corporate tax at the rate of 30%. The tax $0.30 (30% of $1) will be paid to the tax office and the company then records this $0.30 into their franking account. The franking account is only a record of what was paid and does not contain actual money. As the company pays franked dividends it debits its franking account. The company’s ability to pay franked dividends depends on the balance of the franking account. If the franking credit contains a surplus, the company may continue to declare fully franked dividends. If the franking account isn’t large enough, perhaps because it pays tax primarily overseas and not in Australia, or the company has made loss for one or more years, then the company may declare a partially franked dividend. If the franking account is zero then any dividends our XYZ company pays will be unfranked.
But how can a company pay a dividend if it makes no profit? It is possible for a company to continue to pay a dividend, even when it had made one or more reporting period losses by tapping into their cash reserves. Of course this is not sustainable and the company’s operations and dividend policy would come under watch from lenders, shareholders, analysts and possbly authorities.
Unfranked dividends are treated entirely as income by the tax department. This income is taxed at the marginal tax rate, similar to the way interest payments are taxed. Hence it is always in the shareholders best interest to receive fully franked dividends in preference to partly franked or unfranked dividends.