Companies are required to pay taxes on their profits at the marginal tax rate of 30 per cent. If they paid taxes before paying dividends, the paid tax value may be passed on to shareholders in the form of franking credits. Individual shareholders could, in turn, apply the franked amount to their tax payable when filing their tax return.
If that still seems a little confusing, here’s a quick discussion about what franking credits are, how it works and how to apply it to tax returns.
What are franking credits?
Franking credits are taxes that a company has already paid on its profits before distributing it as dividend payout.
Companies can pay out fully franked or partially franked dividends to their shareholders, since corporate entities may also pay taxes using tax loss claims and other methods. The main difference between fully and partially franked dividends is that shareholders benefit from the full 30 per cent company paid tax on fully franked dividends while having partially franked dividends means shareholders can only claim a tax offset for the franked portion of the dividends.
Since dividends also form part of an individual’s income and must be included in the tax return, franking credits could lower the individual’s tax obligation for the year. In some cases, they may also claim a refund. This is why it is important for a shareholder to understand their dividend statement to know how much franking credits they can benefit from.
How do franking credits work?
As mentioned earlier, investors in some countries experience double taxation on their dividends because they are subjected to tax at the corporate level. Then they are still subject to taxes at the individual’s marginal tax rate upon receipt.
The example below illustrates how an investor who is due to receive a $10 gross dividend can benefit from the imputation system. Assuming that the shareholder has a marginal tax rate of 30 per cent:
Without franking credits: The company’s 30 per cent marginal tax rate is applied to the dividend, leaving $7 to be paid out to the investor. Once the shareholder receives the taxed dividend, the $7 is further taxed at their marginal tax rate, leaving only $4.9 to the investor.
With franking credits: The company pays 30 per cent tax on the $10 dividend, then gives the shareholder $7 in dividend and $3 worth of franking credits. The shareholder will indicate this information in their tax return. Since the 30 per cent tax on the dividend has already been paid by the company, the shareholder is exempt from paying tax on the $7.
The issued franking credits saved the shareholder an extra $2.1 to take home or reinvest.
Now consider the benefits of franking credits to shareholders with different tax rates.
Tax-free individuals: Australian residents (for tax purposes) with incomes up to $18,200 are exempt from paying tax for financial year 2017-2018. This means they can get the full dividend amount if they apply for a refund on the franking credits.
Lower marginal tax rate: If an individual has a tax rate lower than 30 per cent, they can do either of the 2 things:
- Apply for a refund on the difference between 30 per cent and their own tax rate; or,
- Apply the excess franking credits to their income tax payable, if any.
Higher marginal tax rate: High-income earners benefit from less tax payable with franking credits because they only pay the difference in tax rates. For instance, an individual with a 40 per cent tax rate would only have to pay the 10 per cent difference in taxes. This is highly beneficial compared to countries that don’t apply an imputation system.
Am I eligible to apply franking credits?
All Australian residents for tax purposes are eligible to apply franking credits to their tax returns. Individuals who receive franked dividends from investments via managed funds and trusts may also apply franking credits.
To be eligible for a refund, they must:
- Not be required to lodge a tax return (tax-free individuals);
- Be an Australian resident for tax purposes for the whole income year;
- Have a total dividend income less than $18,200 or $416 for individuals under 18 years of age on June 30 of the applicable income year;
- Have been issued a dividend statement indicating Australian franking credits;
- Have dividend amounts withheld for not providing their Tax File Number (TFN); and,
- Not claiming a refund for a deceased estate.
Tax offsets and refunds from franking credits should be reflected in the individual’s tax return statement. Those who are not required to lodge a tax return may still claim a refund using the separate ‘application for refund of franking credits’ form available in the Australian Taxation Office (ATO) website—if they pass the eligibility requirements.
Note that only franking credits from domestic Australian companies and some New Zealand companies may be applied. New Zealand companies must also specify that the franking credit is Australian, because New Zealand franking credits may not be applied in Australia.
There are also two strict conditions that ATO implements to prohibit investors from taking advantage of tax offsets from franking credits: the holding period rule and the related payments rule.
Holding period rule requires investors to own the dividend-paying shares ‘at risk’ for a total of 47 days, or 92 days for preference shares, including the date of purchase and disposal. This rule applies to dividend incomes greater than or equal to $5,000.
Related payments rule applies when the individual is under obligation to, or will most likely, make a related payment that would pass on the franking credits to someone else.
Where can I apply franking credits?
Here’s the good news: individuals who receive franking credits may apply it to any income tax liability to decrease or bring it down to zero.
There are actually two ways individuals benefit from franking credits, and they may apply either of the two:
- Refund the franking credit amount; or,
- Use the credits to offset other tax liabilities.
Franking credits do not expire and may be used to offset tax liability in future tax returns.
However, ATO requires that these credits must be used once at the earliest possible opportunity. That is, if franking credits may already be used in the 2017 tax return, the individual may not save it for their 2018 tax return.
Franking credits as tax losses
If the franking credits exceed the income year’s tax liability, individuals, companies and other entities may turn franking credits to losses. Unlike capital loss which may only be applied to capital gain; however, a tax loss may be applied to any income.
An individual or entity may keep the tax loss as long as they exist without changing ownership of the source of franking credits, but if a tax liability presents itself in two years, they must use the tax loss.
On the other hand, companies should pass the same business test as indicated in Taxation Ruling 1999/9. Otherwise, it has to work out the taxable income and tax loss following subdivision 165-B of the Income Tax Assessment Act (ITAA) 1997.
Companies, organisations and trusts are subject to legislation and additional restrictions from the government that may limit their claims for tax loss and the application of tax offsets would depend upon the type and structure of the entity.
This information has been sourced from the Australian Taxation Office and Australian Investors Association.