What is Franking Credit?
Also known as imputation credit, franking credit is an example of a tax credit that enables a company to pass on the tax paid at the corporate level to its stakeholders. The idea behind the tax credit is to help reduce the income tax that needs to be paid on dividends. Alternatively, shareholders can receive franking credits as a tax refund.
Developed in 1987, franking credits are mainly used in the Australian tax system. They were created to eliminate the double taxation imposed on corporate profits. It’s also important to note that for a shareholder to be eligible for franking credit, his or her tax bracket needs to be considered.
How It Works
In most countries, dividends are treated as a form of income. It means that they are usually grouped with other types of incomes to determine their taxable income. Whenever a company earns profits, it must pay tax on this profit. In Australia, the corporate tax is set at 30%.
Before the introduction of franking credits by the Hawke/Keating government, the country’s tax authority used to impose a tax on the company profits, as well as on the dividends paid out to investors. The total dividends are simply the profits left after the corporate tax’s been paid. Essentially, the practice meant that there was double taxation.
However, since the introduction of franking credits, the tax authority imposes a tax on just one front. Therefore, investors who receive dividends are not required to pay additional tax except when their marginal tax rate is higher than the corporate tax paid on the dividends. Even then, an investor only needs to pay the difference between his marginal tax rate and the 30% corporate tax.
Consider an investor whose marginal tax rate is 30%. Since the company already paid a 30% tax on the profits earned, the investor would not incur more tax on his dividends. However, if his marginal rate is 45%, then he will pay the difference, which is 15% (45% – 30%).
On the other hand, if the investor’s tax rate is 0%, then it means he will receive all the franking credits as a refund. In 2000, franking credits were made fully refundable, making them a powerful investment strategy.
How to Calculate Franking Credits
To illustrate the concept of franking credit, check the diagram below:
If a shareholder is receiving a dividend amount of $70 from a company that is incurring 30% tax rate on its profits, then the stakeholder’s franking credit totals to $30 for a grossed-up dividend of $100.
The formula for calculating the credits is:
Franking Credit = (Amount of Dividend/ (1 – Tax Rate on Company Profits)) – Amount of Dividend
Using the figures given above:
Franking Credit = ($70/ (1 – 30%)) – $70 = $30
In other words, apart from the dividend amount of $70, each shareholder is also entitled to $30 franking credits, which sums up to a total assessable income of $100. However, as mentioned earlier, an individual’s marginal tax rate needs to be considered to determine whether they’ll receive the credits as a tax refund or whether they’ll pay an additional tax to the Australian Taxation Office (ATO).
Holding Period Rule
Obviously, investors were very pleased after the introduction of franked credits. However, the tax authority wasn’t too happy about that. So, to prevent investors from taking advantage of franked dividends, the ATO came up with conditions that needs to be fulfilled before one can offset their tax using franking credits.
One such condition that every investor should familiarize himself with is the holding period rule. It states that:
- Taxpayers need to hold “at risk” shares for a minimum period of 45 days (this is exclusive of the days of purchase or sale, so, in effect, it is a 47-day holding period).
Franking credit is a tax credit used in Australia and other nations used to eliminate double taxation. Under this system, the Australian Tax Office takes into account that companies pay tax on their profits, and thus there’s no need to tax shareholders’ dividends. The after-profit tax is transferred to investors using imputation or franking credits; hence, reducing their tax liability.
However, investors need to consider their marginal tax rate to determine if they are eligible for `tax credits. They also must hold shares at risk for 45 days or more, so they can be allowed to take advantage of franking credits.
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