What are franking credits and how do they work?

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What are franking credits and how do they work?

So what are franking credits? You might also see them referred to as imputation credits. These are the same thing.

These credits represent tax that has been paid on your investment. They relate only to Australian shares, and then only to the portion of profits that those Australian companies have generated within Australia and paid Australian company tax on. You use these credits to reduce the tax that you would otherwise be required to pay.

Franking Credit Example

Let’s imagine you own shares in Telstra. Telstra generates all of its profits in Australia and will have paid Australian company tax on anything it has earned. As a shareholder you are entitled to a portion of those profits, paid out to you as dividends. Attached to these dividends will be a franking credit. This is not a cash payment to you, but is a credit used when you do your tax. It reflects the fact that 30% tax has already been paid on the company profit that is being shared out to you via this dividend. Were it not for the franking credit, this income would effectively be taxed twice, once when the company makes the profit, and then again in your hands when it’s received as a dividend. From this perspective, franking credits would seem to be quite obvious and necessary, yet Australia is one of the very few countries that have this provision.

Now likely, you don’t own individual Telstra shares but instead own them through a fund. That’s no problem at all, the funds simply tally up all of the franking credits that they receive and these flow through to you as an investor. You receive a tax statement at the end of the year detailing your credit entitlement.

A consequence of franking credits is that Australian companies tend to be quite generous in their dividend payments relative to companies overseas where this provision does not exist. If you contrast Australia with the United States, U.S. companies pay far less dividends, averaging about 2%, compared to 4% here in Australia. Instead listed companies in the United States tend to use profits to buy back shares, which means greater returns for those remaining shareholders and avoids the issue of double taxation.

Franking credits effectively boost the return you receive from your Australian shares. If you received $1,000 income from your investment property or interest on a term deposit, then you will need to pay your full rate of tax on this income. However where you receive this same amount of income as a franked dividend, then it will have already had $430 worth of tax paid on it, so that you only need to make up the difference between that and your personal tax rate. In fact if your personal tax rate is less than 30% you can actually receive an excess franking credit as a refund, something that can be quite attractive to retirees in particular, who are on a 0% tax rate. For someone who pays no tax, $1 of fully franked dividend is equivalent to $1.43 in the hand, once they receive the refund on their franking credit.

Super funds are another big winner from franking credits, given they pay 15% tax in the accumulation phase, and no tax at all in the pension phase. The excess credits they receive beyond their tax rate are effectively an extra a bit of dividend, very handy.

Interestingly though, for those on the highest marginal tax rate there’s actually a slightly better outcome for them if they generate their returns through capital gains due to the 50% capital gains tax discount where you have held the asset for more than a year.

This difference in outcome highlights the importance of customised financial plans. In some circumstances you want a portfolio that favours franked dividends but in other cases a bias towards capital growth is more appropriate. And of course you don’t make all your portfolio construction decisions based entirely on tax either.

In part because of franking credits, you may stumble across a strategy called dividend stripping. This is where you buy shares and hold them for a relatively short period of time, just long enough to collect the dividend, then on-sell them and redeploy your cash into some other company that is close to paying a dividend. Note that in order to be entitled to the associated franking credit from such a dividend, the tax office requires that you have held the shares for at least 45 days. This sort of short term trading is certainly not a strategy that we would recommend, but I thought I’d mention it in case you see it crop up elsewhere.

Franking credits are an important element of return on Australian shares and so I certainly something worth understanding. Hopefully this week’s episode has brought you up to speed.

 

I was recently looking at the download numbers for our various toolkits. The most popular is our Pathways Self Assessment, which you can download from the Financial Autonomy home page. The other is our Investing – Getting Started download. You can find that on the “Learn” page of the web site – there’s several other downloads in their too.

 

 

Further information:

  • ATO
  • There’s a good video here from Plato Investment Management
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