Dividends & Franking Credits Explained Including Formula
This guide aims to provide a simple plain English answer to some of the more common questions about franking credits.
What are franking credits and why do they exist?
Franking credits represent the taxes paid by a company on earnings that have been distributed as dividends.
So what does that mean for the avid share investor? Dividends are distributed by a company from its after tax earnings. So it receives its revenue, pays its expenses, pays its tax and then pays out its dividends from what is left – its net profit after tax (NPAT).
So you as an individual who receives these dividends because you hold shares in the company are receiving an income that tax has already been paid on. Now you as an individual are separate from the company; you have to pay tax on your income at your marginal rate. The dividends you received are taxable income too and you will have to pay tax on the amount you receive.
'But wait a minute if the company has paid tax on that income already then wouldn’t me paying tax on the income be like the income getting taxed twice?' Yes, that is exactly what would happen; double taxation of the income would occur and this is the system in the US.
Thankfully in Australia though we work under an “imputation system” where a company can distribute its dividends with franking credits equal to the amount of tax it has paid on those earnings. You can get back that tax that has been paid and you will instead pay tax at your own individual tax rate.
Why can’t the company just pay the tax and I receive tax-free dividends?
Well this is because the tax rates for a company and an individual are different. While a company will pay tax at a rate of 30% an individual faces different thresholds and marginal rates of taxation. You can use our online Income Tax Calculator to calculate your income tax.
How do franking credits and dividends actually work?
Let’s look at a calculation example to illustrate how franking credits and dividends work under an imputation system.
In this example a company called Wally’s Widgets earns $100,000 in gross profit for the year. Wally’s pays company tax at a rate of 30% which totals $30,000. This leaves Wally with $70,000 in net profit after tax. Wally’s then distributes all of this $70,000 to its only shareholder John. The dividends have franking credits attached equal to the amount of the tax Wally’s has paid.
John receives his dividends with the franking credits attached. John must add the franking credits onto the cash dividend amount in order to get the total income that should have been received if there were no tax paid by the company. This total amount is called the “grossed-up dividend” and it totals $100,000.
Let's assume John's only source of income is his dividend income. John then has to pay tax at his marginal rate (see marginal rates here) on the $100,000. Using our income tax calculator the amount totals $26,700. However the company has already paid $30,000 in tax so John should actually receive a refund of roughly $3,300.
|Wally's Widgets (Company)||John (Individual)|
|$ ('000s)||$ ('000s)|
|Company Gross Profit||100||Dividends Received||70|
|Tax Payable||-30||Franking Credits||30|
|(Company Tax Rate = 30%)||Taxable Income||100|
|Net Profit After Tax||70|
|Dividends Distributed||70||(Using marginal rates here)
|Franking Credits||30||Franking Credits||30|
|Net Tax Payable||-3.3|
What does “fully franked” mean?
You will often hear the term “fully franked”. Distributions have a franked component and an unfranked component. When the shares are "fully franked" the franked component makes up 100% of the distribution. this describes when you receive 100% of the tax paid on the dividend income as franking credits.
Companies may often not need to pay tax at 30% on its earnings. This is because there are various tax deductions that companies are entitled to claim, including losses made in all previous years. This means that a company does not always pay the full rate of tax on its profits in a particular year.
The result may be that it has not paid enough tax to attach a full tax credit to the whole of the dividend that it pays to shareholders. This means that a tax credit is attached to only part of the dividend which is known as fully franked and the other portion is unfranked. Unfranked dividends are those to which no tax credits apply. This combination is sometimes referred to as partly franked dividends.
Are fully franked shares better than partly franked shares?
The simple answer is yes. Franking credits are a tax offset. They can be used to directly offset the amount of tax you have to pay on your income and can even produce a net refund if you pay tax at a lower rate than the company rate. Also a fully franked share indicates that the dividend is being paid from profits and NOT shareholder capital or borrowed capital. You can increase the rate of return on a share if franking is available.
Free downloadable investment guides
Access our free guides on tax, superannuation and investing, click here to view them.
How do I calculate the franking credits on my dividends?
When you receive your dividend payment the company will notify you of the franking credits attached and should provide you with the “grossed-up” dividend figure.
You could also use this formula to calculate the franking credits on your dividends:
Franking Credits = Dividend * ( 3 / 7) * Franking Percentage
Where the Franking Percentage will vary - with 100% representing fully franked dividends.
You can also use our Franking Credit Calculator below:
Franking Credit Calculator
Is it only companies that pay dividends with franking credits?
Companies are not the only ones that pay dividends with franking credits attached. Trusts may also pay distributions with franking credits attached. This is because trusts may have investments in companies that pay franked dividends. The trust may then distribute the income and franking credits to the unit holders or beneficiaries. For example managed funds and Exchange Traded Funds (ETFs) commonly distribute income to unit holders with franking credits attached. (Check out our Comprehensive ETF Guide for more information).
So how do I account for franking credits and dividends on my tax return?
Ok, so hopefully you have a better understanding of why franking credits exist, how they work, and how they are calculated.
Of course like most people you'd most likely want to know what you need to do to account for dividends and franking credits in your tax return each year. Well, most companies and trusts will send out an Annual Taxation Statement and a Dividend/Distribution Statement to their investors each financial year. They may also send out a Tax Guide for the financial year. These documents contain the relevant info to complete your return.
The Dividend or Distribution Statement is sent following the payment date for the distribution (more info on dividend dates here). It typically states the distribution amount per unit for the period.
Example of info from a Dividend Statement
The following is an example of a Dividend statment from the Commonwealth Bank (CBA) for the final dividend for the year ended 30 June 2008.
|Class Description||Rate per Share||Participating holding||Franked Component||Unfranked Component||Total Amount||Franking Credit||Withholding tax|
Class Description - The type of units or shares held
Rate per unit - The distribution or dividend per share
Participating units - How many shares are eligible for the distribution
Franked Component - The dollar amount of the distribution that is franked
Other Income Component - Income that is not franked
Total Amount - The total distribution before tax
Franking Credits - the franking credits attached.
Dividend statements vary from company to company and trust to trust. Some may not show the franking credits on the statement in which case you can use the formula provided.
Annual Taxation Statement
The distributing entity (i.e. the company or trust) may also provide an Annual Taxation Statement and Tax Guide for the relevant financial year. If provided, these are usually sent around 1-6 weeks after the Dividend Statement. (If you have a self managed superannuation fund you can see an example of how franking credits work in super, read the guide on How franking credits can reduce tax in superannuation.)
The Annual Taxation Statement provides a breakdown of the income that makes up the distribution paid so it will go through items like Australian Income, Foreign Income and Capital Gains. The Franked and unfranked dividend amounts will typically be listed as well as the franking credits for the distribution.
The Tax Guide is a guide written by the distributing entity to help clarify the Annual Taxation Statement and how each item should be treated when filling out your tax return for the financial year.
What about franking credits in superannuation?
As mentioned above franking credits also have a tax impact on your superannuation fund. You can read more about it by going to the Guide on How Franking Credit Reduce Tax in Super.
Do you have an important financial concern? Ask us how we can help you click here to get help.
|Download the Investment Calculator to find out how different investments like shares and property can impact your wealth creation over a projected period of time. Download a Free trial here.|