Investors adore them and politicians argue over during election time – franking credits have been a mainstay of the Australian taxation system since 1987. Yet, there continues to be an air of confusion surrounding the treatment of franking credits received from franked dividends, and the impact on an individual’s personal income.
Dividend imputation was introduced in the 80s to end the double taxation of company profits. Under this new system, tax paid by companies was attributed or “imputed” to investors. Australia was the first country to introduce a dividend imputation regime.
As we should now know, dividends are a portion of the earnings of a business issued to reward its shareholders. Since a dividend is a form of income by the Australian Taxation Office (ATO), you would normally pay tax on it as you would on your hard-earned salary.
This is where franking credits enter the picture.
What are franking credits?
An easy way to think about franking credits is to class it as some sort of compensation from the ATO for double-dipping in tax payments, where tax has already been deducted once.
Dividends are received from earnings already taxed by the ATO, which currently stands at 30%. This means that shareholders earn a discount on earnings distributed as dividends for the tax paid by the company.
This is called ‘franked’ dividends. Franked dividends are entitled to a franking credit representing the amount of tax already paid by the corporation. Franking credits are often referred to as imputation credits.
For any tax paid by a company, a shareholder is entitled to a credit for that amount. The ATO will refund you the difference if your tax rate exceeds the tax rate of the company.
The “45-Day Rule”
Be mindful that when establishing your eligibility for franking credits, individuals that obtain franked distributions frequently fail to comply with the ‘holding period rule.’ In order to qualify for the franking tax offset, the holding period law requires you to keep your shares ‘at risk’ continuously for at least 45 days (90 days for some preferential shares).
One vital aspect is that when assessing eligibility for franking credits, taxpayers often misapply the “small shareholder exonerations” to groups other than persons. The holding term rule shall not apply if your total franking credit entitlement is below $5,000, according to the small shareholder exemption.
Furthermore, investors often neglect to update their unit cost base for earned tax-deferred distributions within a Unit Trust or Managed Fund.
What are the laws governing franking credits and ordinary income?
As per the Income Tax Assessment Act 1997 (Cth) (ITAA97), franking credits constitute “assessable income (statutory income)” under Section 6.10 of the ITAA97.
Franking credits do not fall under the legal definition of “ordinary income” under Section 6.5 of the ITAA97, which typically income received from “direct or indirect sources” such as wages for individuals.
How do franking credits impact my tax?
Surplus franking tax offsets of those individuals and superannuation funds are generally refundable.
It ultimately comes down to the marginal tax rate and the dividend franking rate. You may gain any of the franking credits back as a refund if the dividend is completely franked and the marginal tax rate is below 30% (or all of them back if your tax rate is 0%).
You may need to pay extra tax on your dividend if your marginal tax rate is over 30%.
Since dividend payments are a source of revenue, when you file your tax return, you will need to include these in your overall taxable income. However, you may not be required to pay a lot of tax on your dividends due to the franking credit system in Australia (or any at all).
A shareholder counts both the dividend and franking credits as income when measuring assessable revenue, but the franking credits may be used to decrease the overall tax due. If the shareholder has any available franking credits and no further taxes to pay, the franking credits can be returned to the shareholder as a tax refund.
Please note: The information contained is general and does not constitute legal, taxation, or financial advice specific to your circumstances. For details about franking credits and the effect of your tax, consult with your accountant or tax advisor.
Trust the system – for now…
With the current operation of the scheme, a shareholder is able to use the franking credit to potentially reduce their own tax or obtain a refund if no tax is payable. In other words, either paying your tax with a refund or enjoying it is as good as cash. This is why you are expected to count franking credit as part of your personal, taxable income.
It is also worth bearing in mind that the legislation on the reimbursement of excess franking credits is periodically reviewed. It is always a good idea to check in with the ATO’s website to stay up to date with the new regulations on company tax rates and franking credits.
