What is Franking Credit and why is it important?

By | March 19, 2016

What you need to know about franking credits - dividends down under blog

Author: Mr DDU.

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What is Franking Credit?

Franking credit is all about tax; most of the time tax is bad, but this type of tax is good. Essentially, a franking credit is a refund of the company’s tax given back to the individual (you) to avoid double taxation.

How Franking Credit Works:

Let me introduce you to the company ABC Ltd and my best friend, Joe Bloggs. Joe Bloggs doesn’t have any income but is the sole shareholder in ABC Ltd, ABC Ltd has made a net profit of $100 (keeping it small for easy sake).

Australia’s company tax rate is 30%, so on $100 profit ABC Ltd would pay $30 in tax, leaving $70 of Net Profit After Tax (NPAT). If ABC Ltd then paid all profits as a dividend to Joe Bloggs, meaning a $70 dividend, Joe would then be receiving $70 as personal income in his hands.

In most countries that $70 would be what’s declared on Joe’s tax return and if he had enough income to be in a taxable income bracket, he would pay tax on that dividend too. So by the time it fully reached his hands, it might only be a $50 after-tax dividend or even less, on $100 profit.

Not so in Australia. It’s the same process where the company does its tax return and pays the 30% tax, but in addition, ABC Ltd keeps a track of all the income tax it pays in an account called a franking credit account.

ABC Ltd gives Joe the $70 dividend, with the $30 franking credits attached (but doesn’t receive the credit until he does his tax return). In Joe’s tax return he declares $70 dividend income and the $30 franking credit, which also counts as income, so he has $100 income in total. But the great thing is, as Joe hasn’t earned any other income (you can earn $18,200 income tax free in Australia), the franking credit is refunded to Joe. Joe will receive a $30 refund from his tax return.

If we made these examples 100x bigger, it’s still the same deal. ABC Ltd makes $10,000 profit, then pays $3,000 tax. ABC Ltd gives Joe a $7,000 dividend with franking credits attached. On Joe’s tax return he declares the $7,000 dividend and $3,000 tax, totalling $10,000. As his income is still under the tax free $18,200 amount, he gets a $3,000 tax return refund.

Very powerful stuff, right? A lot of retirees find themselves in that position, their income is less than $18,200 and they get all the franking credits refunded to them each year on their tax returns. But what about people who have jobs and pay tax? It’s the same concept of a tax credit, but it reduces the taxes owed.

The below rates include the 2% medicare levy and 2% budget repair levy where applicable:

$0 – $18,200 is 0% tax rate

$18,201 – $37,000 is 21% tax rate

$37,001 – $80,000 is 34.5%tax rate

$80,001 – $180,000 is 39% tax rate

$180,000+ is 49% tax rate

So let’s see how the franking credit works for the different rates:

Franking credit table

“Tax payable without franking” means what would happen in other countries without the effect of franking credits.

As you can see, every single tax rate is better off because of franking credits, just not as good for the higher tax rates.

 

So how does that affect the dividend yield? Well, it basically increases it by a half, by adding the 30% franking credit. A 5% yield becomes 7.14%, a 4% yield becomes 5.7%, a 3% yield becomes 4.2% and a 2% yield becomes 2.85%. It really improves the yield, at no disadvantage to the company.

 

There are a number of caveats to franking credits, as not every dividend has franking credits. I’ll name a few:

Firstly, only Australian profits can generate franking credits, as they’re created from the Australian tax return. That’s why Altium (ASX:ALU) probably won’t ever pay franking credits.

Secondly, businesses that run as trusts don’t generate franking credits because they don’t pay tax, they just distribute the profit onto the owning company / individual. Real Estate Investment Trusts, such as Westfield (ASX:WFD), are good examples of that (But a trust that receives a franked dividend can pass those franking credits on).

Thirdly, a company may just want to pay an unfranked or partially franked dividend. This could happen if the company’s franking account doesn’t have enough credits or a company that has made a loss (and doesn’t pay tax) still wants to declare a dividend.

I hope that gives you a bit of an insight into franking credits and its unique position in Australian investing.

 

Thanks for reading this article about our investing journey Down Under.

Onwards and upwards!

13 thoughts on “What is Franking Credit and why is it important?

  1. adela putri

    great post as usual. i am an avid reader and was reviewing similar stocks in the last couple months. so your insights on challenger, altium and suncorp were very much appreciated.

    cheers from melbourne
    -Adela-

    1. Dividends Down Under Post author

      Hey Adela,

      Thanks for your comment and support. We’re really glad you enjoyed our posts on the companies you mentioned. It’s great to hear you’re an avid reader, hopefully you like reading our articles for years to come 🙂

  2. liveoffmydividends

    DDU,
    Thanks for sharing. That was an interesting post! I just found your website. Keep up the great posts! Nice goals btw.
    Take care
    LOMD

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