Franking credits are a tax credit as result of company paying tax on its earning which is then passed on to the companies owners (investors). Under the Australia imputation tax systems, companies can pass on the taxable income to their shareholders which will limit the extent of double taxation.
Double taxation in this case is the tax of dividends which are an after tax cashflow from investments. Dividends attached with franking credits are called franked dividends.
Essentially investors only pay income once either at the company level if the earnings of the company is retained to fund future growth or on the individual level if the earnings are passed on to shareholders.
This limit the extent of companies hoarding cash and elevate the level of dividend payout as seen the dividend yields of some of the largest companies in the ASX 20 Index and strong cashflow businesses like the Big Four banks.
Dividends passed on from trusts or Exchange Traded Fund does not contain franking credit if no taxes were paid by the fund. Dividends without any franking credit are called unfranked dividends.
Only Australian taxpayers benefit from using franking credit in franked dividends when individuals file their tax returns.
Franking Credit from Investment Income
Preference shares are a form of hybrid investment which sits in between debt and equity. Australia banks preference shares comprise the largest segment of the market. The holding rule for preference shares are more onerous where it is required for investors to hold the investment for more than 90 days to qualify for the franking credit.
Superannuation Franking Credits
Income is not taxed on superannuation investment. This means that dividend income that include significant franking credits can be attractive for superannuation funds. The imputation credit is claimed and refunded by the ATO when the tax return is submitted. Effective, the real dividend yield is equivalent to [dividend / (1-tax)].
Income from listed trust structure like Australian Real Estate Investment Trust are called distributions not dividends. These investment vehicles are essentially passive investments where the trust simply collects the income and passing it on the unit holder.
Income is is not taxed at the trust level, hence it is atypical that distributions from listed trusts included franking credits. The exception being it is a staple trust which every share of the REIT is stapled with a trading corporation.
Franking credits are the result tax paid on income from development or active management of real estate assets. Examples of staple securities included Mirvac (ASX MGR) and Stockland.
Franking Credit Formula
Franking Credits= Dividend x (30/70)
Franked Dividend Example
- Investor owns 100 shares in an Australian Company. The company pays $1 dividend per share.
- Income from the company amounts to $100 with franking credits of $100 x (30/70) = $42.85
- The above makes the total income at $100 with imputation benefit of $42.85.
Implication for investors with the above franked dividend income stream:
- Individuals with expected zero liability will receive $42.85 back from ATO following filing taxes as any taxes already paid is refunded.
- Individuals with 15% tax rate will receive half of the imputation benefit $21.42 as the whole income is taxed at 15%.
- Individuals at 30% tax bracket will keep the $100 in income with no additional tax obligations
- Individuals at the highest bracket 45% with pay additional 15% on top of the imputation credit embedded in the dividend received
The above example applies if the dividend is fully franked or at 100% basis.
In the case of partial franking credits attached to the divided. The franking portion is simply percentage times the franked amount.
You can use the above franking credit calculator to find the value of the franking credit attached various dividend amounts.
45 Day Holding Rule
To qualify the benefit of franked dividends investors must meet the 45 holding rule outlined by the ATO. The rule states that Individuals must maintain ownership or at risk for 45 days. The dates are not inclusive of the purchase and sale dates.
Additionally if any sale occurs over the period after the dividend has been paid. Investors must maintain more than 30% overall ownership of the original holding.
Small Investors Exemption
Smaller investors are exempt from this rule where over a financial year, total franking credits does not exceed $5000 which is equivalent to $11,666 fully franked dividend amount.