What is a franked dividend and what does it mean to have a franking credit?
Obviously there are advantages in receiving dividends from your share investments, but there is a huge difference between getting dividends that are franked and dividends that are not franked.
But first, let’s start with some basics and talk about the difference between unfranked dividends and franked dividends (two types of dividends).
When you buy shares in a company, you buy a small percentage of ownership in the company and this makes you a “shareholder.”
As a shareholder, you get a portion of the profit of the company paid to you called “dividends.” The amount of dividends paid to you depends on the number of shares you own and how much is paid depends on the company’s profits.
Some companies pay no dividends and they invest all their profits back into growing the business. With these types of companies, your benefit is capital growth and share price growth rather than dividends
Companies that pay no dividends tend to be younger businesses looking to grow their businesses by reinvesting their profits rather than paying it out to the shareholders in the form of dividends and companies that pay dividends tend to be more mature and have stable cash flows.
Generally, dividends are paid to shareholders after tax has been paid by the company, but not all dividends are fully franked or are paid on profits that have been taxed.
The reason is because some portion of the profit of the company may not attract tax, the profit is distributed to shareholders as untaxed dividends or as unfranked dividends.
Unfranked dividends do not have franking credits, which means that if you get an unfranked dividend, that will add onto your taxable income and you have to pay tax on it.
Dividends paid by a company on after-tax-profits are called “fully franked”. Fully franked dividends are dividends with “franking credits” attached because the company has already paid tax on the income.
Tax paid by companies is tax paid on the dividends that belong to the shareholders. In other words, shareholders get a personal tax credit from the tax paid by the company on their behalf (franking credits), which they can use when completing their tax returns with the ATO.
How Do Franking Credits Work?
Unlike other parts of the world, in Australia, income tax paid by companies at, say 30% of their annual profit is paid on behalf of the shareholder, similar to the way PAYG is withheld from your wages and sent to the ATO.
The remaining 70% is then paid as a Franked Dividend to shareholders and the 30% tax that was paid by the company is passed to the shareholder as well. So a fully franked dividend will already include the 30% tax paid by the company on your behalf.
Example, if you receive a $100 Franked Dividend you will also deem to have received $42.85 in tax credits (at 30%), so you declare $142.85 in your tax return because $42.85 in tax (30%) has already been sent off on your behalf by the company to the ATO.
If your personal tax rate is only 20% ($142.85 x 20% = $28.57) and the company has deducted 30% tax ($42.85) from your dividends then when you lodge your tax returns you will get a refund back from the ATO of 10% ($42.85 less $28.57 = $14.28 refund).
Further if you were receiving a Franked Dividend of 5% and the company tax rate is at 30%, it actually equates to a Grossed up Return of 7.14% (5% divided by 70%) or if your Franked Dividend was 8% then that equates to a Grossed Up Dividend of 11.43% (8% divided by 70%).
So an Unfranked Dividend of 5% is not the same as a Franked Dividend of 5%. When you are looking at investing in companies that pay dividends, you need to know how to calculate the Returns so you can compare apples with apples.
An Unfranked Dividend of 5% means you have to pay tax on the 5%, leaving you possibly with a Net Return of 3.5% (assume tax rate of 30%), whereas,
A Franked Dividend of 5% is “After Tax” (has tax paid) which is the equivalent of an Unfranked Dividend of 7.14% (grossed up).
So be careful when you are determining where to invest your money and be sure that you are comparing returns correctly.
How to Save Taxes on Franking Credits
If your tax rate is only 15% then you get a refund of 15% (30% less 15%), and if your SMSF was in pension mode and pays zero tax when the refund is the full 30% tax that was paid by the company.
As you can imagine this boosts your returns from your investments greatly.
Getting your dividend income right is important, particularly during tax time. So, if you need help with your dividends, contact a professional.
A Chan & Naylor Accountant will know how franking credits work and will be able to help you better manage which entity to invest through in order to fully benefit from the Franking Credits system.
Ed Chan is the Co-Founder and Non Executive Chairman of Chan & Naylor and a leading authority in property and business tax.