Franking refers to tax credits, and the process that eliminates or reduces the taxation of cash payouts to its shareholders is referred to as dividend imputation. The tax credits are beneficial to individuals on high tax rates and to individuals on lower tax rates, as any tax credit that is not utilised is compensated as cash. This is only applicable to Australian residents for tax purposes.
Franking credits and the method of dividend imputation were introduced to prevent company earnings being taxed twice. In the past, a business would pay tax on its earnings then afterwards typically allocate this tax-paid profit to shareholders, who would pay tax once again.
Shareholders today receive a tax credit for the tax that an Australian company has already paid off. Therefore, companies with profits entirely from outside the country generally do not offer franking credits due to the fact that they would not have paid tax in Australia.
On the other hand, for companies that have paid full company tax in the country, the franking credits will be a tax credit for that profit at the company tax rate of 30%.
If an individual obtains a fully franked or 100% franked dividend, it implies the dividend comes along with the tax paid, right up to the company tax rate of 30%.
If an individual obtains a 50% franked dividend, it indicates that the dividend includes 50% tax paid on the dividend at the company tax rate.
If you receive a 0% franked dividend, it means the dividend includes no tax credit. This occurs when the business has not paid tax in Australia, usually since it has offset previous losses against profit or due to the fact that most or all its revenue originate from overseas.
Fully franked dividends
When it comes to a fully franked or 100% franked dividend, if an individual is on a marginal tax rate greater than 30%, they pay for the difference between tax at their marginal rate minus a tax credit at 30% (company tax rate).
If an individual is on a marginal tax rate equivalent to 30%, they pay no tax on the dividend.
If one is on a marginal tax rate below 30%, they are compensated the tax credit that has not been utilised.
Labor’s proposed changes to the dividend imputation system
Labor is proposing to remove franking credit refunds. This would mainly affect individuals on a tax rate of less than 30%. This involves low-income individuals, SMSFs in pension phase, super funds, and trusts. Individuals who are on a lower rate of tax would find themselves paying tax at 30% on fully franked dividends.
However, there is a proposed exemption referred to as the Pensioner Guarantee. This would be for full and part pensioners, and individuals on other allowances such as carers, the unemployed, disability support pensioners, and parenting payments. SMSFs with at least one exempt person would also be excluded. This policy would commence this July 2019 if Labor was voted at the next federal election.
Even though dividend franking would certainly continue, all tax credit or imputation credit not used would not be returned in cash. For this reason, dividend franking would end up being better to individuals on higher marginal tax rates, and most individuals on lower marginal rates could pay out tax on dividends at a higher rate.
Ershad Ullah is the Managing Partner of Chan & Naylor Sydney CBD. He is very passionate in helping his clients increase their personal wealth and grow their business by advising on various areas like tax minimisation, investment property, start-up business structures, restructure of business for future growth and exit strategies with estate planning.