60 second guide: Franking credits

Australia is one of a handful of countries that offers franking credits, making the nation’s investors the envy of their counterparts elsewhere in the world.

A franking credit is an income tax credit that companies can pass on to their shareholders. It is the result of dividend imputation, or attribution.

At its heart, the imputation system and the franking credits it produces aims to prevent double taxation. The Australian Taxation Office introduced the system in 1987 and, in 2000, changed the system to the one in place today.

In many larger markets, including the United States, companies pay tax on profits, including monies used to pay dividends. Shareholders pay income tax on the very same dividends, allowing the Internal Revenue Service, the US tax authority, to collect twice on the same money.

In Australia, shareholders are not taxed on fully franked dividends and are credited for the tax already paid by the company in which they own shares.

Here’s how it works:

An Australian resident company pays the corporate tax rate, currently 30%, on their profit.

The company may decide to pay part of that after-tax profit to shareholders as dividends.

When shareholders declare their dividends for tax purposes, the ATO credits them for the amount of tax already paid by the company.

Follow ATO conditions

If an investor’s personal tax rate is below 30%, the ATO refunds them the difference. If their tax rate is above 30%, the ATO reduces their tax bill by the amount already paid by the company.

“The franking tax offset can be used to reduce your tax liability from all forms of income (not just dividends), and from your taxable net capital gain,” the ATO said.

However, investors must follow ATO conditions to claim this tax-effective investment strategy. For example, an investor must hold shares for at least 45 days, excluding the day of purchase and the day of sale, to receive franking credits greater than $5,000.

Know your risk

Like anything connected to the world of investment, franking credits come with a note of caution because market performance, dividends and even tax rates can change. Here are a few of the risks:

Tax rates

If Australia’s corporate tax rate falls so does the value of the franking credit.

“At the moment you get a credit of 30% because the company tax rate is 30%,” said Australian Shareholders Association chairman Ian Curry.

Dividends

If a company is not performing well, it may lower the dividends it pays to shareholders.

“Investors shouldn’t necessarily invest purely for the franking credits or the dividend, even though we know a lot of investors are being driven at the moment purely by yield,” Curry said.

Investing in shares: beware the dividend yield

Company decision

Companies are not obligated to pass all franking credits to their shareholders, which can leave investors with partially franked dividends. In some cases, companies do not pass on any franking credits.

Lack of understanding

Share investors may not always understand the business in which they are investing and that could be problematic. Curry said the best investment decisions are based on a company’s business and long-term prospects.

“The first consideration of investing is that risk must be foremost in mind. It’s no good getting a high return [dividend] if you lose your money.”