Before 1985, Australian companies, like those in other advanced economies, faced a punitive double taxation quagmire on company profits. The company paid the tax on the profits it made at the company tax rate of 30% and the shareholder who received the dividends subsequently paid taxes on the dividends at their marginal tax rate. This resulted in a double taxation of the dividends with some shareholders paying as much as 62.55% on their dividends!
To correct this anomaly, the Australian tax authority introduced the dividend imputation system that allowed the company to pass on a notional amount to the shareholder that represented the taxes that the company had already paid. This notional amount is called the imputation credits. More colloquially, the amount is generally referred to as franking credits.
Suppose a company makes a profit of $200. The company tax rate currently stands at 30% so the company will pass on $140 to the shareholder along with a franking credit of $60 that represents the tax that has already been paid by the company. At the end of the day, the tax collected by the Australian Taxation Office must be consistent with a shareholder’s marginal tax rate. The tax is calculated thus:
- When declaring their assessable income, the shareholder must include both the dividend and the notional franking credits.
- The gross tax that is payable by the shareholder will then be calculated at the shareholder’s marginal tax rate.
- The franking credit or the imputation credit will be applied as a tax offset and deducted from the gross tax amount that is payable by the employee.
In the event that the franking credits are greater than the gross tax payable by the shareholder, then they are refunded the difference.
Franked Dividends and SMSFs
Franking credits generally offer a huge boost for the self-managed superannuation funds. If an SMSF is in the retirement phase, meaning that it incurs a zero tax rate, the contributor can get a full refund of the tax that the company has already paid on their behalf.
A superannuation fund that is in the accumulation phase (the money is going into the fund) will pay a 15% tax on the investment earnings. The fund will also pay a 15% tax on concessional contributions made by the members. Members that earn more than $300,000 pay a higher tax rate. When the SMSF reaches the pension phase (when the money is going out), it pays zero tax on its investment earnings. Whether in the accumulation or pension phase, a superannuation fund can leverage franking credits to minimize its tax burdens. Depending on their overall tax liability, the SMSF can even get a tax refund for the franking credits that they have received.
Not all dividends are franked
It is important to keep in mind that not all dividends are franked. The dividend imputation system only recognizes taxes that have been paid to the ATO. This means that if a company has operations overseas and is paying taxes in other jurisdictions, it cannot frank its dividends.
Also, if a company has carried forward tax losses and is not paying company tax, it cannot frank its dividends even when it may now be profitable.
As an investment strategy, it is always prudent to buy shares from companies that pay franked dividends as this will help boost your returns. Most of the companies listed in the ASX pay taxes to the Australian Taxation Office and can frank their dividends so these provide a good option for many Australian investors. However, you shouldn’t entirely discount companies whose dividends are unfranked; there are instances where some have outperformed those with franked dividends.
An important development to watch in this area is the current push by Labor to scrap tax refunds for the franking credits received by SMSFs, a move that is likely to affect all super funds with Australian shares. Should it succeed, contributors can expect to lose thousands of dollars in annual tax refunds emanating from their franking credits.