Tax alert! Bill Shorten (on behalf of the ALP) promises that his party will ban cash tax refunds for excess franking credits for Australians not receiving a government pension, taking effect from 1 July 2019. Such a promise can only happen if a federal election is held in early 2019, and such a promise is also subject to the Australian Labor Party (ALP) winning the next election.
You can receive a tax credit by buying shares in Australian companies that pay franked dividends. Dividends paid to shareholders by Australian resident companies are taxed under a system known as imputation.
Introduced in 1987, the dividend imputation system eliminates the double taxation of company profits. Before 1987, companies paid tax on their profits and share investors then paid tax on the dividends that were paid from taxed profits – double taxation. Since 1987, Australian resident shareholders receiving franked dividends get a tax credit for the tax already paid by the company. These tax credits are known as franking credits and the dividends that provide these tax credits are known as franked dividends.
How the franking credits system works
Australian companies that pay franked dividends are popular investments for many direct investors, including SMSF trustees and self-funded retirees. Investors (and the politicians) need to fully appreciate however that a franking credit is merely pre-paid tax. Even so, it is a great feeling when you receive dividend income from your share investments, which can in turn reduce your income tax bill when you lodge your tax return.
Example 1 explains how the franking credits system works.
Example 1: Franked dividends are grossed up
Company ABC makes a profit of $300 million. Company ABC pays tax on the profit at the corporate tax rate (30%) – $90 million. The company’s after-tax profit is $210 million. Company ABC pays a franked dividend of $1 per share from the after-tax profit, which means each dividend has a 30-cent franking credit.
Alan has 3,000 shares in Company ABC, which means he receives $3,000 in franked dividends, and $1,285 in franking credits. For Alan’s tax return, the share dividend income is grossed up, which means Alan has to divide his $3,000 dividend by 70 then multiply that calculated amount by 100. The grossed-up amount works out to be $4,285 ($3000 + $1,285 in franking credits).
Alan has other income of $70,000, which means his taxable income is $74,285. Before taking into his franking credits, Alan’s estimated tax bill is $15,689.62 (using the ATO income tax calculator). Alan’s tax payable is offset by the $1,285 franking credits, reducing income tax payable to $14,404.62.
If Alan has other shareholdings that pay franked dividends, he can further reduce his income tax bill, also noting that his income will be grossed up in line with the additional franked dividends.
Why are franked dividends so popular with SMSF trustees?
Franking credits are popular with Australians who run self-managed super funds, not because they run SMSFs per se, but because SMSFs are a low-tax investment vehicle, and in retirement phase, are a no-tax investment vehicle.
A super fund in accumulation phase pays a maximum of 15% investment income tax, which means it is possible to eliminate, or significantly reduce, a super fund’s tax bill by investing in companies that pay franked dividends. Franked dividends represent income that has pre-paid tax of 30%.
A super fund paying a pension in retirement phase pays no tax on investment earnings from assets supporting that pension. When no tax is payable, the trustees of the super fund receive a tax refund from the ATO representing the value of the franking credits. (The opportunity to receive a cash refund for unused franking credits was introduced in 2000).
Note that large super funds also benefit from franking credits in the same way as SMSFs, but SMSFers can more actively control their super investments and their fund’s tax bill.
Important: An investor must hold a company’s shares for at least 45 days, excluding the day of purchase and the day of sale, to be entitled to franking credits. The 45-day rule does not apply to individuals whose total franking credit entitlement for a financial year is below $5000. SMSFs are not natural persons, which means the $5,000 threshold exemption does not apply to SMSFs (see SuperGuide article SMSF investment: Franked dividends and the 45-day rule).
Example 2: Tax benefits of franked dividends depends on income
Merryl, Martin and Mavis each own the same number of shares in Company ABC. They each receive $7,000 in franked dividends, but the effects of the franking credits will be different, depending on each taxpayer’s marginal rate of tax.
A $7,000 franked dividend will appear as grossed up taxable income of $10,000 (which includes the payment of the 30% company tax). The $7,000 franked dividend is divided by 70 then the calculated amount is multiplied by 100, to arrive at the grossed-up amount of $10,000.
Meryl has a marginal tax rate of 19% (earns just under $37,000). The income tax payable on her $10,000 dividend income is $1,900, while she receives a tax offset of $3,000 from the franking credits. Meryl is able to use the remaining tax credits to reduce the tax on her other income by another $1,100.
Martin has a marginal tax rate of 32.5% (earns just under $90,000). The income tax payable on his $10,000 dividend income is $3,250, while he receives a tax offset of $3,000 from the franking credits. Martin only has to pay an additional $250 tax on that $10,000 income, because $3,000 of the income tax has been pre-paid by Company ABC.
Mavis has a marginal tax rate of 45% (earns just over $180,000). The income tax payable on her $10,000 dividend income is $4,500, while she receives a tax offset of $3,000 from the franking credits. Mavis now only has to pay an additional $1,500 tax on that $10,000 income, because $3,000 of the income tax has been pre-paid by Company ABC.
For more information…
For information on the ALP’s proposal to ban the refund of excess franking credits, see the following SuperGuide articles:
- ALP’s franking credits policy targets shareholders with low taxable incomes
- Excess franking credits: Shorten shortchanges millions of retirees
- Guest contributor: ALP’s plan to confiscate franking credits hits retirees
For more information on franked dividends and franking credits see the following SuperGuide articles: