What Are Franking Credits & How Do They Work?
Taxes are complicated.
There are a number of things you have to consider when running your business, and your corporation taxes are one of the big ones.
Many companies will have individuals who own shares in the business, these are known as shareholders. When it comes time for a company to pay dividends to their shareholders, they will first pay a corporation tax on the dividends. However, once the shareholder receives the payment, they may have to pay tax on it again.
This is where franking credits come into play. But what exactly are franking credits and how do they work?
We’ll take an in-depth look at what franking credits are and how they work within the corporate structure of Australia’s business world.
Here’s What We’ll Cover:
What Is a Franking Credit?
A franking credit, sometimes known as an imputation credit, is a form of tax credit. It is paid by corporations to their various shareholders along with their dividend income payments. Australia and a number of other countries allow franking credits as a way to reduce double taxation.
Developed in 1987, franking credits are a common occurrence in the Australian tax system.
They are known as an entitlement to a reduction in personal income tax that is payable to the Australian Taxation Office. It comes attached to a dividend which the company pays to a shareholder out of its after-tax profits. The value of a franking credit is equal to the tax paid on the shareholder’s holding of the company's profit before it was given out as a dividend.
An alternative to this method is a shareholder receiving franking credits in the form of a tax refund.
How Do Franking Credits Work?
The main function of a franking credit is to help towards avoiding double taxation. The company has already paid the corporate tax on the dividend. So the franking credit reduces the tax that the individual shareholder has to pay on their total taxable income.
So when the shareholder calculate their personal income tax, they are able to deduct the value of the franking credits. These are the credits that they’ve accumulated from the tax payable.
The level of franking on the dividend can vary from company to company. This would be based on the amount of tax that they have paid, but they cannot offer more franking credits than they have paid in company tax. They also cannot offer any franking credits for the tax that they have paid overseas.
Who Can Claim Franking Credits?
Franking credits are only claimable by Australian residents. So any foreign owners of Australian companies cannot claim them.
The Australian Tax Office did not originally refund an individual with cash for any franking credits that exceeded their tax payable. But this was changed in 2000 to allow people to receive cash refunds even if they don’t pay any personal income tax.
What Is Double Taxation?
In most countries, dividends are seen as a form of income. This means that they are usually grouped with various other forms of income that are used to figure out a person's total taxable income.
When a company earns profit, they must pay tax on this profit. In Australia, the corporate tax is currently set at 30%.
Before the introduction of franking credits in 1987, the tax authority used to put tax on the company’s profit as well as the dividends paid out to investors. This essentially meant that the profit was taxed twice; once with the company as corporate tax, once with the investor as personal income tax. This is known as double taxation.
Since the introduction of franking credits, the ATO imposes tax on one front. That means that investors who receive dividends are not required to pay additional tax.
Though there is an exception; when an investor's marginal tax rate is higher than the corporate tax rate paid on the dividend. Though even in this scenario, they would only have to pay the difference between their marginal tax rate and the corporate tax rate of 30%.
How Do You Calculate Franking Credits?
There is a formula that is used by businesses to calculate their franking credits. The formula is as follows:
Franking Credit=(Amount of Dividend / (1-Tax Rate on Company Profits)) - Amount of Dividend
So let’s say that a shareholder received a dividend amount of $700 from a company that has a 30% company tax rate on its profit. This would mean that the shareholder’s franking credit would total to $300 for a dividend of $1,000.
So using the formula, we would calculate it as such:
Franking Credit=$700 / (1-30%)) - $700 = $300
So each shareholder is entitled to a $300 franking credit. This is on top of their original dividend payment of $700 which adds up to a total assessable income of $1,000.
What Is the Holding Period Rule?
There was a worry that investors would take advantage of franking credits. This lead to the ATO introducing conditions that need to be fulfilled before you can offset your tax using credits.
One of these conditions is known as the holding period rule:
Taxpayers need to hold “at risk” shares for a minimum period of 45 days (this is exclusive of the days of purchase or sale, so, in effect, it is a 47-day holding period).
Franking credits are tax credits that are used in Australia to reduce or eliminate double taxation.
Companies pay tax on their profits, and therefore shareholders have no need for a tax payment on the same income.
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