With interest rates at historical lows, investors now have to work extra hard to achieve a decent return on their money. But don’t forget that it is the after-tax return that counts – which is why investors with money invested in Australian shares can benefit from gaining an understanding of the Dividend Imputation System and how Franking Credits work.
Dividend imputation was introduced in July 1987, one of a number of tax reforms by the Hawke/Keating Government. Prior to that shareholders suffered double taxation on their dividends. That is, first the companies paid tax on any profits they had made, then the shareholders were taxed again at their marginal tax rate when they received these tax-paid profits in the form of dividends. This double taxation was overcome through the introduction of the Dividend Imputation System.
The word “impute” means to “give credit for” and this is exactly what the imputation system does. It allows shareholders to receive credit for the tax already paid by the company at the 30% company tax rate, and pay tax only on the difference between that and their own tax rate. This means for an individual on the top marginal tax rate of 49% (including Medicare & Budget Repair Levy) will only pay the difference which is 19%.
Since 2000, provisions have been made to receive franking credits back as a tax refund where the tax rate is less than the company rate. Therefore, for a super fund in pension phase, where the tax rate is nil, the full franking credit will be refunded by the tax office.
Let’s take a look at this concept in more detail by using an example.
The Beauty of Franking Credits
Company XYZ Holdings Pty Ltd makes a profit from its business activities of $10,000 which is fully taxable. It pays tax at the current company tax rate of 30% which equates to tax paid of $3,000, leaving a $7,000 after-tax profit. The company can either reinvest some or all of this money back into the business or pay out some or all to shareholders as a dividend. In this example, XYZ Holdings Pty Ltd decides to pay out all profits to shareholders.
If there are 10 equal shareholders, each receives an after-tax dividend of $700, with a $300 franking credit attached (the tax paid by the company). Since the profits associated with the dividends have been fully taxed, the after-tax dividends are said to be 100% franked or fully franked.
The grossed-up dividend amount is $1,000 ($700 plus the $300 franking credit) and is included in the shareholder’s assessable income. Tax is then payable at the shareholder’s applicable marginal tax rate. The tax paid by the company (franking credit) is then used to offset the shareholders tax payable.
The table below shows the effects of taxation by comparing 5 individuals, all on different individual and superannuation tax rates:
*The above rate does not include the Temporary Budget Repair Levy; which is payable at a rate of 2% for taxable incomes over $180,000 to 30/06/2017.
Individuals 1, 2 and super fund members in accumulation or pension phase all receive tax refunds due to the tax rates being less than the company tax rate of 30%. The higher income earners, individuals 3, 4 and 5 have to pay tax on their $1,000 dividends but they have both reduced the tax payable due to the franking credits.
Josh Scipione is a financial adviser providing personal financial planning and investment advice. He holds a Bachelor of Commerce and Advance Diploma in Financial Planning.
Please note: The information provided in this article is general advice only. It has been prepared without taking into account any person’s individual objectives, financial situation or needs. Before acting on anything in this article you should consider its appropriateness to you, having regard to your objectives, financial situation and needs.