Franking credits – a concise explanation

Franking credits are a powerful tool in the world of investing, yet many investors may not fully understand how they work or the benefits they offer. In this guide, we will delve into the intricacies of franking credits, exploring everything from the basics of what they are to how they can be utilised to reduce tax liabilities and boost investment returns.

Whether you’re a seasoned investor or just starting out, this guide will provide you with a solid understanding of franking credits and how they can play a crucial role in your investment strategy.

Basics of franking credits: What are they?

Franking credits, also known as imputation credits, are an integral part of the tax system in several countries, including Australia. They were introduced to prevent double taxation of company profits and ensure that shareholders are not taxed twice on the same income.

At its core, a franking credit represents a portion of tax that has already been paid by a company on its profits. When a company distributes its profits to its shareholders, in the form of dividends, franking credits may attach to those dividends. These credits reflect the amount of tax the company has already paid on the profits being distributed.

The purpose of franking credits is to enable shareholders to offset or reduce their own personal income tax liability. By attaching the franking credits to the dividends, the tax already paid by the company is attributed to the shareholder, effectively reducing their taxable income as investors may be able use these credits to offset their tax liability.

How franking credits work

Understanding how franking credits work is crucial to fully grasp their benefits and implications. As such, we will delve into the mechanics of franking credits, including the concept of the imputation system, how companies allocate franking credits, and how investors receive and utilise them.

The concept of imputation system

The imputation system is the foundation of franking credits. It ensures that the taxation of company profits aligns with the taxation of individual shareholders. Under this system, a company is required to pay corporate tax on its profits before distributing dividends to shareholders.

How companies allocate franking credits

When a company distributes dividends to its shareholders, it attaches franking credits to those dividends. These credits represent the amount of tax the company has already paid on the profits being distributed. The allocation of franking credits is based on the company’s tax rate.

How investors receive franking credits

Once the company has allocated franking credits to dividends, individual shareholders are entitled to receive those credits. When a shareholder receives a dividend with franking credits attached, they can use these credits to offset their own personal income tax liability. If the franking credits exceed the shareholder’s tax liability, they may be entitled to a tax refund or to have their tax liability reduced.

Benefits of franking credits

Franking credits offer several significant benefits to investors and can play a crucial role in optimising their investment returns and tax strategies.

Reducing tax liability

One of the primary benefits of franking credits is their ability to reduce an investor’s tax liability. When a shareholder receives dividends with attached franking credits, they can use these credits to offset their own personal income tax liability. This means that the tax already paid by the company on the distributed profits is attributed to the shareholder, effectively reducing the amount of tax they owe.

Boosting returns on investments

Franking credits can significantly enhance the overall returns on investments. When a shareholder receives franked dividends, the value of the franking credits effectively increases the yield of the investment. This means that shareholders can potentially earn higher after-tax returns compared to investments that do not offer franking credits.

Avoidance of double taxation

Another advantage of franking credits is the prevention of double taxation. Without franking credits, company profits would be subject to corporate tax, and when those profits are distributed to shareholders as dividends, the shareholders would also be subject to personal income tax on those dividends. This would result in the same income being taxed twice. However, with franking credits, the tax already paid by the company is attributed to the shareholder, preventing double taxation.

Understanding the franking credit tax refund

The franking credit tax refund is a vital aspect of the franking credit system that allows eligible investors to receive a cash refund if the franking credits received exceed their tax liability.

For additional information on tax, please see our tax resources.

Who is eligible for franking credit refunds

To be eligible for a franking credit refund, investors must meet certain criteria set by the tax authorities. Generally, individuals who have a taxable income below a certain threshold or have a tax liability that is lower than the amount of franking credits they have received are eligible for a refund. Eligibility criteria may vary, so it’s important for investors to consult their the Australian Tax Office for specific guidelines or an appropriate professional adviser for advice

How to claim franking credit refunds

To claim a franking credit refund, investors are typically required to include relevant information on their tax return. This may involve completing specific sections or providing supporting documentation to substantiate their claim. It’s crucial for investors to follow the guidelines provided by the tax authorities and ensure that they accurately report their franking credits to claim the refund they are entitled to.

Potential risks and limitations of franking credits

While franking credits offer numerous benefits, it’s essential to understand the potential risks and limitations associated with them.

Change in corporate tax rates

One of the risks of franking credits is the potential impact of changes in corporate tax rates. If the corporate tax rate decreases, the amount of franking credits attached to dividends may also decrease, leading to a reduction in the benefits investors receive. Conversely, an increase in corporate tax rates could result in higher franking credits, potentially boosting the advantages for investors. Monitoring changes in corporate tax rates is crucial for investors to understand the impact on their financial situation.

Impact of company’s profitability

The profitability of the company issuing dividends plays a significant role in the availability and value of franking credits. If a company experiences a decline in profitability or reports losses, it may not have sufficient profits to generate franking credits. This can limit the availability of franking credits for investors and reduce the potential benefits they can receive.

Understanding the 45-Day rule

The 45-day rule is an important consideration when it comes to franking credits. This rule stipulates that to be eligible for franking credits, investors must hold the shares for at least 45 days, including the ex-dividend date. If the shares are held for a shorter period, the franking credits may be reduced or even disallowed. It’s crucial for investors to understand and comply with the 45-day rule to ensure they can fully utilise the benefits of franking credits.

Do Betashares fund pay franking credits?

To the extent that the underlying holdings of the Fund receive franking credits, these credits will normally be passed on to the Fund’s investors.

You can find distribution information and current yield/franking levels on the individual product page of the Fund you are interested in.

From the above, it is clear that understanding franking credits is essential for investors looking to maximise their returns and reduce the amount of tax payable. By grasping the basics, mechanics, benefits, tax refund processes, and potential risks of franking credits, investors can make informed decisions and effectively utilise this unique feature of the tax system to their advantage. It is strongly encouraged that you speak with an appropriate professional adviser for tax specific advice.