What are Franking Credits and how do they work?
This week we had a pretty good question from one of our clients:
What are these franking credit things and how do they work for tax?
Basically franking credits represent the taxes paid by a company on earnings that have been distributed as dividends.
So what does that mean for you as an individual share investor? Dividends are distributed by a company from its after tax earnings (net profit after tax). So you as an individual who receives these dividends because you hold shares in the company are receiving an income that tax has already been paid on. The dividends you received are taxable income to you and you will have to pay tax (at your marginal rate) on the amount you receive.
‘But wait…if the company has paid tax on that income already then wouldn’t me paying tax on the income be like the income getting taxed twice? ‘ Correct, double taxation of the income would occur.
To avoid double taxation, Australia has an “imputation system” where a company can distribute its dividends with franking credits equal to the amount of tax it has paid on those earnings. You as an individual can then get back that tax that has been paid and
you will instead pay tax at your own individual tax rate.
Let’s take a look at an example to illustrate how franking credits and dividends work under an imputation system:
Stars Digital Agency Pty Ltd earns $100,000 in gross profit for the year. Stars Digital Agency Pty Ltd pays company tax at a rate of 30% which totals $30,000. This leaves $70,000 in net profit after tax. The company then distributes all of this $70,000 to its only shareholder Poppy. The dividends have franking credits attached equal to the amount of the tax Stars Digital Agency has paid ($30,000).
Poppy must add the franking credits ($30,000) onto the cash dividend amount ($70,000) in order to get the total income that should have been received if there were no tax paid by the company. This total amount is called the “grossed-up dividend” and it totals $100,000.
Let’s assume that this is Poppy’s only source of income. Poppy then has to pay tax at her marginal rate on the $100,000 income. This totals $24,947 (based on 2014 rates and excludes Medicare levy). However, the company has already paid $30,000 in tax so Poppy should actually receive a refund of roughly $5,053.
Stars Digital Agency (Company)Source: www.accountancyonline.com.au