What are franked dividends and how do franking credits work?

One out of every three Australians owns directly held shares.

It’s really quite common, and many of them receive dividends on those shares.

But when it comes to how dividends are taxed, it can suddenly seem very confusing.

Let’s explore what franking credits and fully franked dividends are all about    

Think back to the 2019 Federal election, when ‘franking’ was one of the hot topics. Lots of Australian voters’ eyes glazed over.

That was, until entrepreneur Dick Smith announced that he got an ATO tax refund of $500,000, thanks to franking credits.

At that point, many of us became very interested.

What is a franked dividend?

To understand how franked dividends and franking credits work, let’s start with some basics.

When you invest in shares, you’re buying a small slice of ownership in a company. This applies even if you buy shares in a big company like BHP, Woolworths or one of the big banks. 

As a shareholder, you get a slice of the company’s profit, paid to you in what’s called a dividend. This is normally based on an amount per share. For example, a company may pay a dividend of $0.10 per share. That may not sound like much. But if you own 10,000 shares, the dividend works out to a tidy $1,000.

Dividends are a nice financial boost, sometimes twice per year.

In Australia, dividends can be especially sweet because they are very tax-friendly. And that’s where franking credits come in.

Franking credits recognise tax paid by a company.

Just like people pay tax on their annual income, companies pay tax on their annual profit.

A key difference is that companies pay a flat rate of tax of 30%. Small companies may pay 27.5%. But when it comes to companies listed on the Australian Securities Exchange (ASX) the tax rate is generally a flat 30%. (That’s a lot less than what many Australian workers pay in tax, by the way.)

Put simply, the company makes a profit. It pays tax of 30% on those profits. Then a dividend is paid to shareholders from the profits left over after tax.

For shareholders, dividends are taxable income. In years gone by, dividends were added to a shareholder’s other income and taxed at their personal tax rate.

Back in 1987, the government realised the system meant, dividends were taxed twice: First when the company paid tax on its profits, then a second time when shareholders paid tax on their dividend income.

This led to the introduction of our current system of franked dividends and franking credits, which prevents double taxation of dividends.

How do franking credits work for me?

A dividend paid by a company on after-tax profits is known as ‘fully franked’. The dividend notice a shareholder receives will include an item called ‘franking credits’. This is the amount of company tax that relates to the dividend.

Here’s how franked dividends and franking credits can dish up valuable tax savings

As a shareholder, when you fill out your annual tax return you’ll need to include the dividend received plus the franking credit. You receive a tax credit for the value of the franking credit, which can be offset against other income.

Remember, the company tax rate is 30%.

So if your personal tax rate is 30%, dividends are pretty much tax free as you get credit for the 30% tax the company has already paid.

If your personal tax rate is 45%, you pay 15% on dividends after subtracting a tax credit for the 30% tax paid by the company.

Even better, since July 2000, if your franking credits are greater than your tax bill, then you get a refund of those excess credits.

So you get to enjoy dividend income plus a refund of the tax paid by the company. That is how Dick Smith gets a half-million dollar tax refund – it’s his franking credits!

An example of a dividend and franking credit

Nicki earns $30,000 taxable income. This means her personal tax rate is 19%. During the year she received a dividend for $70. Here is how her dividend will be treated in her tax return:

For the record, Labor was proposing to ban refunds of excess franking credits if it won the Federal election. The Liberals said Labor was going after retirees’ money and that wasn’t exactly an honest way to describe this complex issue. This put the whole concept of franking credits and franked dividends firmly in the spotlight. However, the Liberal party won the election and it’s business as usual for franking credits.

Why franking credits matter

The tax savings on fully franked dividends mean shareholders get a lot more bang for their buck on dividends in terms of investment returns.

If you receive a franked dividend of 4%, this works out to a ‘before tax’ dividend of 5.71%. Not a bad return at all. To work out the before tax return, just divide 5% by 0.70 (assuming the company tax rate of 30% applies).

What are unfranked dividends?

Not all dividends will be fully franked. Which means, dividends are not always paid on profits that were taxed.

It’s possible that a part of the company’s profit didn’t attract tax. This can happen, for instance, when the company sells an asset that is tax exempt.

Unfranked dividends do not have a franking credit attached. Therefore, if you receive this sort of dividend, it adds onto your taxable income and you have to pay tax on it.

It is important to get your dividend income right at tax time. The good news is that your Etax tax agent knows exactly how franking credits work, and how to accurately record dividend income in your annual tax return.