What a Franking Credit really is…

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Despite the dividend imputation system having been in place since 1987, the concept is still poorly understood by many investors. Investors seeking to reduce their tax can benefit from imputation credits and can receive franking credits by investing in shares directly or through a managed fund.

What are imputation credits?
Dividends paid to shareholders by Australian resident companies are taxed under a system known as ‘imputation’. This means that the tax the company pays is imputed, or attributed, to the shareholders. Imputation credits are also available through managed funds. The difference with a managed fund is that the franking credits received from dividends are taken into account and a franking level is determined for the fund. The credits are passed to unit holders in much the same way as with dividends from shares held directly.

Tax benefits:

When resident taxpayers receive franked dividends, they are included with imputation credits in their assessable income. The tax credit may then be used to reduce the tax liability from all sources of income, not just from dividend income. Until 1 July 2000, the tax offset could not create a refund. If taxpayers had any excess imputation credits available after their tax liability was reduced to nil, the balance of the imputation credits was disregarded. However, for dividends paid on or after 1 July 2000 excess imputation credits are refunded to eligible resident individuals and certain other entities.

Tax rates and imputation credits:
When a dividend is received by a shareholder it includes a franking credit equal to the amount of tax paid by the company on its earnings. The credit is then used to offset income tax payable on an individual’s annual tax return. When lodging a tax return, the full or ‘grossed-up dividend’ (which equals the cash received plus the franking credits) is shown as income with the franking credits used as a tax offset. Dividends that have franking credits attached at the 30 per cent company tax rate are referred to as ‘fully franked’. However, depending on how much tax a particular company has paid on its profits, the ‘franking rate’ may fall below the 30 per cent. These are referred to as a ‘partially franked dividend’. Superannuation funds pay tax on income at the rate of 15 per cent tax on income, meaning imputation credits can contribute significantly to a retirement planning strategy. The benefits of the imputation system are largely determined by the individual tax rate and franking level.

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