Definition
A Franking Credit, also known as a tax credit or imputation credit, is a type of tax credit that allows Australian companies to pass on the tax paid at the corporate level to their shareholders. When a company pays dividends to its shareholders, these payments get a franking credit that represents the amount of tax the company has already paid. This system helps to avoid double taxation.
Key Takeaways
- Franking credit, also known as imputation credit, is a type of tax credit that allows Australian companies to pass on the tax paid at the corporate level to shareholders. It prevents the double taxation of dividends.
- This concept primarily benefits shareholders since it can reduce or even completely offset their tax liability depending on the number of franking credits they have and their individual tax rate.
- The value of franking credits is directly proportional to the corporate tax rate. If a company pays lower taxes, it results in lower franking credits for the shareholders and vice versa.
Importance
Franking credit is a significant concept in finance due to the role it plays in eliminating or reducing the double taxation of dividends in many countries like Australia.
When a corporation has already paid taxes on its profits, any dividends it distributes to shareholders come with franking credits, which represent the amount of tax the company has already paid.
These credits can then be used by shareholders to reduce their own tax liability.
This system encourages a more equitable distribution of taxes, incentivizes investment in the stock market, and prevents the excessive imposition of corporate and income tax on the same earnings.
Explanation
Franking credit is a critical concept in the finance world, mainly involving the taxation system related to dividends from an investment. Essentially, franking credits primarily serve the purpose of avoiding or minimizing double taxation. It refers to a tax credit scheme implemented by countries such as Australia to prevent the taxation of dividends at both the corporate level and the investor level.
The system aims to ensure that income is not taxed twice; once in the hands of the corporation as a profit, and later as income to the shareholder when that profit is distributed as dividends. Franking credits are advantageous to investors as they contribute towards a reduction in their income tax liability. When a corporation pays dividends to its shareholders, it attaches franking credits to those dividends.
These franking credits represent the tax that the corporation has already paid. Thus, the shareholders receive a credit for the tax that has been prepaid on their behalf. This mechanism allows tax authorities to track income from its generation in the corporation to its distribution amongst shareholders and ensures the taxation of this income only once.
Examples of Franking Credit
**Corporate Taxation**: Suppose Company XYZ based in Australia earns $100,000 in profit and is subject to a 30% corporate tax rate. After paying its corporate tax of $30,000, the company is left with $70,
If this company distributes all of its after-tax profit as dividends to its shareholders, it will also distribute the franking credits associated with these dividends. In this case, each shareholder receives a share of the $70,000 dividends, and also a share of the $30,000 franking credits. Shareholders can use these tax credits to reduce their personal income tax liability.
**Investments in Tax-efficient Funds**: An Australian investor purchases shares in a managed fund that invests in Australian companies. The managed fund receives dividends from the companies it invests in, along with franking credits. When the fund distributes income to its investors, it also distributes these franking credits. The investors can then use the franking credits to offset their personal income tax.
**Retirement Fund Distribution**: Consider a retiree in Australia who has a self-managed super fund (SMSF). The retiree’s SMSF invests in Australian shares and receives dividends that come with franking credits. When the retiree starts taking his regular pension from the SMSF, he can also receive his share of the franking credits, which can be used to offset any tax on the pension income.
Frequently Asked Questions about Franking Credit
What Is a Franking Credit?
A franking credit (also known as an imputation credit) is a type of tax credit that allows Australian companies to pass on the tax paid at the corporate level to shareholders. The benefits are these credits can be used to reduce the income tax paid on dividends or potentially be received as a tax refund.
How Does Franking Credit Work?
When a company pays dividends to its shareholders, those dividends come with a franking credit if the company has already paid tax on its profits. This mechanism is designed to prevent double taxation – once at the corporate level and again at the individual level. The franking credit equals the amount of tax the company has already paid. Shareholders can then use these credits to reduce their own tax liability.
Who is Eligible for Franking Credit?
Franking credits are available to Australian resident shareholders who hold their shares at least 45 days excluding the purchase and sell dates. It’s worth emphasizing that this rule does not apply to shareholders whose total franking credit amounts are below AU$5,000 in a year, which is generally the case for small individual investors.
How are Franking Credits Calculated?
Franking credits are calculated based on the company tax rate. The grossed up dividend represents the full amount of the profits before company tax was deducted. The franking credit is the company tax that has been paid by the company that is attributable to the grossed up dividend.
What is the Benefit of Franking Credit?
The main benefit of Franking Credits is the prevention of double taxation. They give shareholders a tax credit that they can use against their income tax liability. If the tax credit is more than what they owe in income tax, they may be eligible for a cash refund from the Australian Taxation Office. Thus, investors often preferentially invest in companies that offer fully franked dividends.
Related Entrepreneurship Terms
- Dividend Imputation
- Tax Credits
- Shareholder Returns
- Corporation Tax
- Double Taxation
Sources for More Information
- Australian Taxation Office: An authoritative source on tax-related topics including franking credits.
- Investopedia: A comprehensive web-based resource for a wide range of finance and investment terms, including franking credits.
- MoneySmart: An Australian Government resource offering advice on franking credits and other financial matters.
- Australian Securities Exchange (ASX): The official site of the Australian stock market, a useful resource about franking credits in the context of stock trading.
