Australia has a progressive tax system that increases your tax rate as your income increases. Furthermore, the use of franking credits is a distinctive feature of the country’s tax system.
Franking credits are a tax offset that can be used to reduce the amount of tax you pay on your taxable income. In order to be eligible for franking credits, you must be a shareholder in an Australian company.
When done right, you can use franking credits to reduce your tax bill by thousands of dollars. Here’s more information on how franking credits can help reduce your tax.
What are Franking Credits?
Franking credits are credits you can receive from dividend-paying companies in Australia. The company will offset the tax they’ve already paid on your behalf to the Australian Taxation Office (ATO) against the tax you owe.
You’ll receive a franking credit for each share you own in an eligible company. The size of the credit will depend on how much tax the company has already paid on your behalf.
The company will pass on the credit to you through a dividend statement or notice of assessment. You can then use the franking credit to reduce your tax payable on your investment earnings.
That said, not all Australian companies offer this perk. Some companies remain ineligible for franked dividends, which include foreign-owned companies, as well as unlisted public companies.
In essence, franking credits is an investment strategy that grants you the option to pay less on the taxes of your dividends. If approached the right way, you could offset a partial or full tax bill.
How Does it Work?
Most companies listed on the Australian Stock Exchange pay a company tax rate of 30% for their taxable income.
This is the tax that the company pays on its profits before they distribute it to shareholders as dividends. When a shareholder receives a dividend, they’re required to pay tax on that income at their marginal tax rate.
However, if the company has already paid tax on the dividend at 30%, the shareholder can claim franking credits for their dividend share.
There are three potential outcomes for eligible companies and individuals.
- Fully franked dividend: There has already been a 30% payment before the shareholder receives the dividend.
- Partly franked dividend: The franked portion of the payout has already been taxed at 30%, with no tax has been paid on the unfranked portion.
- Unfranked dividend: No tax has been paid.
Given the reality that each person falls under various marginal tax rates relative to their holdings and income bracket, it’s important to recognize one’s own circumstances when looking into this concept. Learn more on how do franking credits work with HALO Technologies.
Generally speaking, if you’re on a lower marginal tax rate, you’re more likely to benefit from franking credits than someone on a higher marginal tax rate. But in reality, there are more ways than one for high-income earners to get the most out of this system.
3 Ways Franking Credits Reduce Tax
Let’s look at the three ways franking credits reduce tax and improve an investor’s financial standing.
- This system prevents you from getting taxed twice
The company whose shares you own will have already paid tax on the profits that were used to pay the dividend. By receiving a franking credit, you’re only being taxed once on those profits – when the company pays tax.
Without franking credits, you would be taxed twice on the same income – once when the company pays tax, and again when you include your marginal tax rate.
That said, there are times when you’ll still be taxed a partial amount. If the company’s tax rate is lower than your marginal tax rate, you’ll only receive a partial offset.
Moreover, you’ll still have to declare your dividend tax value. But if you have franked credits, you can use that to offset a portion or all of your tax payable for the period.
- Individuals may request a refund of excess franking credits
Did you know that Australia’s taxation system allows the ATO to pay eligible people for their excess credits?
While not reducing tax per se, another benefit of Australia’s franking credits system is the ability for individuals to receive a refund of any excess credits.
This is useful if you have unused franking credits, which often happens when your (as the shareholder) income tax bill would have been lower than the value of their share’s franked credits. It’s essentially a way to turn your tax offset into physical cash.
- Superannuation fund owners benefit the most from this payout
The majority of the beneficiaries of the franking credits system are people nearing or at retirement age. This is because these people have already amassed a big financial, tax-free super fund, an investment vehicle that’s paid by your employer that doesn’t pay income tax on earnings.
As a result, when they receive franked dividends from shares, they aren’t expected to pay any tax on these earnings. Rather, the government can refund the franking credits as a cash handout should this be requested by the shareholder.
Takeaway
Franking credits can provide significant relief from taxes payable by investors.
If you’re an Australian resident shareholder, you may be eligible for a number of different offsets and exemptions that can reduce your overall tax liability.
Need assistance? Get in touch with a tax specialist, accountant, or financial advisor to learn how to make the most out of the imputation system.