Franked credits are also known as imputation credits. They are a category of tax credit that corporations pay to their shareholders alongside the payment of their dividends. Many countries in the world, including Australia, allow franked credits to act as a form of elimination or reduction of double taxation for investors.
What does this mean? Since organizations already paid taxes while distributing dividends to the shareholders, the credit makes it possible for them to assign a tax credit to shareholders. Now, depending on the tax situation of the shareholders, they can get a tax refund or a reduction in income taxes.
How do Franked Credits Work?
Most countries of the world treat dividends as an income. In other words, they are mostly categorized with other kids of income when determining the taxable income. When an organization earns profits, they have to pay tax on the profit.
For instance, the corporate tax in Australia is set at 30 percent. Before Franked credits were introduced, the tax authority in the country imposed taxes on the company’s profits and dividends paid to investors.
However, since the paid dividends are the leftover profit after the payment of the corporate tax, dividend income was being paid twice. When franked credits were introduced, the tax authority levies a tax on a single front.
That means shareholders that get dividends do not have to pay extra tax except when the marginal tax rate is more than the paid corporate tax rate on dividends. Even at that, a shareholder will only pay the difference between the marginal tax rate and the corporate tax rate, which is 30%.
So, let’s say a shareholder has a 30% marginal tax rate. If the company paid a 30% corporate tax on profits earned, it means that the shareholder will not have to pay any more tax on their dividends. Conversely, if the marginal tax rate is 45%, they will need to pay the difference of 15% to make up the marginal tax rate after the company pays the 30% tax.
How to Calculate
The franked credit is the dividend amount divided by 1 – company tax rate minus dividend amount. So, let’s work this out to give a clearer guide. So, let’s say a shareholder gets a $70 dividend from an organization that pays a 30% corporate tax rate on its profits.
The franked credit of the shareholder will be $30 for the grossed-up dividend of $100. That means apart from the amount of dividend of $70, the shareholder will also earn $30 franked credits, making $100.
This is the total sum of assessable income by the shareholder. However, as stated earlier, the marginal tax rate of an investor should be considered when determining whether they will get a tax refund for the credits or pay an extra tax to make up their marginal tax rate.
The introduction of the franked credits by the Hawke/Keating government was a big relief for investors since they can have more money in their pockets. However, this is not so for the tax authority.
Therefore, to prevent investors in the country from taking advantage, the Australian Tax Office came up with a set of conditions that must be fulfilled before an investor can offset their tax with franked credits.
One of such conditions is the holding period rule. The rule states that a taxpayer must hold “at risk” shares for at least 45 days, which is exclusive of the days of sale or purchase. That makes a holding period of 47 days. That means they must hold their stocks for 45 days plus the purchase and sale date to be eligible for a franked credit.