In Australia, businesses can reduce their profit-related tax liability by taking advantage of a tax credit known as the franking credit. This system functions by enabling these businesses to “frank” their dividends, or return to their investors a portion of the tax they have already paid. Shareholders, who are cut into the company’s profits without having to pay any tax on it, also gain from this structure.
In this article, we’ll know what is franking credit. So, let’s delve into the nuances of Australia’s franking credit system and examine its importance in the country’s tax system.
How Does A Franking Credit Work?
In Australia, businesses can claim a tax credit known as a franking credit to distribute to their shareholders the amount of tax that has already been paid. The corporation is given a credit equal to the amount of tax it has already paid, which can be applied to the corporation’s future profit tax liability. The credit is distributed to shareholders in the form of a decrease in the dividend tax they must pay. If dividends were taxed at both the corporate and individual levels, double taxation would result. This is what the franking credit system is designed to prevent.
Businesses have an advantage in avoiding double taxation thanks to the franking credit scheme. Whenever a business generates a profit, it must pay taxes on that cash infusion. If the corporation then decides to pay out a portion of its earnings to its shareholders in the form of dividends, the payouts will be considered taxable dividend income for the owners. So that dividend income is only taxed once, at the shareholder level, the franking credit enables the firm to pass on the tax it has previously paid to the shareholders.
The effective tax rate of a firm is calculated by dividing its total tax payments by its taxable income; this is the value of the franking credit. If a shareholder has a tax liability related to dividends, they can apply the franking credit to reduce that liability, and if the franking credit is more than the tax liability, the shareholder may be entitled to a refund.
The franking credit system is an integral part of Australia’s tax system since it serves to lessen the incidence of double taxation and rewards both corporations and their shareholders.
How Franking Credits Are Issued
Companies in Australia are subject to the corporate tax rate on any profits they produce. When a business decides to pay out dividends to its investors, those investors will owe taxes on the amount received based on their tax bracket. To ensure that dividend income is only taxed once, at the shareholder level, the franking credit mechanism permits the corporation to pass on the tax it has already paid to the shareholders.
Taxes paid by the corporation are offset by an amount equivalent to its effective tax rate (the amount of tax paid divided by taxable income). The credit is distributed to shareholders in the form of a decrease in the dividend tax they must pay. A shareholder may be eligible for a tax refund if their franking credit is larger than their tax liability.
Because of this franking credit scheme, businesses and shareholders are not taxed twice on the same income.
Franking Credits: What’s The Benefit?
If dividends were taxed at both the corporate and individual levels, franking credits would assist in mitigating some of the double taxations that would result. The franking credit mechanism ensures that dividend income is taxed only once, by the shareholders, by allowing firms to distribute the tax they have already paid to their shareholders.
In addition, franking credits can be useful for both businesses and their shareholders. By reducing the tax burden on shareholders, franking credits can boost demand for a company’s stock. Since shareholders receive a percentage of the company’s profits without having to pay additional tax on them, franking credits can improve their after-tax return on investment.
The franking credit system, which aims to encourage investment and lessen the amount of double taxes, is a crucial part of Australia’s tax landscape.
Example
Let’s consider an example to further understand the benefits of franking credits.
Suppose a company has a taxable income of $100,000 and has already paid $30,000 in tax. Its effective tax rate would be 30% ($30,000 tax paid / $100,000 taxable income). If the company decides to distribute $50,000 of its profits to shareholders as dividends, the shareholders would also be taxed on that income at their tax rate.
However, with the franking credit system, the company can pass on the $30,000 tax it has already paid to its shareholders through dividends. This means the shareholder would only need to pay tax on the remaining $20,000 ($50,000 dividend – $30,000 franking credit). The shareholder would receive a tax credit equal to the franking credit, which would reduce their tax liability on the dividends.
In this example, the franking credit system has the effect of increasing the after-tax return on the shareholder’s investment, as they receive a portion of the company’s profits without having to pay additional tax on them.
So, the benefit of franking credits is that they can provide a tax-effective way for companies to distribute profits to shareholders, while also providing benefits to shareholders in the form of increased after-tax returns on their investments.
Who Qualifies For Franking Credits?
When an Australian resident receives dividends from a corporation that has already paid the corporate tax, they may be entitled to a franking credit. The shareholder must be a tax resident of Australia to claim franking credits.
In addition to traditional investment vehicles like super funds and SMSFs, franking credits can also be distributed to other forms of investment vehicles including unit trusts. However, franking credits are not available to non-resident shareholders and some exempt corporations like charitable institutions.
Understand that a shareholder’s franking credit eligibility may change based on several criteria, including the type of organization the shareholder is a part of, the nature of the dividends the shareholder receives, and the shareholder’s tax residency. Additionally, there are limitations on who can utilize franking credits and how they can be used.
In particular, the usage of franking credits may be limited by the tax treatment of some investment companies like SMSFs. The ability of SMSFs to claim franking credits is also influenced by how they are taxed.
The shareholder’s marginal tax rate may also cap the value of the franking credits the shareholder is eligible to receive. There may be limitations on how the returned franking credits should be used if the shareholder’s marginal tax rate is lower than the company’s effective tax rate.
Conclusion
Franking credits are an integral part of the Australian tax system because they mitigate the level of double taxation that would be incurred if dividends were subject to taxation at both the corporate and individual levels. As a result of franking credits, businesses can distribute dividends to shareholders net of the tax they have already paid on the income. Increasing the attractiveness of a company’s shares by making the dividends they pay more tax-effective is only one way in which franking credits help both the company and its shareholders.
Consult a tax expert to learn more about franking credits, whether or not you qualify, and any limitations that may apply. With their guidance, you may decipher the maze of franking credit restrictions and reap the benefits of this critical part of Australia’s tax system to the fullest extent possible.