Franking credits - definition & overview

Franking credits, a term that may seem complex at first glance, is a fundamental concept in the realm of Australian small businesses. It is a tax credit that a company passes on to its shareholders along with dividends. The term 'franking' is derived from the process of stamping or 'franking' a document to denote payment. In this context, it refers to the tax paid by the company on its profits, which is then passed on to the shareholders in the form of a tax credit.

Understanding franking credits is essential for small business owners, as it can significantly impact their tax liability and overall financial health. It provides a way for companies to distribute their profits more equitably among their shareholders, reducing the double taxation of dividends. This article will delve into the intricacies of franking credits, exploring its various aspects in detail.

Understanding Franking Credits

Franking credits are a unique feature of the Australian tax system, introduced to prevent the double taxation of company profits. When a company earns a profit and pays corporate tax on it, this profit, when distributed as dividends to shareholders, is taxed again in the hands of the shareholders. The franking credit system allows the company to pass on the tax paid on dividends to the shareholders, reducing their tax liability.

Franking credits are attached to the dividends that a company pays to its shareholders. The total value of the dividend, including the franking credit, is known as the 'grossed-up' dividend. Shareholders can use the franking credits to offset their own tax liability. If the franking credits exceed their tax liability, they may even receive a refund from the Australian Taxation Office (ATO).

Calculation of Franking Credits

The calculation of franking credits is based on the corporate tax rate. The franking credit on a dividend is calculated by multiplying the dividend amount by the corporate tax rate divided by (1 - corporate tax rate). This gives the amount of tax that the company has already paid on the dividend.

For example, if a company pays a dividend of $70 and the corporate tax rate is 30%, the franking credit would be $70 * (30 / (1 - 30)) = $30. This means that the company has already paid $30 tax on the $70 dividend. The grossed-up dividend, in this case, would be $70 + $30 = $100.

Impact on Shareholders

Franking credits can significantly reduce the tax liability of shareholders. When a shareholder receives a franked dividend, they include the grossed-up dividend in their income and pay tax on it. However, they can use the franking credit to offset this tax.

For example, if a shareholder is in the 37% tax bracket and receives a grossed-up dividend of $100 with a franking credit of $30, they would initially have to pay $37 tax on the dividend. However, they can use the $30 franking credit to reduce this tax to $7. If the shareholder is in a lower tax bracket, say 15%, they would initially have to pay $15 tax on the dividend, but could use the franking credit to completely offset this tax and receive a refund of the remaining $15.

Franking Credit Policy

The franking credit policy is governed by the ATO and has undergone several changes since its introduction. The policy requires companies to maintain a 'franking account', which records the tax paid by the company that can be passed on as franking credits.

Companies can choose to pay fully franked, partially franked or unfranked dividends. Fully franked dividends carry a franking credit for the full amount of tax paid by the company on the dividend. Partially franked dividends carry a franking credit for part of the tax, while unfranked dividends carry no franking credit.

Franking Credit Limitations

There are certain limitations on the use of franking credits. The ATO imposes a '45-day rule', which requires shareholders to hold the shares 'at risk' for at least 45 days, not including the purchase and sale days, to be eligible to claim the franking credit. This rule is designed to prevent 'dividend stripping', where shares are bought just before a dividend is paid and sold immediately afterwards.

There are also limitations on the use of franking credits by foreign residents and tax-exempt entities. Foreign residents can't claim franking credits to offset Australian tax on other income, and tax-exempt entities can't claim a refund of franking credits.

Changes in Franking Credit Policy

The franking credit policy has undergone several changes since its introduction. Initially, franking credits were non-refundable. However, in 2000, the policy was changed to allow individuals and superannuation funds to claim a refund of excess franking credits.

In recent years, there have been proposals to change the policy again, with suggestions to limit the refundability of franking credits. However, these proposals have been met with opposition, as they would impact low-income earners and self-funded retirees the most.

Franking Credits and Small Businesses

Franking credits can have significant implications for small businesses. For small business owners who are also shareholders in their company, franking credits can reduce their personal tax liability.

Moreover, the ability to pass on franking credits can make a company's shares more attractive to investors, as it increases the after-tax return on the shares. This can be particularly beneficial for small businesses seeking to attract investment.

Managing Franking Credits

Small businesses need to carefully manage their franking credits to maximise their benefits. This involves keeping accurate records of the tax paid by the company that can be passed on as franking credits, and timing the payment of dividends to optimise the use of franking credits.

Businesses also need to be aware of the limitations on the use of franking credits and ensure that they comply with the ATO's requirements. This may involve seeking advice from a tax professional.

Impact of Changes in Franking Credit Policy

Changes in the franking credit policy can have a significant impact on small businesses. For example, a change to limit the refundability of franking credits could reduce the after-tax return on a company's shares, making them less attractive to investors.

Therefore, small businesses need to stay informed about changes in the franking credit policy and consider their potential impact. They may need to adjust their dividend policy or investment strategy in response to changes in the policy.

Conclusion

Franking credits are a unique and important feature of the Australian tax system. They provide a way for companies to pass on the tax paid on dividends to shareholders, reducing the double taxation of dividends. While the concept may seem complex, understanding franking credits is essential for small business owners, as it can significantly impact their tax liability and overall financial health.

As with any aspect of tax law, the franking credit system is subject to change, and it is important for small businesses to stay informed about these changes. By carefully managing their franking credits and considering their potential impact, small businesses can maximise their benefits and navigate the complexities of the Australian tax system.