What is a franked dividend?

There are two concepts in paying dividends that business people must know – franking credits and dividend yield.  The concept of dividend yield means the financial ratio that measures the quantum of dividends paid to shareholders relative to the market value per share.  The dividend yield is more desirable when franking credits are included.  Part IIIAA of the Income Tax Assessment Act  1936 (Cth)(Act) deals with legal aspects of franking of dividends, including what constitutes franking and company requirements for dividend statements to shareholders. This article discusses what a franked dividend is, the types of franked dividends, how they work and dividend imputation.

What is a franked dividend and a franking credit?

A dividend is a transfer of something of value from a business to a shareholder.  Companies pay dividends to their shareholders out of profits often on a periodic basis or on a standalone basis for a special distribution.  All dividends paid to you as a shareholder form part of your taxable income.

As these payments are drawn from company profits, it is implied that these dividends have already been subjected to tax at the corporate level.  A shareholder should not be obligated to pay the tax on the dividend they receive through their individual income tax or this would result in double taxation.

A franked dividend is an arrangement that was introduced in Australia to eliminate the double taxation of dividends.  A franked dividend has attached to it what is known as a franking credit, which represents the amount of tax that has already been paid on the dividend by the company.  A shareholder is able to reduce the tax paid on a dividend by an amount that is equal to the franking credit.

What is dividend imputation?

Dividend imputation is the system used to eliminate double taxation on payments received by securitiy holders through the use of franking credits, which are be used to offset taxes.  This system is known as imputation because is ‘imputes’ or attributes taxes that are owed by the corporation to the shareholders.

How does dividend imputation work?

A franked dividend eliminates the double taxation issue by providing investors with a tax credit for the amount of tax that the company has already paid on that dividend, known as a franking credit.  The shareholder is then able to submit the dividend income with the franking credit as income and they will only be taxed on the dividend portion.

How much tax an individual owes on a dividend is affected by their marginal tax rate and the tax rate for the company that is issuing the dividend.  For example, if a company is subject to a tax rate of 26%, the Australian Tax Office will refund an individual the difference if their maximum tax rate is less than 26%.

What is a fully franked and partially franked dividend?

A franked dividend can either be fully or partially franked.  If a dividend is fully franked, this means that the company has already paid tax at a rate of 30% on the money at the corporate level.  An individual still needs to include the dividend in their individual taxable income, however they will receive a credit that will reduce the taxable income amount by that already paid on the dividend by the company.

Whilst many companies within Australia pay franked dividends, they aren’t required to pay tax on profit that the company chooses to redistribute amongst shareholders.  A shareholder may also receive unfranked or partially franked dividends, meaning that the company has not paid all or any of the tax on the dividend.  Unfranked dividends mean the shareholder will be responsible for paying all of the tax.

The formula used for calculating the franking credit applicable on a fully franked dividend is:

Franking credit = (Dividend amount ÷ (1 – Company tax rate at the time)) – Dividend amount.

For a company paying a dividend of $2,000 on a company tax rate of 30%:

Franking credit = ($2000 ÷ (1 – 0.30)) – $2000

= ($2000 ÷ 0.70) – $2000

= a franking credit of $857.14

The shareholder would therefore receive a fully franked dividend of $2,000 with a franking credit of $857.14 on their dividend statement.

If the dividend was not franked, the shareholder is responsible for taxes on the entire amount of $2,857.14 ($2,000 + $857.14).  When the dividend is fully franked and a franking credit applies, the person still declares $2,857.14 as taxable income but taxes only apply to the $2,000.

Takeaways

Dividend imputation is a system used to eliminate double taxation and offset taxes payable on a distribution through the use of franking credits.  The shareholder is able to submit the dividend with the franking credit as income and they will only be taxed on the dividend portion.  A shareholder will only be required to pay the difference between their marginal rate and the corporate rate.

Links and further references

Legislation

Income Tax Assessment Act 1936 (Cth)

Further information about franked dividends

If you need advice on franked dividends or franking credits for your company, contact us for a confidential and obligation-free discussion:

Disclaimer

This article contains general commentary only.  You should not rely on the commentary as legal advice.  Specific legal advice should be obtained to ascertain how the law applies to your particular circumstances.

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