Ten tips to understanding franking credits

Unlike the last federal election, this year’s national plebiscite on who will govern the country from Canberra isn’t a referendum on franking credits.

This time around, investors don’t have to worry about losing franking credits.

Given it’s unpopularity, Labor buried that policy as fast as the federal opposition leader’s recent gaff on interest rates and the unemployment level.

Nevertheless, despite everything that’s been written around franking credits, many investors still struggle with what they are and how they work.

Tip: When it comes to explaining franking credits – the simpler the information the more you’re likely to understand.

They're simply a form of tax refund when too much tax has been paid.

What is a franking credit?

First brought in by the Hawke government in 1987, franking credits prevent double taxation of company profits: Once for the company itself, and once for the investor receiving dividends.

By any other name, a franking credit is simply a tax credit or offset that shareholders receiving dividends can use when their dividends have already been “franked”.

When companies pay net profits out as dividends to shareholders, they will have already paid corporate tax on those profits.

The workings

Much of the mystique around franking credit is revealed in the explanation around how they operate.

Understand this, and you’ll quickly demystify all the long-winded poop, histrionics and recent political backdrop around franking credits­-which frankly is tedious and superfluous.

Here are some simple numbers

Let’s assume for a moment that you pay $45 on $100 of interest income, based an income tax rate of 45%.

If you earned that $100 as dividends from a large company that pays Australian tax, then without the franking credit system, that company would pay tax at 30% ($30 of tax) and would then be able to distribute $70 as a dividend.

The application

In their tax return, the shareholder includes $100 of income - $70 cash dividend and the $30 franking credit - and pays tax at 45% on the grossed-up amount of $100 ($45).

But now we need to factor in the franking credit of $30, which slashes their tax payable to $15.

The net effect under the franking credit system is a tax payment of $45: $30 by the company, and $15 by the individual shareholder.