Tax Tip 114: Franked Dividends and Tax

Franked Dividends and Tax

When companies make a profit they pay tax on this profit. Companies may then retain or pay out this profit to the owners of the company, the shareholders, in the form of ‘dividends’. It would be unfair for shareholders to pay additional tax on this profit of the company as the company has already paid tax on it so there is a system in place to avoid this – it is called the ‘imputation system’. This stops company profits from being taxed twice.

When dividends are paid they include ‘franking credits’ where that profit has already been taxed. The company will pay a dividend and the dividend may have ‘franking credits’ attached. Franking credits are credits for the tax already paid by the company. Where the dividend is pretax or if Australian tax hasn’t been paid (such as non-resident company dividends) the dividend may be unfranked which means no franking credits are attached.

A dividend may also be partially franked, which means part of the profit passed on has had tax paid on it.

To work out the benefit of franking credits you have to gross up the amount first. This means the dividend has the tax the company paid added back to it. It is then added to the other income of the recipient and a credit is given for the tax already paid - franking credits.

Example 1
$99,000 in dividends (fully franked),
$42,428 gross up amount ($99,000 x 30/70) (franking credits)
$141,429 in taxable income

If this person has no other income other than these dividends then, Tax on this amount of $141,429 is (2015-16 tax year)
$40,275, tax payable plus
$2,828 medicare levy
$43,104 in total tax

but,
$42,428 in franking credits will be received, so the actual extra payment require will be just $676.

Example 2
As above but the person earns $100,000 taxable income for work. Their income will be
$241,429 income, which results in
$82190, tax payable plus
$4828.58 Medicare levy
$1228.58 Budget repair levy
$88247.21 in total tax payable

But they have a credit for $42,428 so they must pay an extra $45,819

-

If you have no other income, you can earn $99,000 in dividends from fully franked shares and pay just $676 in tax out of your pocket. (you are not actually getting off paying tax completely because the company really has paid 30% tax on your behalf).

 

Excellent explanation with really good examples.

Just to expand the $99,000 dividends example by giving more details on how big portfolio needs to be.

Currently, most large LIC (ARG, AFI, MLT) and Index ETFs (VAS) are grossing (incl franking credits) between 6%-6.5%.

To generate $99,000 fully franked you need to earn gross income of $141,428. That equates to portfolio size of about $2,357,143.

LIC dividend will be fully franked while Index ETF will be around 70% franked. So you might have to pay bit more tax than $676.

You can always go individual shares route where you can achieve higher yields which means the size of the portfolio becomes smaller.

For eg. at
- 8% yield the size required is $1,767,857
- 9% yield the size required is $1,571,428


Cheers,
Oracle.

 

Compare that to property.
Say a 4% yield or 3% after costs
To earn $99k you would need $3.3mill worth of property, unencumbered

And that $99k would be mostly taxable income, although there may be some non-cash deductions for depreciation etc.

 

Are franking credits totally useless for non-residents ? I assume so, so I will be paying tax again in Spain on my fully franked dividends.

Do any funds or investment vehicles exist that would pay out a higher untaxed dividend that might be more suitable for non-residents ? Then the Australian tax paid by the non-resident can be used to offset Spanish tax (double tax agreement), whereas I don't think imputation credits can be.

 

Another point is that if your income is below the tax threshhold with the dividends included, you can lodge a simple form and get the franking credits back at tax time. A nice bonus!
Marg

 

Ok hang on, can we calculate what's needed for something lower, like net 50K a year? I don't have $2.3M but about a third of that can be done with some savings and property growth.

 

To work it out just divide the annual income needed by the expected dividend

If you need just $50,000 and assuming a 5% yield this would be:
$50,000/5% = $1mil

$1mil generating 5% would give you $50,000 pa

 

Yes. Non-residents are not assessed in Australia on fully franked dividends. Unfranked dividends are only subject to non-resident withholding. Full and final tax is paid in the taxpayer country with a credit given for the WHT paid if it is a tax treaty nation. Likewise if the shares are listed public company shares and the taxpayer wons less than 10% there is no CGT on sale of AU shares by a non-resident.

 

Sleight of hand tax grab in the budget - company tax rate down means less franking credits

 

That's only if the turnover < 10 Million.
Companies paying franked dividend usually turnover > 10 million

 

I was looking at distributions from Pty Ltd companies and small caps not 1st board ASX

 

Then you will have to wait for Prime Minister Shorten to correct the wrongs

 

Less tax paid by the company means more net profit and maybe a higher dividend.

 

@York - just a bigger shortfall between franking credits and what you have to pay - net dividend is the same.

 

Good point.

 

Apologies if it sounds dodgy:
Is it possible to borrow shares from the foreign entity with a view to retain dividend and franked credits in the Australian entity assuming the 45 day holding rule is complied with?

 

How can you borrow shares? The dividend will be paid direct to the owner of the shares who also gets the paperwork to claim franking credits.
Marg

 

Love this post.

I have been baffled by franking credits for years but never understood it properly.

This is crystal clear - esp using both examples.

Thanks Terry!

 

Institutions do it all the time
ASLA | Australian Securities Lending Association
What is Securities Lending? - ASX - Australian Securities Exchange
I am still researching if it is possible to do so at a retail level, and if so what is the implication with regard to dividend and franking credits

 

@Terry_w can the dividends and the franked credits be distributed to different beneficiaries in trust structures ?