By Westcourt Blogger.
To understand franking credits we need to take a step back.
Australian tax law has an underlying principal. Regardless of how you take cash from a company: the ultimate tax payable by you is the same.
So a company can pay you rent on a factory you own. Or it could pay you a salary. It could pay you interest on a loan. Or it could pay you consulting fees. Whatever the form of payment the tax outcome will be the same.
The company will enjoy a tax deduction for the payment to you (or your family) and you (or your family) pay tax on the income.
Dividends are slightly different. A company does not enjoy a tax deduction when it pays you a dividend. And you will pay tax on the dividend.
If the government left it at that the total tax on a dividend would be higher compared to the other ways of accessing cash (salary, rent etc).
To avoid this situation the government gives you a tax credit for the amount of company tax paid. This tax credit is referred to as a “franking credit” and it can come back to you as a cash payment in some circumstances.
The operation of franking credits is best explained by an example using two different shareholders on different tax rates.
If a company makes a profit of $100 it will pay $30 in tax (ignoring small business rates) so it will have $70 left over to pay to the shareholders.
If a shareholder did not pay tax (like a superannuation fund) the government would give the shareholder $30 in a tax refund (cash). So the initial $100 profit made by the company would translate into $100 for the shareholder.
If the shareholder was incurring tax at the rate of 49% the shareholder would pay an additional $19 on the receipt of the $70 dividend. So the $100 cash generated by the company will translate into a full tax payment of $49. The company will pay $30 of the tax liability and the shareholder will pay the $19 of the tax liability.
The interplay of how this factor can work creates interesting outcomes. A superannuation fund will be able to increase the cash return from an investment by targeting the use of franked dividends (with the cash refund from franking credits). A person on the highest marginal tax rate will likely find a benefit in accessing a capital gain where half of the income is tax free.
Using this opportunity in different ways for families can create interesting outcomes. And if as that opportunity is magnified across larger sums of money the outcome can make a meaningful impact on the size of the legacy you create for your family. Alternatively you can reduce the cash outflow from your family business.
Either way an understanding of how franking credits work is critical to the cashflow management and structuring of your business and investments. An independent, focussed, tax advisor is a crucial element in long term planning.