Franking credits are essentially refunds given to shareholders of Australian companies. Since these companies have already paid taxes on their earnings, the concept is to prevent double taxation of the same profits for the shareholders. Hence, investors receive a tax credit for these dividends at tax time.
Investors typically enjoy franking credits when their Perth tax accountant either prepares their income tax return or gives strategic tax advice to maximise their access to franking credits.
The issue of franking credits gained prominence during Australia’s 2018 federal election. The Labor party proposed changes to the franking credits system in their campaign, a move speculated to have contributed to their electoral loss. Afterwards, Labor dropped this proposal before the next election, which they won.
Self-funded retirees especially favoured debit credits as they can enhance their income from share investments. Let’s delve into the details of how franking credits function.
Top of Form
Franking Credits Explained: Preventing Double Taxation
Franking credits are designed to avoid double taxation. Here’s how they work: Companies that profit must pay corporate income tax on these earnings. The profit left after paying tax can be given to shareholders as dividends. These dividends might include a franking credit, representing the tax already paid by the company.
Under the Australian tax system, shareholders can use these franking credits as a tax offset. This means when they receive dividends with franking credits, they must declare the sum of the dividend and the franking credits on their personal income tax return.
Should an individual’s tax rate be lower than the corporate tax rate, they might receive a refund of the extra franking credits or have their tax liability decreased. If their personal tax rate is higher, they may owe additional tax. However, the franking credits help reduce their overall tax liability.
Ordinarily a Perth tax accountant will quantify the tax benefit enjoyed by the franking credits in the personal tax assessment.
How Are Franking Credits Calculated?
The process for calculating franking credits is somewhat intricate. It begins with a company determining its taxable profits, which involves assessing its revenue, expenses, deductions, and other relevant factors. The company then pays tax on these profits at the corporate tax rate.
Once the tax is paid, this amount becomes a franking credit. When distributing dividends to shareholders, the company includes these franking credits with the dividend payments. This system ensures that the tax paid at the corporate level is accounted for when shareholders declare their income.
Tax Benefits of Franking Credits from a Tax Perspective
Franking credits offer three primary benefits: cash refunds, reduced tax liabilities, and enhanced investment returns.
- If your franking credits are higher than your tax liability, you might be eligible for a cash refund from the government. This scenario provides additional income, especially beneficial for those in lower tax brackets or retirees.
- Franking credits serve as a tax offset, reducing the total income tax you must pay. They decrease your tax liability, leading to a lower tax bill or a higher refund. This feature is particularly appealing as it allows taxpayers to retain more income. Many Perth tax accountants will focus on franking credit strategies when considering short, medium and long-term tax structuring options.
- Investing in Australian companies that pay dividends with franking credits can boost the return on your investments. Since these credits represent tax already paid by the company, your effective after-tax dividend is higher, enhancing the overall value of your investment.
Are franking credits part of my income?
Franking credits are a tax credit attached to your dividends. However for accounting purposes they reduce your tax expenses – they do not increase your dividends.
The process of recording franking credits as a tax reduction and not as a revenue recognition is endorsed by the Australian Accounting Standards Board. Further, court cases, including Thomas Nominees Pty Ltd v Thomas & Ors has also indicated that franking credits cannot form part of the net trust income that can be distributed to beneficiaries as the beneficiaries can never be paid the franking credits in cash by the trust.
Fully vs Partially Franked Dividends
Dividends can be either fully franked or partially franked, and the distinction lies in the amount of franking credits attached to them.
Fully Franked Dividends
A fully franked dividend occurs when a company attaches franking credits equal to the entire tax it has paid on the profits being distributed as dividends. This means the company has paid the total tax due on these profits, and the franking credits attached to the dividends represent this tax payment. Shareholders can use these credits to offset their tax liabilities.
Partially Franked Dividends
Regarding partially franked dividends, the company attaches franking credits that only cover part of the tax paid on the profits. This indicates that not all the profits distributed as dividends have been taxed, or the company chooses not to attach full franking credits. Shareholders receiving such dividends can still benefit from the franking credits, but these credits may not cover their entire tax obligation.
Unfranked Dividends Explained
Unfranked dividends are those without any franking credits. This situation arises when a company either hasn’t paid tax on the dividends’ profits or decides not to attach any franking credits to the dividends. Shareholders who receive unfranked dividends must include only the dividend amount in their tax returns, without the benefit of any tax offsets to lessen their tax burden.
Who is eligible for franking credits?
Eligibility for franking credits depends on three main criteria.
- You must be a resident of Australia for tax purposes. Non-residents may have limited or no access to franking credits, depending on the specific tax treaties and rules applicable to their situation.
- To be eligible for franking credits, you must be a shareholder in an Australian company that pays dividends with attached franking credits. This means you own shares in the company and are entitled to receive dividends.
- To claim franking credits, you typically need to hold the shares “at risk” for a certain period, known as the holding period rule. The holding period rule requires you to hold the shares for at least 45 days (excluding the day of purchase and sale) within a specified period around the ex-dividend date. This rule prevents “dividend washing” or artificial transactions solely to claim franking credits.
When structuring your affairs to stock market investing the ability to use and retain the tax benefit from franking credits is a primary factor.
Understanding a Franking Account
A franking account is essentially a record of the tax transactions within a company, showing the flow of income tax payments and refunds. It should be maintained by your Perth tax accountant on an ongoing basis when the tax return is prepared. The balance of the franking account indicates the tax the company has paid, which can be passed on to shareholders as franking credits with dividends.
This account’s balance carries over from one year to another without resetting. It increases (credited) when tax is paid and decreases (debited) when tax is refunded or received. A positive balance in the franking account means the credits surpass the debits, while a negative balance arises when debits exceed credits.
A company must avoid a negative franking account balance at the end of the year, as this could lead to a franking deficit tax liability. Understanding the tax events that cause debits or credits and the timing of these transactions is vital for proper management.
Examples of Credits in a Franking Account:
- PAYG Instalment Payments: The credit equals the payment amount and is recognised on the payment date, provided there is an actual liability for the instalment. Credits are not recognised for voluntary payments without a liability.
- Year-End Income Tax Payments: The credit is the payment amount and is acknowledged on the payment date. The liability for this payment typically arises upon lodging the tax return.
- Liability for Franking Deficit Tax (FDT): When a company incurs a liability to pay FDT, the credit equals the FDT amount. This is recognised as a credit on June 30 of the income year when a deficit occurs.
Examples of Debits in a Franking Account
A franking account also incurs debits under various circumstances, which are crucial for maintaining an accurate balance. Here are some common examples:
- Franking a Dividend: When a company issues a franked dividend, the franking account is debited by an amount equal to the franking credits attached to those dividends. This debit is recognised on the date the dividends are distributed.
- Refund of Income Tax: If the company receives a income tax refund, the franking account is debited by the refund amount. This is typically recognised on the date the refund is received.
- Under-franking a Distribution: When a company doesn’t attach enough franking credits to a dividend.
- Involvement in Linked Distributions: Participation in specific connected or related distributions.
- Distribution Streaming: Engaging in practices where dividends are selectively distributed to shareholders to maximise franking credit benefits.
- On-market Share Buy-backs: When a company buys back its shares from the open market, it can also impact the franking account.
Ensuring your Perth tax accountant properly maintains your franking account is critical for long-term tax structuring success. It is relatively easy to “forget” about a franking credit or a franking debit, and this mistake can last for a long time and be challenging to uncover many years in the future.
How to Frank a Company Dividend
For a company to frank a dividend, it must meet specific criteria:
- Tax Residency: The company needs to be a tax resident of its country when the dividend is distributed.
- Frankable Distribution: The dividend must qualify as a ‘frankable distribution’, making it eligible for franking credits.
- Allocation and Disclosure of Franking Credits: The company must allocate franking credits to the dividend and inform the shareholder about this allocation through a distribution statement.
If you engage your Perth tax accountant to prepare dividend resolutions, you will ordinarily find that your company will have appropriately franked the dividend.
Certain types of distributions do not qualify as frankable distributions, such as:
- Distributions related to non-equity shares.
- Distributions derived from the company’s share capital account.
- Distributions considered deemed dividends under Part III Division 7A of the Income Tax Assessment Act 1936.
- Distributions of profit to shareholders from certain exempt capital gains tax (CGT) gains.
Determining the Franking Level of a Dividend
A company has a degree of discretion in deciding how much to frank a dividend. Nonetheless, there are specific rules that limit this discretion.
- Maximum Franking Credit Rule: The franking credit on a distribution must not exceed the ‘maximum franking credit’ amount. This is calculated as the amount of the frankable distribution multiplied by [1 / the applicable gross-up rate]. The ‘applicable gross-up rate’ is determined by [1 – corporate tax rate] / corporate tax rate (expressed in decimal form).
For example, consider ABC Pty Ltd distributing $10,000 to its shareholder, taxed at a corporate rate of 30%. The maximum franking credit is calculated as:
- Applicable gross-up rate = [1 – 0.3] / 0.3 = 2.3333.
- Maximum franking credit = $10,000 x [1 / 2.3333] = $4,285.
In cases where the maximum franking credit is surpassed, the company should only record a debit in the franking account up to the maximum franking credit. Similarly, the shareholder can only declare the maximum franking credit in their income and receive a tax offset for that amount.
- Benchmark Franking Percentage Rule: This rule stipulates that all dividends paid in a franking period (usually the income year) must have the same franking percentage. This is especially relevant for certain public companies that may experience multiple franking periods in a year. The aim is to prevent tax avoidance by distributing differently franked dividends to different shareholders based on their tax situations.
Non-compliance with the benchmark franking percentage can lead to either over-franking or under-franking situations, which can disadvantage the company and its shareholders. Hence, companies should comply with this rule to avoid such scenarios.
Understanding Over-Franking and Under-Franking
Over-Franking: Over-franking occurs when the franking percentage of a distribution surpasses the set benchmark percentage, leading to an over-franking tax. The tax is calculated using the formula:
Frankable Distribution Amount x [Franking Percentage Differential / Applicable Gross-up Rate].
The ‘Franking Percentage Differential’ is the difference between the franking percentage for the distribution and the benchmark franking percentage for that period.
For instance, ABC Pty Ltd makes a $7,000 distribution to a shareholder with $1,200 in franking credits, setting a 40% benchmark percentage (1,200 / 3,000 maximum franking credits). Later, the same company distributes another $7,000 with $2,100 in franking credits. This leads to a 70% franking percentage (2,100 / 3,000 maximum franking credit). The over-franking tax is $7,000 x [30% differential / 2.3333 gross-up rate] = $900.
While the entire franking credit of the over-franked distribution remains valid for the shareholder, the company must pay the $900 over-franking tax by 31 July (a month after the income year-end). This tax payment doesn’t credit the franking account and isn’t deductible or offset against the company’s income tax liability.
Under-Franking: Under-franking happens when the franking percentage for a distribution fall below the benchmark percentage, resulting in an under-franking debit to the franking account. This leads to ‘wasted’ franking credits rather than a separate penalty tax. The calculation for under-franking debit is like that of over-franking tax.
However, the Australian Taxation Office (ATO) may waive penalties related to deviations from the benchmark percentage in certain limited circumstances. Section 203-55 of the Income Tax Assessment Act 1997 can be referred to for more details.
Understanding Franking Deficit Tax
Franking deficit tax applies when a company’s franking account has a deficit balance at the end of an income year. This deficit occurs if the opening balance, minus debits, plus credits results in a negative amount. Notably, if a company receives a tax refund within three months of the year-end, it might sometimes prevent the application of franking deficit tax.
Key points about franking deficit tax include:
- Tax Payment Liability: The company must pay this tax within one month of the income year’s end, typically by 31 July.
- Franking Account Adjustment: A credit is applied to the franking account at midnight on 30 June, resetting the account to zero for the start of the new income year.
- Non-Refundable Tax Offset: The amount of franking deficit tax becomes a non-refundable tax offset for the company. However, if the deficit tax exceeds 10% of the total franking credits, the offset entitlement is reduced by 30%.
For example, consider XYZ Pty Ltd in the FY 2023-24 with total franking credits of $100,000 and a franking account debit deficit of $5,000 at 30 June. The 30% offset reduction does not apply here since the deficit is only 5% of the total franking credits.
Conversely, if the deficit was $15,000 at year-end, exceeding 10% of the total franking credits, the 30% reduction applies. In this case, the franking deficit tax the company can use as a tax offset is reduced to $10,500 (i.e., $15,000 deficit minus $4,500, which is 30% of the deficit). This results in an effective penalty, with the company losing the right to a tax offset of $4,500.
Franking Deficit Tax Concessions for New Companies
There’s a specific concession in the case of franking deficit tax that applies to companies in their first year of operation. This rule acknowledges that new companies might not have paid any PAYG instalments in their inaugural year and thus wouldn’t have accumulated any credits to attach to distributions.The criteria for this concession are as follows:
- Company Status: The company must be a private entity.
- Tax Liability Presence: The company is expected to have a tax liability.
- No Prior Tax Liability: The company hasn’t incurred a tax liability in any previous income year.
- Income Tax Liability Proportion: The income tax liability should be greater than 90% of the franking account deficit.
Additionally, the Australian Taxation Office (ATO) can waive penalties in cases where the 10% tolerance threshold is exceeded due to factors beyond the company’s control. Situations that might be considered include:
- Unanticipated Franking Account Debits: If the company faces a franking account debit that was unforeseen and not within their control.
- Delayed Franked Distributions: If the company doesn’t receive a franked distribution at the expected time.
- Business Downturn: If the company experiences a sudden decline in business, leading to lower PAYG instalments, especially after it has already issued franked dividends.
Getting franking credits right
Franking credits are one of our primary tax strategies to maximise an intelligent business family’s working capital and wealth and the companies they control. The strategy is simple and can become increasingly nuanced with innovative tax thinking on family business operations. If you are focused on long-term strategies, careful management of your franking account, and getting franking credits into the correct tax structuring, you can make a significant impact on the success of a family in business.
At Westcourt, we focus on making families in business great. And given our deep global connections through GGI International, our proven excellence in tax structuring and tax leadership and our independent, impartial advice, we are the logical choice for a family in business looking for tax and business advice on structuring and strategy with their long-term business and personal investment operations – So why not give us a call today?