Investing basics: your guide to franking credits

If you've kept your finger on the pulse in recent weeks, you will have noticed franking credits are back in the news.

The inherent complications of the franking credit system – or dividend imputation – partly explain the impassioned debate, along with changes made over the years.

In this article, we'll attempt to explain exactly what franking credits are, so you can confidently wade into the debate should you choose.

Photo: Paul Harris / Sydney Morning Herald

What are franking credits?

An imputation or franking credit is a note that comes with share dividends that says company tax has already been paid on the dividend. This gives the shareholder a discount on their tax at tax time and thus avoiding double taxation.

Confused? Let's break it down.

Australian companies get taxed on the profits they make. They can then choose to distribute after-tax profits to shareholders as dividends.

Here's the rub. In this scenario, the tax office appears to be claiming tax on those company profits twice. Once as taxation of profits when earned by a company, and again when a shareholder receives a distribution and declares it as income tax. Some people see this as a bad thing.

Before dividend imputation was introduced, Australian companies would pay company tax on profits, and then if it paid a dividend to shareholders, this was taxed as part of the individual's income.

Dividend imputation was implemented in 1987 by the Hawke-Keating Labor government, to prevent double taxation. Under this system, Australian companies would still pay company tax and post-tax dividends to shareholders, but they could declare how much tax it pays to be "imputed" with the dividend it paid.

Dividends with imputed tax are called "franked dividends". Under the previous system, shareholders who receive franked dividends can declare both the dividend and any imputation credits on their tax return, and are entitled to claim a tax credit from the Australian Taxation Office.

At this stage, excess franked credits over a taxpayer's tax liability were "lost". Essentially, shareholders could decrease their tax liability down to zero, but they couldn't claim cash back.

Enter the Howard-Costello Liberal Government. In 2000 they made franking credits fully-refundable, meaning shareholders could reduce their tax liability past zero and receive cash refunds.

Here's how it works in practice:

Step 1: You own 1,000 shares in company ABC. ABC makes a pre-tax profit of $100 and pays company tax of $30 - the 30 per cent corporate tax rate. This leaves ABC with $70 in after tax profit. ABC decides to distribute all after tax profit in a franked dividend to shareholders. Dividends are a portion of company profits paid to shareholders, in return for their investment.

With me so far? Here's where things get complicated:

Step 2: The Australian Taxation Office receives $30 in tax from ABC. The ATO also incurs a $30 franking credit obligation - essentially an "IOU" to shareholders.

Step 3: You as a shareholder in ABC now receive $70 in dividends and a $30 tax credit from the ATO. Therefore, your taxable income is $100. Your current marginal tax rate is 45 per cent. Therefore, you incur a tax obligation of $45, 45 per cent of $100. However, your tax obligation is minimised by the amount of the franking credit of $30. If you trade in your franking credit, your final tax obligation is reduced to $15.

It's important to note that excess franking credits also apply to shareholders who pay no income tax. So, using the example above, if your marginal tax rate is 0 per cent – for instance, you're retired or are otherwise not in paid employment – you could receive the full $30 credit in cash.

The policy really kicked into gear in 2007, when the government made benefits paid from taxed sources – like super benefits – tax free for those over 60. In conjunction with the 2000 changes, many untaxed retirees could now receive dividend imputation cheques – a cash refund – from the government.

This was capped in 2017 by the Malcolm Turnbull government, who limited tax free super to accounts with less than $1.6 million.

Labor says cash refunds for excess imputation credits are costing the budget $5 billion a year.

What is Labor proposing now?

Opposition leader Bill Shorten announced in March last year Labor's plan to return the dividend imputation system to the original 1987 format, by axing cash refunds of excess franking credits.

"Australia is the only country in the world with fully refundable imputation," Opposition Treasury spokesman Chris Bowen says. "Dividend imputation will remain, but cash payments will no longer be made to people who have managed to reduce their tax rate to zero or have paid no income tax."

Labor's scheme references Parliamentary Budget Office modelling that suggests 85 per cent of retired non-pensioner recipients of franking credit refunds are in the top wealth quintiles of households.

As yet, no PBO modelling has been conducted by the opposing camp, as embattled Liberal National Party MP Tim Wilson told Morningstar in November.

Tim Wilson, the Liberal MP leading the franking credits inquiry, has been accused of unethical behaviour.

The policy caused an initial backlash, which forced Labor to exempt those on the Age Pension, charities and not-for-profit institutions. Pensioners and SMSFs with at least one member who is either a pensioner or allowance recipient are also exempt.

Want to know more? At Morningstar.com.au we've been covering this issue since Labor first proposed the policy shift in early 2018:

• Franking fright: Labor plan sparks SMSF investment switch [02 Jan 2019]
• Franking credits shape as election battleground [30 Nov 2018]
• Franking changes won’t deter stock investors [19 Nov 2018]
• Divergent views on proposed franking credit overhaul 13 Nov 2018]
• Draconian franking credit plan will spur recession, says Wilson [30 Oct 2018]
• Impact and opportunity: Bracing for Labor’s franking credit overhaul [19 Oct 2018]
• Dividend imputation: New tax grab or return to original purpose? [14 Mar 2018]
• Dividend imputation: Is class war raging? [15 Mar 2018]

This article previously said "SMSFs with at least one pensioner or cash-rebate recipient" would be exempt from Labor's proposal to remove excess franking credits. It should have said at least one recipient of an Australian Government pension or allowance.