How Does Franked Investment Income Work?
Learn the mechanics of the dividend imputation system. This guide clarifies how franking credits connect company tax to an investor's tax assessment.
Franked investment income is a dividend paid to a shareholder on which the company has already paid corporate income tax. This system, common in countries like Australia and called a dividend imputation system, is designed to prevent the double taxation of corporate profits. Double taxation occurs when profits are taxed at the corporate level and again when a shareholder receives a dividend.
When a company pays tax on its profits, it can attach a franking credit to its dividends, which represents the tax already paid. Shareholders can use this credit to reduce their personal income tax liability, ensuring the profit is ultimately taxed at their individual marginal rate.
The Corporate Franking Account
A company that pays franked dividends maintains a special account called a franking account. This account operates like a ledger to track the company’s income tax payments and the franking credits it attaches to dividends. It is a notional account for tax-tracking purposes, not a bank account with cash. The balance in the account represents the total amount of franking credits a company has available to pass on to its shareholders.
When a company pays its income tax, it generates a credit in its franking account. When the company pays a franked dividend to its shareholders, it makes a debit to the account, reducing the available credits. The company cannot attach more credits to its dividends than it has available in its franking account, which ensures the credits correspond to actual taxes paid.
The maximum franking credit a company can attach to a dividend is determined by its corporate tax rate. While many companies pay tax at a 30% rate, a lower rate of 25% applies to certain smaller companies. A dividend paid with the maximum possible credit is called a “fully franked” dividend. If a company has not paid tax on the full amount, it may issue a “partially franked” dividend with a smaller credit attached.
Calculating Tax on Franked Dividends for Individuals
The first step for an individual shareholder is to “gross-up” the dividend by adding the cash dividend received to the franking credit amount on the dividend statement. This combined total is the income that must be reported for tax purposes. It represents the shareholder’s share of the company’s pre-tax profit.
For example, an investor named Lee receives a fully franked dividend of $70 with a franking credit of $30. Lee must “gross-up” this income by adding the two amounts ($70 + $30). This results in a total assessable income of $100 from this dividend, which is the figure he will include in his taxable income.
The next step is to calculate the tax on the grossed-up amount using the individual’s marginal tax rate. If Lee’s marginal tax rate is 16%, the initial tax on the $100 of dividend income would be $16. This is the preliminary tax liability on the investment income before any credits are applied.
Finally, the franking credit is applied to reduce the tax payable. In this example, Lee subtracts the $30 franking credit from his calculated tax of $16. Since the credit is greater than the tax owed, Lee owes no tax on the dividend and is entitled to a tax refund of the excess $14. If Lee’s marginal tax rate had been 45%, the tax on the $100 would be $45, and subtracting the $30 credit would leave a final tax bill of $15.
Franked Income for Other Entities
When a company receives a franked dividend from another company, it includes both the dividend and the franking credit in its assessable income. The company receives a tax offset for the franking credit amount. The received franking credit is also added to the balance of the recipient company’s own franking account. This makes those credits available to be attached to future dividends paid to its own shareholders.
For trusts, franked dividends involve a “flow-through” process. The trust receives the dividend and associated franking credits, then distributes them to its beneficiaries along with other income. The beneficiaries are then responsible for the tax implications.
Each beneficiary receives a statement from the trust detailing their share of the franked dividends and attached credits. The beneficiary then treats this income as if they received it directly. They perform the same gross-up calculation and apply the franking credit against their personal tax liability, similar to an individual shareholder.
Reporting Franked Income and Credits
When completing an individual tax return, the dividend statement from the paying company is the source document for the required figures. Taxpayers must report the “unfranked amount,” the “franked amount,” and the “franking credit” in separate fields on the tax form. It is important not to simply report the cash amount received in the bank.
On the Australian Taxation Office’s (ATO) individual tax return, for example, these amounts are entered in the “Dividends” section. The form requires the taxpayer to separately list the unfranked portion of any dividends and the franked portion of the dividend.
The franking credit is reported at a specific label, often titled “Franking credit” or “Imputation credit.” Tax return software will then automatically add the franked dividend and the franking credit to calculate the grossed-up income. The system then subtracts the total franking credits to determine the final tax payable or refundable.