What Are Franking Credits, And How Do They Work?

Australia’s unique approach to offering investors franking credits on dividends aims to ensure that company profits are only taxed once.

The system was introduced in the 80s, then evolved in the 2000s to allow investors to claim a cash refund if their franking credit exceeded their tax owed.

Controversy arising from an attempt to reverse that generous policy — by ending cash refunds — was a major reason for Labor’s surprising loss in the 2019 election.

It’s rare that tax policy doesn’t become political.

Still, the issue of double taxation has been a particular bone of contention both in the public sphere and among ordinary Aussies — in part driven by confusion about how franking credits work and divisive views on their fairness.

Let’s explore why they exist and how franking credits work.

(Related: How To Buy Nvidia Stock In Australia)?

What Is Franking Credit?

Dividends are drawn from a company’s income and become investor income once distributed.

Both types of income are taxed by the ATO.

However, franking credit, also known as imputation credit or imputed tax credit, negates your share of tax paid by a company that pays you dividends.

What’s The Difference Between Fully Or Partly Franked Dividends?

The difference between fully and partly franked dividends lies in how much of the profits used to payout shareholders was taxed.

How Are Franking Credits Calculated?

Investors receive franking credit in addition to a cash dividend payment.

You’ll receive annual statements from the companies/funds you’re invested in that indicate unfranked and franked amounts of dividends, and franking credit, related to your shareholding for the financial year.

(Related: Guide To Dividend Investing In Australia)

You need to declare these figures on your tax return to reduce your tax liability, and potentially be eligible for a cash refund.

The tax you’ll pay on dividend earnings will also depend on your marginal tax rate based on your overall income.

Easy Example Of A Franked Dividend Calculation.

Let’s say you held 10,000 shares in National Australia Bank — whose most recent dividend is 84 cents per share, fully franked — you’d receive a dividend payment of $8,500, with $3642 in franking credits.

The calculation used to determine the franking credit on a dividend amount is:

Based on an $8,500 fully franked dividend payout from the shares you held in NAB, which paid the 30% corporate tax rate:

In this scenario, the original $8500 dividend plus franking credit of $3642 would mean you’d received a total dividend income of $12,142—which would be taxed at your marginal tax rate.

The credit would be applied to lower the remaining tax bill or entitle you to a refund.

Your end position would depend on your tax rate.

Which Government Introduced Franking Credit, And Why?

Originally introduced by Paul Keating’s Labor Government in 1987, through what’s known as the dividend imputation system, franking credits were designed to avoid the ‘double taxation’ issue.

Keating described it as a “world first” that would put Australia at the forefront of tax reform and improve the climate for investment in domestic businesses.

He said:

The move did increase the popularity of Australian stocks that offered franked dividends, especially combined with a tax on superannuation fund earnings introduced the following year (1988), which increased the attractiveness of funds holding equity relative to alternative assets.

Why Are Franking Credits Controversial?

For 14 years, you could only use franking credits to offset any tax liability down to zero.

Then, in 2001, John Howard’s Coalition Government changed the system to enable the government to pay investors if the offset from franking credit exceeded their taxable income.

However, criticisms of the policy include the fact that it can result in company profits being effectively tax-free and unfairly reduces the public purse.

In the lead-up to the 2019 election, Labor campaigned on a policy to scrap the cash refund element of the imputation system — and a bloodbath ensued.

The strident public discourse essentially amounted to a “rich versus poor” dichotomy.

Labor claimed removing the refund would bring equity by targeting millionaire retirees, while the Coalition argued it would hurt low-income earners and ‘mum and dad investors’.  

Speaking on the policy at the time, its conceiver Paul Keating said:

However, Labor was defeated, and franking credit cash refunds remain.

In November 2023, the current Labor Government was able to pass a bill that prevents certain dividend distributions from being franked if they’re funded by capital raising, which was seen as a potential manipulation of the system in contravention of the ATOs anti-avoidance measures.

(Related: How To Invest In Index Funds In Australia).

Are Franking Credits A Band-Aid Solution?

A significant number of tax concessions — capital gains discount, franking credit cash refunds, higher income tax scale thresholds, removing tax on super — have been introduced since the early 2000s that predominantly favour wealthier Australians.

Some argue Labor’s efforts to cut the franking credit cash refund was a cynical move by a government unwilling to face the political hurdle of taxing wealthy retirees’ large super balances, or instigating more systematic tax reform.

Who Benefits From Franking Credits?

Any Australian investor who receives franked dividends can use the credit to lower their tax bill or potentially get a refund.

Investors eligible for this extra bonus get the cash included in their refunds from the tax office (or through a direct application to the ATO if not submitting a tax return).

Stockbroker Marcus Padley describes the key traits of a typical ‘set and forget’ retiree investor as follows:

What Is The 45-Day Holding Rule?

If your total franking credit amount in a year is $5,000 or more, you’ll be subject to tax rules designed to ensure you pay your fair share.

Learn more about ATO conditions that could mean you’re not entitled to claim a franking tax offset.

Final Thoughts On Franking Credits.

It’s worth noting that Australia’s model is not widely adopted. Some countries do provide some level of tax offset for dividends paid to investors.

A number have also pared back such arrangements — sometimes in favour of corporate tax cuts — and now offer credits equal to 10-50% of the value of the dividends.

Whether it’s wise, or fair — or not — it is true that franking credits and cash refunds currently provide an opportunity for investors to generate inflated returns from ASX-listed stocks that offer franked dividends.

Whether the tax policy is sustainable or whether future governments will manage to overcome the public outcry to change it in future, remains an unknown quantity.

Jody