How do franking credits work?

What is a Franking Credit?

A ‘Franking Credit’ is also known as ‘imputation credits’. The simplest way possible is that it’s a credit for income tax that’s already been paid by the company. So when a company makes a profit it will pay tax on those profits. The tax the company pays will also give rise to a franking credit.

For example, when a company pays $2,500 in tax this will generally give rise to $2,500 in franking credits.

Now, you’re probably thinking, so what if the company has franking credits? How does that affect me?

If you’re a shareholder of a company and the company pays out dividends to its shareholders (so you receive them), it will normally pay dividends out of after-tax income. Meaning, the dividend a shareholder receives has already been taxed once in the hands of the company.

As a shareholder, you are receiving money left over after the company has already paid tax on it. Then what happens is, when the money hits the shareholders account (so you receive the dividend), it’s going to get taxed again in your hands. So if you got once in the company and once in the shareholder’s hands, you might be thinking that you’re getting twice tax on the same dollars! Yes, you heard it right, it’s twice!

Luckily, the lawmakers understand that getting taxed twice is not good so that’s when the franking credits come in. A franking credit which remembers is a credit for the tax that’s already been paid by a company is normally attached to a dividend when they’re paid out. The shareholders will then receive the franking credit and the cash dividend and they can apply for the credit against the tax they need to pay on the dividend they receive. Honestly, I think I should have called this a company tax credit but you know can’t make things too simple for people.

Let us take a look at some scenarios of how ‘franking credits’ work.

Scenario 1: NO FRANKING CREDITS

CryptoCo makes $10,000. Meaning CryptoCo has $10,000 sitting in their bank account. CryptoCo will pay tax on that $10,000, let’s say the tax rate is at 25%. So CryptoCo will pay $2,500 tax. After paying tax, CryptoCo will now have $7,500 left in its bank account. Let’s say CryptoCo wanted to pay out all of its profits to its shareholder Elon. So Elon receives a cash dividend of $7,500 and also has his money sitting in his bank account. Now, let’s say Elon’s tax rate is also at 25%. Elon will pay $1875 tax on the $7,500 cash dividend that he receives. After paying the tax Elon will have $5,625 left in his bank account.

As you can see, that $10,000 became $5,625 by the time Elon had finished paying tax on it. And that’s not good that you are being taxed on the same dollar twice.

SCENARIO 2: WITH FRANKING CREDITS

CryptoCo makes $10,000. Let’s say the tax rate is at 25%. So CryptoCo will pay $2,500 tax. After paying tax, CryptoCo will now have $7,500 left in its bank account same as before. But this time, because it had paid the tax it will also have $2,500 in ‘franking credits’. Let’s say once again CryptoCo decides to pay out $7,500 as a cash dividend to Elon, so all the money it has it will pay as a dividend. This time, it will attach those $2,500 franking credits to go along with that dividend.

In this example, Elon receives $7,500 in cash and $2,500 in franking credits. So Elon receives $10,000 in total in a combination with cash and franking credits. Let’s say Elon pays tax at the same rate before at 25% then Elon will have a $2,500 tax bill. Before Elon needs to pay anything though we can apply those franking credits that came along with the dividend from CryptoCo. Remember, these are credits for the tax that CryptoCo has already paid, and this can be used as a tax credit for Elon. Elon will apply his $2500 franking credits against his $2500 tax bill which completely wipes out his tax bill. Elon still has $7,500 left in his bank since he didn’t have to pay any tax because of those tax credits. So Elon is happy! Woohoo!

Let’s compare those two examples.

SCENARIO 1: We started at $10,000 and ended up at $5,625.

SCENARIO 2: We started at $10,000 and we ended up at $7,500. Not paying tax twice. It makes a huge difference! Right?!

See, Franking Credit makes a huge difference. If I will ask you, would you like to pay tax twice? Come to think of it. (Of course, our answer here is ‘no’)

You may also visit the ATO website to learn more about ‘Franking Credits’: https://www.ato.gov.au/Non-profit/Your-organisation/Investments,-credits-and-refunds/Franking-credits/

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