Let’s be frank — there’s a lot of jargon out there when it comes to the stock market.
Investors who don’t know their self-managed super fund from their share purchase plans could get lost at sea when navigating the local bourse.
There’s one realm that can seem especially daunting to the newly attuned: franking credits are an interesting beast, and there’s a lot to learn about their impact on your tax return.
So just what does this credit have to do with your investment, and how is it linked to the dividend system?
All about dividends
When a company is performing well, it can return some of its earnings to shareholders in the form of a dividend.
There are many kinds of dividends — they’re usually paid out in cash or stock and are announced during reporting season when the company recaps its performance in the last financial year.
Think of a dividend as a way the company thanks shareholders for their investment, ensuring they get to reap some of the financial rewards outside of its share price performance.
And it’s not just companies that hand out dividends — passive investments like exchange-traded funds (which you can learn more about here) also reward investors.
Dividends are usually calculated on a per-share basis, meaning every share you hold in the company is eligible to receive so many dollars or cents back as a dividend.
Typically, in order to be eligible for a dividend, all shareholders have to do is own stock in the company before what’s known as the ex-dividend date.
If you’re looking for an investment that pays dividends, it’s best to look at established, large-cap stocks that have a history of turning a profit.
These companies have a pattern of making dividend payments on a regular basis, and they can even issue non-recurring special dividends if things are tracking especially well.
Now, in Australia, investors can receive dividends that are franked or unfranked.
What’s the difference, you ask? It’s all about taxation.
Let’s be frank
When a company pays out dividends, it can take from profits that have already been taxed, resulting in what’s known as a fully franked dividend.
The Australian company tax rate currently stands at 30% — in this case, that means 30 cents from every dollar distributed in dividends has already been taxed.
So, in an effort to avoid double taxation on dividends, and to stop the government from effectively ‘double dipping’ on taxed income, shareholders can apply for a credit on any tax the company has already paid.
This is known as a franking or imputation credit, and it ensures you’re not taxed twice on your dividend income.
Think of it this way. You invest in Company X. They’ve had a good year, and you’ve got a substantial parcel of shares, so you’re set to receive $700 in dividends.
But what if Company X’s profit hadn’t been taxed? If that was the case, your dividend would be $300 more, and you’d walk away with $1,000 in your pocket.
So it’s tax time, and you’re ready to declare your dividends on your tax return. Company X gave you $700 in fully franked dividends, as well as a $300 franking credit that represents the tax that’s already been paid.
Both these things count as taxable income, so you need to declare $1,000 on your tax return.
Now, if your marginal tax rate — that’s the amount of additional tax you pay for every additional dollar earned as income — is 15%, you’re set to pay $150 in tax on that $1,000 dividend payout.
But because $300 has already been paid in company tax, you get the difference back in your pocket — in this case, that’s $150.
But what if a dividend wasn’t fully franked? Sometimes, they can be partially franked, or not at all.
In the former case, only part of the 30% company tax rate has been paid on the dividend. As above, a partly franked dividend that’s only 50% franked will involve a credit of $150 — half of the $300 credit you’d receive on a fully franked dividend.
Unfranked dividends, as the name suggests, haven’t had any tax paid, so this needs to be covered in your text return.
The bottom line
There’s still a lot to learn about franking credits and their implications for your investments, but being armed with the basics is crucial for the early investor.
Talk with your tax professional about how franking credits can impact your tax return, and how to report them come June 30.