The tax gift of franking credits and how they can work for you
As part of a diversified investment portfolio, Australian shares that deliver franking credits can be a smart investment that provides tax benefits.
Shareholders are passionate about their franking credits – and with good reason, as they can be a valuable tax tool.
Controversy over possible changes to the benefits, also known as imputation credits, during the 2019 federal election campaign served as a reminder as to just how much investors, and retirees in particular, love them.
So, what are franking credits? In essence, they are a rebate that some Australian shareholders receive from the government at tax time in relation to their share dividends. Those dividends represent a portion of earnings that a company passes on to shareholders as a reward. As a form of income, that dividend, is normally subject to tax.
However, criticisms that government was engaging in double-taxation led to the introduction of the franking credits system in Australia in 1987. The theory is that because a company distributing dividends has already paid taxes on those dividends, it is unfair to then slug individual shareholders with a tax on those dividends, too. In effect, the franking credits allow companies to allocate a tax credit to their shareholders.
How they work
In Australia, franking credits are paid to investors who fall into a tax bracket from 0% to 30% (investors with a tax rate above 30% are not eligible). If your tax rate is 0% – which is often the case for retirees – you will receive the full tax payment paid by the company to the Australian Taxation Office as a tax credit. The credits decrease proportionally as your tax rate rises.
Here is a simple example of franking credits at play. Think about an Australian company that makes a $100 profit. It pays $30 tax on that profit and distributes a $70 cash dividend to shareholders. They also receive a franking credit of $30.
As a result, the shareholder declares that $100 as part of their assessable income in their tax return. If the total income they receive is too low to be taxable, the shareholder gets a tax offset of $30.
Clearly, the extent of any gains will depend on an individual’s tax rate, but the benefits can be significant for shareholders with a large portfolio.
Shares can be fully franked, partly franked or unfranked. Fully franked dividends mean the company’s total profit, from which dividends are paid, has been subject to corporate tax in Australia. They offer the maximum franking credits available. Partly franked or unfranked assets involve those when a company has not paid tax on the full amount being distributed to shareholders.
Diversification still crucial
One key point to remember is that franking credits apply only to Australian equities from companies which pay tax on their Australian earnings. The credits do not apply to global equities or property trusts. You must also be an Australian resident for taxation purposes to receive the benefit.
The exclusion of global shares from the franking credits system means you should be selective about the equities you buy if you are trying to maximise credits from your portfolio.
Here is a message of caution, though. In the quest to get franking credits, some investors may deliberately ignore global investment opportunities and focus only on Australian shares. This may be an unwise move because international assets may deliver strong returns and help diversify your portfolio.
Just because a company pays tax domestically and delivers a franking credit does not mean that it is a good buy. Any credits will be largely irrelevant if your shares are market underperformers and keep dropping in value. We refer to this scenario as a value trap – that is, what may appear on the surface to be a good investment opportunity can be illusionary because of any number of factors.
In this case, the trap is to fall in love with equities that deliver a modest tax benefit through franking credits, but which deliver poor long-term earnings.
Seek expert advice
As with any investment, the quality of share purchases should be assessed carefully through expert research to ensure that myriad factors have been weighed up. Is the company making strong profits? Is it driving down costs and ramping up efficiencies? Is it a sustainable enterprise? Are franking credits available?
Depending on the size of a share portfolio, franking credit calculations can get complicated for the uninitiated, so it is important to seek professional advice to maximise any tax advantages.
With the backing of experienced financial advisers, franking credits can be a gift that keeps giving.
To find out more about franking credits and equity investments, speak to one of our Adrians Private Wealth partners.