How Franked Dividends Work: Eliminating Double Taxation and Maximizing Investor Returns

What are Franked Dividends?

Franked dividends are a type of dividend that comes with attached tax credits, known as franking credits. These credits represent the tax already paid by the company on its profits before distributing them as dividends. Unlike unfranked dividends, which do not include these tax credits, franked dividends provide a significant advantage to investors by reducing their overall tax liability.

The introduction of franked dividends was a strategic move to address the issue of double taxation. Before 1987, companies would pay tax on their profits, and then shareholders would be taxed again on the dividends they received. This system ensured that the tax burden was shared fairly between companies and their shareholders.

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How Franked Dividends Work

The process of how franked dividends work is straightforward yet beneficial for investors. Here’s a step-by-step explanation:

• Company Tax Payment: When a company makes a profit, it pays tax on that profit at the corporate tax rate.

• Dividend Distribution: The company then distributes some of these after-tax profits to its shareholders in the form of dividends.

• Franking Credits: Along with the dividend, the company attaches franking credits equal to the amount of tax it has already paid on those profits.

• Shareholder Taxation: Shareholders include both the dividend income and the franking credit as part of their taxable income. However, they are only taxed on the dividend portion at their marginal tax rate.

For example, if an investor receives a fully franked dividend of $100 with a $30 franking credit (assuming a 30% corporate tax rate), they would include $130 ($100 dividend + $30 franking credit) in their taxable income. However, they would only pay tax on the $100 dividend amount at their marginal tax rate.

Types of Franked Dividends

There are two main types of franked dividends:

Fully Franked Dividends

In this scenario, the company pays tax on the entire dividend amount before distributing it to shareholders. As a result, investors receive 100% of the tax paid as franking credits. For instance, if a company distributes a fully franked dividend of $100 and has paid 30% corporate tax ($30), the investor receives both the $100 dividend and the full $30 franking credit.

Partially Franked Dividends

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Sometimes, companies may only pay tax on a portion of the dividend amount. In such cases, investors receive partial tax credits corresponding to the portion of the dividend that was taxed by the company.

Calculating Franking Credits

To calculate franking credits for fully franked dividends, you can use the following formula:

[ \text{Franking Credit} = \left( \frac{\text{Dividend Amount}}{1 – \text{Company Tax Rate}} \right) – \text{Dividend Amount} ]

For example, if you receive a fully franked dividend of $100 and the company’s tax rate is 30%, you would calculate:

[ \text{Franking Credit} = \left( \frac{100}{1 – 0.30} \right) – 100 = \left( \frac{100}{0.70} \right) – 100 = 142.86 – 100 = 42.86 ]

However, since this calculation is based on simplification for illustration purposes, in practice, you would simply receive a franking credit equal to the amount of tax paid by the company (in this case, $30).

Tax Implications for Investors

The tax implications of franked dividends can vary significantly depending on an investor’s marginal tax rate:

• Higher Marginal Tax Rate: If an investor’s marginal tax rate is higher than the company’s tax rate (e.g., 40% vs 30%), they will still benefit from receiving franking credits but will pay additional tax on their higher marginal rate.

• Lower Marginal Tax Rate: If an investor’s marginal tax rate is lower than or equal to the company’s tax rate (e.g., 20% or 30%), they may receive a tax refund for any excess franking credits.

• No Tax Liability: In some cases where investors have no other taxable income or are eligible for certain tax offsets, they might receive a full refund of their franking credits.

Comparative Analysis: Franked vs Unfranked Dividends

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When comparing franked dividends with unfranked dividends, several key differences emerge:

• Tax Treatment: Franked dividends come with attached tax credits that reduce an investor’s overall tax liability. Unfranked dividends do not include these credits.

• Benefits: Franked dividends offer potential tax refunds for investors with lower marginal tax rates or no other taxable income. Unfranked dividends do not provide such benefits but can offer diversification benefits when derived from international companies that operate under different tax regimes.

For investors seeking to minimize their tax burden while maximizing returns, franked dividends are generally more advantageous due to their built-in tax credits.

Practical Examples and Case Studies

Let’s consider a hypothetical example:

Suppose John receives a fully franked dividend of $500 from an Australian company that has paid 30% corporate tax ($150). If John’s marginal tax rate is 25%, here’s how it works out:

• John includes both the $500 dividend and the $150 franking credit in his taxable income ($650).

• He pays 25% tax on the $500 dividend portion ($125).

• Since he has already included the full $150 franking credit in his taxable income, he gets a refund for the difference between what he included ($150) and what he actually owes ($125).

This results in John receiving a refund of $25.

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