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London South East does not authorise or approve this content, and reserves the right to remove items at its discretion. One of the ways a company will reward it’s shareholders is by paying out a dividend. Dividends are distributions that are paid using profits that a company has made during the year. For more information about dividends, please visit the dividends page. What is the dividend imputation system? Generally when a company earns profit, they will pay this out to their shareholders in the form of a dividend. Before the dividend imputation system was introduced, the tax office would tax both the companies and the investor, even though this money has already been taxed, so it was a form of double taxing.
How does the franking credit system work? The franking account is only a record of what was paid and does not contain actual money. The company’s ability to frank its dividend will depend on the balance of this franking account. If the franking account isn’t large enough, perhaps because it pays tax overseas, then the company may declare a partially franked dividend. If company XYZ does not make any profit it will pay no tax. Franking credits calculations Here is an example of what the tax implications are of franking credits. Suppose you had 625 units of shares in ANZ.
With the franking calculation above we can see the benefits of the dividend imputation system. The fully franked credits has lowered the investors overall tax rate from 46. Comparing this to a term deposit or fixed interest Lets compare the yield of a fully franked dividend to a term deposit or fixed interest account earning the equivalent 7. So if we compare a fully frank dividend and fixed interest investment, both at 7. For a fixed interest investment to earn the equivalent after tax income, it would need to yield 12. The partially franked imputation credit has effectively reduced the investor’s tax rate from 46.
Franking credits at different tax rates The benefits of the dividend imputation system. The 45 day rule As the examples have shown fully franked dividends and franking credits make investing in Australian shares a tax effective strategy. However, the ATO realises this and to prevent investors from abusing the system they introduced the 45 day rule. A word of warning before you decide to put your life savings into chasing shares with high dividends. Always research the company and look for strong fundamentals, for example what does the company’s dividend history look like? Are the dividends growing year on year in line with the earnings per share?
Is there long term potential for this company? Before 1 July 1987 corporate profits were subject to two lots of tax. Firstly, companies paid company tax on their earnings. Only the “after tax” earnings were then available for dividend declarations. Secondly, individual shareholders paid personal income tax on any dividends received by them, despite the fact that the companies paying them had already paid tax on the underlying profits. This unfair approach has now been replaced.
Under the current system, which is called “dividend imputation”, companies still pay tax on their earnings and then declare dividends, if they wish, out of their “after tax” incomes. However, these transactions no longer involve double taxation. Such dividends are known as “franked” dividends. The company tax which was paid by the company on the portion of the gross profit relating to the dividend is called the “imputation credit”. Individuals receiving a franked dividend are then treated, for tax purposes, as having received as assessable income both the dividend and the associated imputation credit, and as having already pre-paid as tax a sum equal to the imputation credit. Individuals on marginal tax rates which are less than the company rate of tax thus become entitled to a refund of the amount overpaid. If not required as an offset to tax this refund is now available in the form of cash.