What Is Franking?

A Simple Explanation of Franking

A member asked - we should all know the basics. You only need to learn them once.

A company earns $100:

• The company pays $30 in tax to the ATO.
• The company has $70 of retained earnings.
• The company pays a $70 fully franked dividend to X.

This is where franking starts. The ATO decided that if they then taxed X on his $70 as assessable income, they would be taxing the $70 twice (it is post-tax money after all - the company has already paid tax on the $70). So, when the $70 arrives in the hands of the shareholder, the ATO hypothetically adds back the $30. It is an imputed (not real) credit so is called an imputation credit.

• So for tax purposes, X gets $70 and an imputation credit of $30 (tax already paid on the dividend).
• X is entitled to a tax rebate (refund) equal to the amount of the imputation credit.
• Both the dividend and the imputation credit are included in X’s assessable income, so he is now assessed on $100.
• X's tax for the year is worked out and the $30 is taken off the tax bill.

The huge development is that originally you had to be paying tax to claim the rebate. For the $30 to be any good to you, you had to be paying $30 or more in tax. But this has changed.

'Excess' franking credits can now be claimed off the ATO as cash.

Suddenly, all the low and no-tax-paying entities (retirees in pension mode) can make use of franking credits. They can claim franking credits back as cash, even though they don’t pay any tax to offset the credits against. In the new world of super legislation and a zero-tax environment, you can see that stocks offering franking credits are now targeted by a huge body of retirees who previously weren't interested. Everyone wants them... not just taxpayers but tax-free investors, because they can claim back all the tax paid to the government on the dividend by the company and they are not taxed on it. Only companies that pay taxes to the Australian government can offer their shareholders franking on their dividends. Australian listed companies that earn all their money overseas and don’t pay any Australian tax will have no credits imputed (imputation credits), and cannot offer franking to their Australian shareholders. Companies that have paid the Australian government tax on all their retained earnings can then pay out a dividend and offer 100% franking. Some companies pay some Australian tax on some of their earnings and none on other earnings made outside Australia. So, they have a mixture of retained earnings, some of which have imputation credits attached, and other retained earnings with none. These companies will pay partly franked dividends.

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REITs are also different. They (generally) have no franking because they pay no tax to the government. They are trusts, and have to distribute their retained earnings. The earnings are taxed in the hands of the shareholder (beneficiary), and so they have zero franking because no tax has been paid on the dividend (it's not strictly a dividend, it's a distribution). Some REITs do have partial franking when they also own a business that is not in a trust structure. In other words, not all companies can offer franking, and those that earn their money overseas and pay tax over there, but are listed here, are not paying Australian tax on all their earnings, so their dividends are only partially franked or unfranked. In the US, you get taxed on dividends even after the company has already paid tax on the retained earnings used to pay the dividends. It is a 'double dip' by the government. This is the main reason why Warren Buffett’s Berkshire Hathaway didn't pay a dividend in over 40 years. It is why there is a culture of not paying dividends in the US, and using bonds, not equities, for income.

Note:

You have to be an Australian or Australian entity paying tax in Australia to claim franking credits. This is an interesting point, because it means that international fund managers don't have any interest in franking as they can't claim it. In fact, they are disadvantaged by share prices reflecting the value of franking. So, international institutions (fund managers) are thought likely to sell banks into the pre-dividend rally and buy them back after they go ex-dividend because they think that prices get pumped up by Australians chasing franking. They take advantage of that, and in so doing avoid the ex-dividend period. This is why the banks are thought to peak a week ahead of the ex-dividend date.   More about the author – Marcus Padley Marcus Padley is a highly-recognised stockbroker and business media personality. He founded the Marcus Today Stock Market Newsletter in 1998. Over the years, the business has built a community of like-minded investors who want to survive and thrive in the stock market. This is achieved through a combination of daily stock market education, ideas and activities.

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