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What are franking credits in Australia?

Learn how to calculate franking credits on your investment portfolio.

Ever wondered about franking credits while living in Australia? Put simply, franking credits – also called imputation credits – are a tax break for shareholders who receive dividends from companies that have already paid tax on their profits.

To help you discover more, this guide will talk about franking credits covers topics like the definition of franking credits, their calculation, examples, benefits for investors, and why they are controversial.

What is a franking credit?

Franking credits are tax rebates for shareholders of Australian companies, designed to avoid double taxation on dividends. They reflect the tax already paid by the company on its profits, credited to shareholders at tax time. Unique to Australia's tax system, franking credits have both proponents and critics, and their complexity often confuses many.

Here's what this means for you: If you're invested in the Australian stock market, franking credits are an integral part of your dividends.

Dividend explainer

When you buy shares in a company, you may be eligible to receive a slice of its profits, which comes in the form of dividends. Dividends are offered twice a year and are calculated as a percentage of the total value of the shares held by the investor.

These credits are particularly beneficial for self-funded retirees, enhancing income from share portfolios. The system ensures that corporate profits are not taxed twice – first at the corporate level and then at the shareholder level.

How to calculate franking credits

To understand how franking credits are calculated you need to understand the tax implications of dividends. Dividends may be fully or partially taxed at the corporate rate of 30% before going on to shareholders. These are:

  • Fully franked dividends. The corporate tax rate of 30% has been applied to 100% of the dividend.Imagine a company makes some money and pays 30% of it as tax to the government. Now, when the company gives you, the investor, a part of its profit (which we call a dividend), it's already paid tax on it. This is a fully franked dividend - the tax is already taken care of.
  • Partially franked dividends. Only a portion of the dividend has had the 30% corporate tax applied.In this case, the company only pays tax on part of the profit it gives you. So, if you get a dividend, only some of it has the tax paid. It's like if someone gave you a sandwich but only put cheese on half of it.
  • Unfranked dividends. No tax has been deducted from the dividend.Here, the company gives you a part of its profit, but it hasn't paid any tax on it. It's all yours to deal with when it comes to tax time.

When investors receive franked dividends they also get franking credits which represent what the company has paid in tax. If your marginal income tax rate is greater than the 30% corporate rate, you'll need to pay the difference. If your tax rate is lower than that, you get a franking credit rebate which will either reduce your final tax bill or result in a cash refund.

Why do investors get tax credits?

The reasoning is that because company profits are already taxed at the corporate rate of 30%, investors shouldn’t need to pay income tax for a second time on the dividends they receive. To avoid double taxation, franking credits are offered to reduce the tax bills of shareholders by the amount that has already been paid by the company.

ATO 2023 update

The Australian Taxation Office (ATO) released a consultation paper on new legislation related to franking credits for distributions funded by capital raisings.

This new legislation, known as the Treasury Laws Amendment (2023 Measures No. 1) Bill 2023, was passed by Parliament on 16 November 2023 and received Royal Assent on 27 November 2023.

The ATO is currently seeking feedback on whether additional public advice and guidance is needed to help entities understand how the new law applies to their circumstances, with submissions due by mid-February 2024.

However, the vast majority of the world disagrees with this assertion.

During the late '90s and early 2000s, countries including the UK, Germany and France removed dividend imputations, while Australia under the Howard government began making excess credits refundable.

Cash refunds for excess franking credits

In 2001, the Howard government introduced cash refunds on excess franking credits. It meant that shareholders with zero tax owing got their credits converted into cash payments at the end of the financial year.

For example, if you’re retired and have no income to declare, you could receive franking credits for assets and shares you own. In this case, you may be able to receive your franking credits as a cash payment from the government.

Note: It’s important to understand that dividends are considered taxable income. So a tax bill on dividends can only be zero if held in a retiree’s self managed super fund (SMSF) or super fund or if the shareholder's total income is less than $18,200 (the minimal marginal tax bracket).

The ATO outlines that to be eligible for a refund of excess franking credits, you must meet specific criteria like receiving franked dividends directly or through a trust or partnership, and your basic tax liability must be less than your franking credits after considering other tax offsets.

Also, there are anti-avoidance rules, including holding period and related payments rules, to ensure fair play.

Example of franking credits in action

There’s no getting around the fact that franking credits are complicated. The easiest way to understand how they work is through a simplified example.

  • Say you own shares in company X, which pays you $1,400 of fully franked dividends in cash during the year. Meanwhile, company X has already paid $600 in taxes on those dividends to the ATO (at the corporate tax rate of 30%) which are converted into franking credits and sent back to you – so you would have franking credits of $600.
  • Your total taxable income on these dividends would be dividend received in cash and franking credits, so $1,400 + $600 = $2,000.
  • Let's say your individual marginal tax rate was 40%, that would mean the tax owing on this $2,000 at 40% = $800. However, as company X has already paid 30% tax on your $600 of franking credits, you would only need to pay the difference of $200 in tax ($800 - $600).
  • If you were on a lower tax bracket of say 15%, you’d receive $300 franking credits, which would be used to reduce your remaining total tax bill and you’d get whatever was remaining of that paid to you in cash.
  • What if your marginal tax rate is zero? On the $2,000 of taxable income above, you would owe $0 tax. As $600 was already paid by the company, this means you would get the full $600 cash back from the government. This is why the franking credit debate has become a focus for retirees who have little or zero tax owning.

Impact of franking credits on tax return

Person 1Person 2Person 3SMSF fund*
A: Individual marginal tax rate40%30%0%0%/15%
B: Dividend received in cash$1,400$1,400$1,400$1,400
C: Franking credit received$600$600$600$600
D: Total amount declarable in tax return (B + C)$2,000$2,000$2,000$2,000
E: Notional tax at marginal tax rate (A x D)$800$600$0$0/$300
F: Tax owed/receivable (E - C)- $200$0+$600$600/$300

*Income on assets held within an SMSF are tax-free until $1.6 million within retirement phase and taxed at 15% in accumulation phase.

How do franking credits benefit investors?

The current franking credits policy benefits all share investors to some degree, but the biggest beneficiaries of cash refunds are retirees and SMSF holders since SMSFs are taxed at 0% when in pension phase and 15% when not.

Using the scenario above, if a retired SMSF holder receives $1,400 of fully franked dividends, they would get a $600 cash refund.

For this reason, SMSF holders benefit by investing in companies that offer fully franked dividends. Rather than selling their shares to gain a profit, shareholders can earn an income solely from dividends with the additional bonus of franking credits. Using this strategy, they may never need to sell their shares.

While investing in dividend-paying companies may be useful under the current franking credits policy, things could change depending on the whims of the government. For this reason, investors are cautioned not to rely too heavily on this investment strategy.

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