Also called imputation credits, franking credits are tax credits Aussie firms can pass on to shareholders to reduce their tax liability. Even though franking benefits offer shareholders substantial benefits, it can create misinterpretations of an investment’s value.
Since most investors are unaware of franking credits’ full implications and how they affect investment decisions, they miss opportunities for higher returns.
The solution to this is understanding franking basics to make more informed decisions. This article explores everything you need to know about franking credits to help you maximize your returns.
Things To Know About Franking Credits
1. Understanding The Math Behind Franking Credits
In Australia, companies must pay corporate tax, which is currently 30% for firms with a yearly turnover above $50 million and 27.5% for those with annual turnovers below $50 million. This tax is applied to the company’s income and is calculated by subtracting deductions from a business’s revenue.
Once a firm pays the tax, it can pass on the franking credits; the transferred credits equal the corporate tax paid. For example, a business paying a 30% tax on $ 32 million in dividends would transfer $600,000 to the shareholders.
You must know a dividend’s franking rate to calculate its franking credit. The franking rate is the percentage of the dividends covered by franking credits.
The formula for calculating a dividend’s franking credit is as follows:
Franking credit = Dividend x (Franking rate / (1 – Franking rate)).
Understanding the effects franking credit have on dividends can help you make informed investment decisions as you’ll look for firms offering fully franked dividends. With fully franked dividends, investors can maximize their after-tax returns since the franking credit reduces your tax liability.
2. Know How Franking Credits Affect Your Tax Returns
When you receive a franked dividend, you’re entitled to a tax credit, the franking credit, which is used to offset your tax liability. Here’s an example to help you understand how franking credits affect your tax returns:
If you own 1000 shares in a company paying a $2 fully franked dividend (with a 30% franking rate) per share annually, you’re entitled to a 60 cents franking credit. This means you receive 1000 shares x $1 in dividend payments and a $600 franking credit which you can use to reduce your tax liability.
To know how much tax you must pay, subtract the franking credit from the tax payable on the dividend income. If you’re paying a 37% marginal tax on the dividend, your tax liability will be as follows:
Tax payable = ($2,000 x 37%) – $600
Tax payable = 140.
It’s essential to understand how franking credits affect your tax liability so that you can compare the after-tax returns for every investment to identify companies offering higher returns opportunities.
3. Understanding Compliance And Eligibility
For you as a shareholder to be eligible to receive franking credits, you must be an Australian resident and hold the shares for at least 45 days. The ATO implemented this rule to prevent investors from purchasing shares solely to receive franking credits and then selling them immediately.
Franking credits and dividend payments are usually paid at the same time. Nevertheless, companies pay dividends and receive a tax refund in some circumstances. In such situations, companies pay the franking credits at a later date.
If your franking credits exceed their tax liability, you’ll receive a franking credit refund, a cash refund for the excess amount. Nevertheless, there are limitations on the franking credit amounts SMSFs and individuals can claim.
Knowing this information will help you consider franking credit payment timing when you’re selling or buying shares and how you can invest in tax-effective structures where you can use excess franking credits.
4. Firms Must Reveal The Franking Credit Amounts They Have
The law requires firms to disclose the amount of franking credits available to investors. This information is essential for investors since it lets them analyze the future tax benefits of investing in the company’s stock.
The information on the number of franking credits a company has is usually found on its financial statements, which are typically released annually. You can also find it in corporate communications, like announcing the organization’s dividend.
Knowing the number of franking credits a firm also allows investors to gauge the potential ROI and tax liabilities. If a firm has higher franking credits on its dividends, you can reduce your tax liability and increase your returns.
Further, knowing the number of franking credits a company offers insight into their financial health—companies with high franking credit levels are more profitable as they can generate adequate taxable income to support their dividends.
If you need help identifying companies that offer high franking credit levels, use tools such as HALO technologies. Click here to learn more about how this platform can help you identify opportunities and manage and maximize investments.
5. Know The Risks Involved
Even though franking credits offer substantial benefits to investors, there are risks involved in investing in them. Investing in firms offering franked dividends exposes you to firm-specific risks like declining profitability, financial instability, and poor management. You’ll lose money if the company reduces dividend payments or financial difficulties.
Financial companies are most likely to offer franked dividends; however, the financial sector is more sensitive to market conditions, commodity prices, and economic policies, which can affect dividend payments.
Investing in franked dividends exposes you to market risks like exchange rates, inflation, and interest rate fluctuations which affect overall returns and your investment’s value. Regulation changes can also affect franking credit value, thus reducing the tax benefits you’ll receive with franked dividends.
To reduce these risks, ensure you assess a company’s financial stability and the sector they’re in before investing. It’s also essential to consider legislative and market volatility impacts on the investments.
Understanding these risks and doing your due diligence before investing will help you make an informed decision and diversify your portfolio to spread risk.
Bottom Line
If you understand how franking credits work, they can offer you substantial tax benefits. Investing in companies offering franked benefits will help you reduce your tax liability and increase your ROI.
Nevertheless, you should carefully research and have the plan to mitigate the risks involved in franking credits to maximize your returns. Assess your investment goals and risk tolerance before investing in franked dividends.
