In most countries company profits are taxed twice. The company pays tax and the after-tax portion is sent to investors as a dividend and is then taxed again as personal income. In Australia, company profits are only taxed once because the shareholder is responsible for the tax on their total share of the company’s profits, not just the dividend they receive in their bank account. Therefore, the shareholder’s personal tax return needs to take into account the pre-paid company tax.
It does this by adding the pre-paid company tax component of the dividend (franking credit) to the personal taxable income of the investor who then pays tax on that larger amount. Shareholders are required to pay tax on income they never received, but the pre-paid company tax becomes a tax credit that can be used to pay that personal tax.
A $100 portion of company profits means that $30 was sent to the ATO as company tax and $70 was sent to the investor as a dividend. But the investor’s taxable income is $100, not $70. That’s why the dividend needs to be “grossed up” - so that it includes the franking credit in the taxable income. If the investor has a marginal tax rate of 45%, they pay $45 tax on that taxable income (and they pay more tax on that $100 company profit than the company did originally), but they can use the pre-paid $30 tax credit to help pay that personal tax bill.
If shareholders have a 30% marginal tax rate their tax bill is $30 which is also their tax credit and they have no more tax to pay. Their dividends are not tax-free; they are tax paid - that’s why it’s called franking - just like pre-paid postage.
If their marginal tax rate is lower than 30%, the tax credit is larger than their tax bill and they get a refund, just like a worker whose employer has paid too much tax on their behalf. It is a tax refund because it comes from the ATO, but it is actually payment of income from the company profit, withheld by the ATO until the investor completed their own tax return, on which no tax is payable.
Franking credits are NOT a refund of tax never paid; they are a refund of income never received.
In fact, it would be more honest if the income derived from Australian shares were quoted as a pre-tax distribution which is the “grossed up” amount - because that is what shareholders pay tax on. That would make comparisons with other investments more valid, because no other investment income arrives with some or all of the personal tax pre-paid.
It would then also be clear that franking credits have the same value of additional income for every shareholder, not just shareholders on low marginal tax rates such as super funds and retirees.
Note that not all company profits are distributed as dividends and not all dividends are paid to Australian shareholders. Importantly, only Australian shareholders can benefit from this additional taxable income. And not all Australian shareholders welcome this additional taxable income - many prefer their investment returns as capital gains in the form of increased share prices.
For Australian investors, franking credits ensure that company profits are taxed only once, and always taxed at the shareholder’s personal marginal tax rate. We could achieve the same result if there were no company tax and all profits were simply distributed to shareholders as taxable income. Changes to the company tax rate would make no difference to the amount of tax collected from Australian shareholders.
Because company tax in Australia is a withholding tax, it ensures that foreign investors always pay tax in Australia at the company tax rate, because it is withheld from their dividends before it is paid. If there were no company tax, foreign investors would pay no tax in Australia.
Changes to the company tax rate would make a large difference to the amount of after-tax profits available to companies for reinvestment and their ability to generate future profits and that may change decisions around the proportion of profits distributed as dividends. Such a change would also change the tax paid by foreign investors in Australia and that may impact the level of foreign investment in Australia.
Jon Kalkman is a former Director of the Australian Investors Association. This article is for general information purposes only and does not consider the circumstances of any investor. This article is based on an understanding of the rules at the time of writing and anyone considering changing their circumstances should consult a financial adviser.