If dividend distributions are timed wisely, attached franking credits could mean more after-tax money in the pockets of shareholders.
What are franking credits and how do they benefit shareholders?
Franking credits represent income tax a company has paid on its profits and can be passed onto shareholders, but only by way of a dividend. This idea underlying the franking system is to prevent double taxation of the company’s profits.
While franking credits are not recognised as an asset on a company’s balance sheet for accounting purposes, they hold substantial economic value for shareholders. In the realm of business valuations, these credits are often overlooked, yet they can be considered an economic asset due to the tangible financial benefits they could provide to shareholders to offset a tax liability and – in certain circumstances – provide a refund of tax.
When a company distributes its after-tax profits to shareholders in the form of a dividend, franking credits can be attached that serve as a pre-paid tax voucher, which shareholders receive along with dividends. This represents the tax already paid by the corporation. If the shareholder is an Australian tax resident, franking credits can be used to offset their personal tax liability. For individual shareholders, any excess franking credits are refundable.
How does it work?
The availability of franking credits is constrained by the balance of a company’s franking account, as well as the highest permissible franking rate. Essentially, a company can only distribute franking credits to its shareholders if it has accrued them in its franking account, and the distribution is subject to the maximum rate set by tax regulations.
The maximum rate at which a dividend can be franked is capped at the company’s corporate tax rate, under the assumption that the company’s aggregated turnover and base rate passive income will be the same as the previous income year.
This means that when the company’s corporate tax rate changes, the franking rate will not follow, and the timing of declaration and payment of franked dividends becomes a key consideration for companies and shareholders.
Case scenario
In terms of use of franking credits, the rate of franking a dividend paid reflects the tax rate paid in the year before the franking year.
Let's assume Company A has a standard year-end of 30 June, and the entirety of income is considered active (this is relevant to the tax rate that applies).
In FY2023-24, Company A’s total turnover rose above $50m, and it was below that threshold in the previous year. Consequently, the corporate income tax rate jumps from 25 per cent to 30 per cent in FY2023-24. Despite this change, the franking rate will hold steady at 25 per cent for FY2023-24 and rises to 30 per cent only in FY2024-25.
If franked dividends were distributed in say in June 2024 i.e. the 2024 tax year, the Australian shareholders would have to pay greater top-up tax or would receive a lower refund on the franked dividends than if the company had delayed distributing dividends until July 2024 or later when the franking rate increases to 30 per cent (see table below).
Further, if dividends were declared in July 2024 or later (i.e. the 2025 income year), then the payment of top-up tax could be deferred to sometime in May or June 2026 depending on the required lodgement date of the shareholder’s income tax return.
Importantly, the deferral means that the cash is available for a longer period, allowing the generation of income or for example, an offset against interest outgoings on home mortgages.
|
Scenario A: Dividend distributed in FY2023-24 (say June 2024)
|
Scenario B: Dividend distributed in FY2024-25 (say July 2024)
|
| Cash Dividend |
$ 150,000 |
$ 150,000 |
| Imbedded Franking Credit |
$ 50,000 (franking credit rate of 25 per cent) |
$ 64,286 (franking credit rate of 30 per cent) |
| Gross Taxable Dividend |
$ 200,000 |
$ 214,286 |
| Assumed tax rate at 47 per cent |
$ 94,000 |
$ 100,714 |
| Less: Imbedded Franking Credit |
$ (50,000) |
$ (64,286) |
| Top-up Tax Payable |
$ 44,000 |
$ 36,428 |
| Effective Tax Rate as a percentage of cash dividend |
29.33 per cent |
24.29 per cent |
| Top-up tax payable deferral up to |
5 June 2025 |
5 June 2026 |
Conversely, if the company tax rate decreased from 30 per cent to 25 per cent, then Company A should consider if it is worthwhile declaring dividends while the franking rate is still 30 per cent. This could bring forward the taxing point, however, it will allow better and more efficient use of the franking credits including avoiding part of the franking credits being unusable and being trapped in Company A.
Other considerations
We have listed below a few matters that should be considered as part of the tax planning exercise:
- Company A should make sure that the distribution of dividends complies with the Corporations Act.
- Whether there are sufficient franking credits to ensure the declaration of franked dividends and make sure that the franking credit balance doesn’t run into a deficit position.
- If the minimum yearly repayments under Division 7A are to be satisfied annually by the declaration of a dividend then the impact of that strategy on the ability to declare franked dividends and the broader dividend strategy of the company.
- The acquisition and disposal of group companies and restructuring of the group are likely to have an impact on the franking credit balance, corporate tax, and franking credit rates.
- The focus should be on the efficient use of franking credits at all times. If a company moves into liquidation, consideration should be given to the nature of distributions and the ability to use the franking credits fully. Liquidation usually means the company has failed and the shareholders have lost part or all of their investment. The proper use of franking credits may provide some respite from the financial loss.
- The rules regarding trusts and flowing franked dividends through the trust are complex. Thought needs to be given to the steps necessary to protect the availability and access to franking credits in that situation.
- The protection of franking credits also needs to be considered against the background of integrity rules designed to restrict access to franking credits where arrangements are designed to enhance the ability to use those franking credits. It is necessary to consider the applicability of the integrity provisions such as the franking credit trading rules.
We’re here to help
If you’d like to discuss your tax planning strategy for franking credits further, please reach out to our team of experts today.
Learn more about how our Private business taxation and structuring services can help you
