If you open a bank account but refuse to disclose your Tax File Number, the bank is required by law to withhold tax from the interest paid to you. Your personal tax return needs to report all of the interest you earned, not just the after-tax portion you received. Your tax return must include that pre-paid tax, otherwise you would be paying tax twice on the same interest income. If you were not required to pay any tax, you would expect this tax previously withheld by the bank, paid to the ATO on your behalf, to be refunded to you. That, in a nutshell, is what franking credits are all about!
In most countries company profits are taxed twice. The company pays tax on its profits; the after-tax portion is sent to investors as a dividend and is then taxed again as personal income. In Australia, thanks to Paul Keating who introduced franking credits in 1987 and made them deductible against other tax debts, and Peter Costello who expanded the operation of franking credits in 2000 to give cash refunds when franking credits more than covered a taxpayer's other tax liabilities, company profits are only taxed once in the hands of shareholders.
As part-owners of a company, Australian shareholders are responsible for the tax on their share of the total company’s profits, not just the portion they receive as dividends. Therefore, their personal tax return needs to incorporate the pre-paid company tax withheld before they received their dividends.
This is achieved by adding the pre-paid company tax component of the dividend - franking credit – on to the personal taxable income of the dividend sent to the shareholder, who then must pay tax on that larger amount. It means shareholders are required to pay tax on income they never received, but the pre-paid company tax becomes a tax credit in that personal tax return.
With a $100 of company profits, $30 was sent to the ATO as company tax (30%) and $70 was sent to the investor as a dividend. The shareholder’s share of the company’s profit is $100, not $70, and so the shareholder’s taxable income is $100, not $70. That’s why the dividend needs to be “grossed up” - to include the franking credit as part of that personal taxable income. The tax payable on that taxable income of $100 depends on the shareholder’s marginal tax rate.
For shareholders with a marginal tax rate of 45%, they must pay $45 tax on that taxable income of $100 - and they pay more tax finally on that company profit than the company did initially. But the $30 pre-paid company tax becomes a tax credit and they only need to pay an additional $15 tax.
If the shareholder has a 30% marginal tax rate, their tax bill is $30 which is equal to their pre-paid 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.
For shareholders with a marginal tax rate lower than 30%, the tax credit is larger than their tax bill and they get a tax refund, just like a worker whose employer has paid excess tax on their behalf. It is a tax refund because it comes from the ATO, but it is actually an income payment from company profit, due to them as shareholders/owners that was withheld by the ATO until they completed their own tax return, on which no tax is payable.
This was all a bit hard to explain without paper and pen, even more so when you're in your swim togs in four feet of warm water and talking to a café owner from Milton who is looking to grow his money but knows nothing more about it than how to make tolerable cappuccinos.
Of all my body parts, my fingers are the most reliable as I can always count on them. So by the time they began to look like prunes from having been in the water for too long, I decided to leave the pool and to continue our discussion next time we pass through Milton when, in return for a free cappuccino, I would lead him deeper into the maze of self-managed superfunds, share investments, and franking credits.
P.S. And here's the usual small print: All advice is general advice and has not taken into account your personal circumstances. Please seek independent financial advice regarding your own situation, or if in doubt about the suitability of an investment.
