How Franking Credits Boost Your Investment Returns
For Australian investors, dividends can provide an important source of investment income, but the headline dividend payment does not always tell the full story. Franking credits can add another layer to the return investors receive from eligible Australian companies by recognising tax already paid by the company. Understanding how the system works can help investors assess dividend income more accurately and compare the potential after-tax return from different investments.
What Are Franking Credits?
Franking credits are essentially a tax credit attached to certain dividends paid by Australian companies. When an Australian company earns profits, it generally pays company tax on those profits before distributing some of the remaining amount to shareholders as dividends.
The franking credit system is designed to recognise that tax already paid at the company level. When an eligible shareholder receives a franked dividend, the associated franking credit can generally be included when calculating taxable income and may provide a corresponding tax offset, subject to the investor's circumstances and applicable rules.
This means investors should not always look at the cash dividend alone when assessing the value of a dividend payment.
Franked vs Unfranked Dividends
Not all dividends come with franking credits. A franked dividend has an associated franking credit because the company has paid Australian corporate tax on the underlying profits. An unfranked dividend does not provide the same tax credit.
The level of franking can also vary. A dividend may be fully franked, partially franked or unfranked depending on the company's circumstances and the tax it has already paid.
For investors comparing income opportunities, understanding the difference between the cash dividend and the associated tax credit can provide a more complete picture of the potential return.
How the Tax Offset Works
The basic concept behind franking credits is to avoid taxing the same company profit twice at the company and shareholder levels.
For example, imagine a company generates $100 of taxable profit and pays $30 in company tax, leaving $70 available for distribution. If that $70 is fully franked, the shareholder may receive the $70 cash dividend together with a $30 franking credit.
The shareholder's assessable dividend amount can therefore reflect the original $100 of pre-tax company profit, while the $30 franking credit may be available as a tax offset. The actual tax outcome depends on the investor's individual circumstances.
Why Franking Credits Can Increase Returns
The potential benefit becomes clearer when investors consider the dividend together with its associated franking credit.
A cash dividend of $70 does not necessarily represent the full economic value of a fully franked distribution if a $30 franking credit is attached. The credit represents tax already paid on the underlying company profit and may reduce the shareholder's tax liability, depending on their circumstances.
This can make franked dividends particularly relevant when investors compare income investments on an after-tax basis rather than simply comparing advertised dividend yields.
The Importance of Your Tax Rate
The benefit received from franking credits depends partly on the shareholder's individual tax position.
Investors whose applicable tax rate is higher than the company tax rate may need to pay additional tax on the dividend after accounting for the franking credit. Investors whose applicable rate is lower may receive a greater tax benefit, subject to the rules that apply to them.
This is why the same fully franked dividend can have different after-tax outcomes for different investors.
Investors should therefore avoid assuming that a particular franking level automatically produces the same benefit for everyone.
Franking Credits and Dividend Yield
Dividend yield is commonly used to compare income-producing shares, but it does not capture the entire potential tax benefit of a franked dividend.
A lower headline dividend yield with a high level of franking may have a different after-tax outcome from a higher unfranked yield. Investors should consider both the cash distribution and the associated tax treatment when comparing investments.
However, franking credits should not be used as the only reason to choose an investment. The sustainability of the dividend, the company's earnings, cash flow, balance sheet and valuation remain important.
Reinvesting Dividends
Some investors choose to reinvest dividends rather than use the income for spending. When distributions are reinvested, investors can potentially increase their shareholding over time.
The combination of dividend income, reinvestment and potential capital growth can contribute to long-term compounding. Franking credits may also form part of the overall tax calculation associated with dividend income.
However, investors should consider whether reinvesting dividends aligns with their portfolio objectives and tax circumstances rather than automatically assuming reinvestment is the best approach.
Common Misunderstandings
One common misconception is that franking credits are an additional cash payment from the company. They are better understood as recognition of tax already paid by the company on the underlying profits.
Another mistake is focusing entirely on the level of franking while ignoring the financial quality of the business. A highly franked dividend does not automatically make an investment attractive if the company cannot sustainably generate the earnings and cash flow required to support future distributions.
Investors should also remember that dividend payments and franking levels can change.
What Investors Should Consider
When assessing dividend opportunities, investors can consider:
- Cash dividend received
- Level of franking
- Company's earnings
- Free cash flow
- Dividend sustainability
- Balance-sheet strength
- Investment valuation
- Personal tax circumstances
- Investment timeframe
Considering these factors together can provide a more complete view of the potential value of dividend income.
Risk Considerations
Franking credits do not guarantee higher investment returns and their tax benefit depends on an investor's individual circumstances and applicable tax rules. Companies can reduce, suspend or change dividend payments and franking levels. Investors should also avoid selecting shares solely because they offer highly franked dividends, as underlying business performance, valuation and financial strength remain important. Tax rules can change over time, so investors should consider obtaining appropriate professional tax advice before making decisions based on franking credits.
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