How Franking Credits Work

Let's take a look at what a franking credit is why some companies have them while others don't. 

Franking credits are simply the tax a company pays on the earnings before it pays out to you (the shareholder) dividends which are typically declared twice a year. Ideally, you should be looking for what are called 'grossed-up' dividends which have the fully franked credits built in. 

But remember, not all dividends automatically have franking credits embedded within them. When companies pay less than 30% tax on their earnings – due to either a tax break, or previous year's losses carried forward – their dividends or other distributions will have both franked and unfranked components. 

As a form of income, you are typically required to pay tax on dividends. However, under Australia's imputation system – whereby companies distribute dividends with franking credits equal to the tax already paid – you are entitled to get that tax back in the form of a rebate when you declare your tax return. 

However, this doesn't mean your dividends are tax free. What tax you get back depends on your personal tax rate, and if it's lower than the 30% a company pays on tax, you're entitled to pocket the difference. Similarly, if your tax rate is above the 30% company tax rate, you'll only pay the difference. 

Tax should never be the primary determinant of any investment decision. However, couples on different tax rates may wish to buy shares in the name of the one who stands to receive a full refund of franking credits. Similarly, a retiree with a tax-exempt pension income can use the refund of the franking credits to supplement their pension income.

Franking credits also represent money in the bank to self managed super funds (SMSF) that pay a tax rate of 15%.

However, if you're buying a stock with the express desire of receiving a fully franked dividend, remember that for any franking credits over $5,000 – which would normally take a $150,000 share portfolio to put you over this limit – you're required to hold shares for a minimum 45 days.

It's important to note that simply having a high franking balance does not necessarily mean a company will succumb to short-term pressure and return it to shareholders. For example, the large capital and debt commitment confronting some stocks – especially miners – means they're less likely to return substantial amounts to shareholders any time soon. 

How franking credits affect your tax bill

Investor 1Investor 2 Investor 3Investor 4
Cash dividend$0.70$0.70$0.70$0.70
Franking Credits$0.30$0.30 $0.30 $0.30
Taxable income$1.00$1.00$1.00 $1.00
Tax rate0%15%30%46.5%
Tax payable before franking credit$0.00$0.15$0.30$0.465
Tax owed (rebated) after $0.30 franking credit($0.30)($0.15)$0.00$0.165
Post tax dividend income$1.00$0.85$0.70$0.535