A franked dividend is a unique financial arrangement in Australia designed to eliminate the double taxation of dividends. When shareholders receive dividends, they can reduce the amount of tax they need to pay, thanks to imputation credits attached to these dividends. The exact tax benefits a shareholder receives are influenced by both their marginal tax rate and the company’s tax rate that issues the dividend.
Key Takeaways
- Tax Credit Benefit: A franked dividend includes a tax credit that aims to eliminate the issue of double taxation.
- Lower Tax Burden: By reporting both the dividend income and the franking credit, the shareholder is only taxed on the dividend portion.
- Types of Franked Dividends: These dividends can be fully franked or partially franked, depending on how much tax the company has paid.
- Market Stability: Franked dividends reduce the tax burden and create more stable, competitive markets.
Understanding Franked Dividends
A franked dividend comes with a tax credit attached, helping to prevent the problem of double taxation. Dividends paid by companies to shareholders are often periodic and derive from the company’s profits, which have already been taxed at the corporate level. Thus, letting the shareholder pay taxes on those dividends again would result in double taxation.
When receiving a franked dividend, shareholders get a tax credit (franking credit) for the tax amount already paid by the corporate entity. The formula to calculate a franking credit for a fully franked dividend is as follows:
Franking Credit = (Dividend Amount ÷ (1 - Company Tax Rate)) - Dividend Amount
For example, if a company issues a fully franked dividend of $1,000 and its corporate tax rate is 30%, the franking credit calculation would be:
Franking Credit = ($1,000 ÷ (1 - 0.30)) - $1,000 = ($1,000 ÷ 0.70) - $1,000 = $428.57
The shareholder, thus, receives a fully franked dividend of $1,000, while the dividend statement reflects a franking credit of $428.57. If the dividend were not franked, the shareholder would owe taxes on the entire $1,428.57.
Types of Franked Dividends
Fully Franked Dividends
In a fully franked dividend, the whole dividend is taxed at the corporate level, and investors receive the full benefit of tax credits. This minimizes their tax burden, enhancing their overall returns.
Partially Franked Dividends
A partially franked dividend occurs when the company hasn’t paid enough tax for a full tax credit. This usually happens when the company leverages tax deductions or previous losses, limiting their tax liabilities for the fiscal year. In these cases, only a portion of the dividend carries a tax credit, leaving the remaining portion unfranked and subject to tax by the investor.
Benefits of Franked Dividends
The tax advantages offered by franked dividends extend beyond individual investors and positively impact the broader market. The elimination of double taxation motivates more investment in publicly traded companies that issue dividends. This is important for economic efficiency and growth since businesses frequently reinvest their profits, leading to competitive and dynamic markets.
Unfranked dividends come with tax disadvantages that sometimes deter investment. For example, growth stocks in the United States, such as Amazon, have outperformed the market by reinvesting profits rather than paying dividends. This reinvestment approach often leads to speculative markets and reduced stability. Franked dividends combat this issue by reducing the tax burden and fostering a more competitive market scene.
Real World Example
From April 2016 to June 2019, New York-based investment firm VanEck operated the VanEck Vectors S&P/ASX Franked Dividend ETF. This ETF tracked companies in the S&P/ASX 200 Index that had paid out 100% franked dividends for an extended period. Although the fund changed its investment objective in June 2019, it previously provided investors an example of how franked dividends can be bundled into investment products.
References
- Australian Tax Office. “How dividends are taxed”.
- VanEck. “VanEck Vectors MSCI Australian Sustainable Equity ETF”.
