Franked Dividend

A franked dividend is a type of dividend payment issued by a corporation to its shareholders, accompanied by a tax credit for the corporate tax paid on the earnings from which the dividend was distributed. The concept is most commonly applied in countries with an imputation tax system, such as Australia. This tax arrangement aims to eliminate the double taxation of company profits—once at the corporate level and again at the individual shareholder level.

Concept and Mechanism

How Franked Dividends Work

When a company earns a profit, it must pay corporate tax on those earnings. Once the tax is paid, the remaining profit can be either reinvested in the business or distributed to shareholders in the form of dividends. A franked dividend includes a tax credit representative of the tax paid by the corporation, which can be utilized by shareholders to offset their own tax liabilities.

For example, if a company pays a 30% corporate tax on $100,000 of profit, $70,000 remains after tax, and this can be distributed as a dividend. If the company decides to pay out $70,000 in dividends as franked dividends, an accompanying tax credit of $30,000 is distributed proportionally based on share ownership.

Types of Franked Dividends

  1. Fully Franked Dividends: These dividends are fully covered by corporate tax credits. For example, if a $1 dividend is fully franked with a corporate tax rate of 30%, the total value of the dividend with the credit is $1.43 ($1 / (1 - 0.30)).

  2. Partially Franked Dividends: These dividends are only partially covered by corporate tax credits. This situation can arise if companies have insufficient franking credits.

Importance in Different Countries

Franked dividends are an integral part of the tax systems in countries like Australia, New Zealand, and, to some extent, the United Kingdom. Each country has its own approach and rules regarding franked dividends.

Australia

Australia introduced the imputation system in 1987. Franked dividends are extremely significant in Australia, as they provide significant tax advantages to shareholders.

  1. Imputation Credit: When shareholders receive a franked dividend, they also receive a tax credit for the tax already paid by the corporation, known as an imputation credit.

  2. Refunds for Excess Credits: If the shareholder’s tax rate is lower than the corporate tax rate, they may receive a refund for the excess imputation credits.

New Zealand

New Zealand adopted a similar system in 1988, aiming to eliminate the double taxation incident. However, the specific mechanisms may vary compared to Australia.

United Kingdom

Though the term “franked dividend” is sometimes used in the UK, it generally refers to the tax credits attached to dividends issued out of pre-tax profits up to the year 1999, when Advance Corporation Tax (ACT) was abolished.

Tax Implications for Shareholders and Companies

Shareholders

  1. Individual Tax Payers: For individual taxpayers, franked dividends can lower the effective tax rate on dividend income. If the shareholder’s marginal tax rate is lower than the corporate tax rate, they receive a refund on the excess franking credits.

  2. Superannuation Funds and Pensions: Superannuation funds or pension funds generally benefit greatly from franked dividends because their tax rates are often lower than standard corporate rates, thus leading to tax refunds.

  3. Non-Residents: Shareholders residing outside the country may not be entitled to imputation credits. However, they may benefit from reduced withholding tax rates under double tax agreements.

Companies

  1. Distributing Companies: Companies distributing franked dividends must keep a “franking account” to record the tax credits attached to dividends. Proper management of these accounts is critical to ensure compliance with tax regulations.

  2. Tax Incentives: The ability to distribute franked dividends can make a company’s stock more attractive to investors, potentially increasing stock prices and market liquidity.

Practical Application and Strategies

Investment Strategies

  1. Dividend Reinvestment Plans (DRIPs): Shareholders can take advantage of DRIPs to reinvest their franked dividends in additional shares of the company, leveraging the tax credits to compound returns over time.

  2. Tax Optimization: High-net-worth investors often strategize to receive dividends in periods when their marginal tax rates are lower, thus maximizing the benefit from franking credits.

Corporate Strategies

  1. Optimal Distribution Policies: Companies may strategically plan their distribution policies to consistently provide franked dividends, thus maintaining shareholder satisfaction and ensuring market competitiveness.

  2. Timing of Dividend Payments: Companies may time their dividend payments to coincide with periods of optimal tax treatment for most shareholders, enhancing overall investor relations.

Regulatory and Compliance Considerations

Companies and shareholders must adhere to regulatory requirements concerning franked dividends to avoid penalties and legal issues.

Companies

  1. Franking Account Maintenance: Companies must maintain accurate franking accounts, documenting the tax credits attached to dividends.

  2. Record Keeping: Proper and up-to-date records are essential to substantiate franking credits claimed and ensure regulatory compliance.

Shareholders

  1. Documentation: Shareholders must retain documentation related to franked dividends and credits to support tax filings and potential audits.

  2. Understanding Eligibility: Ensuring eligibility for imputation credits involves understanding specific national and international tax laws and bilateral tax agreements.

Case Studies and Examples

Case Study 1: An Australian Company

Consider an Australian manufacturing company, OzManufacture Ltd., with a profit of AUD 1 million and a corporate tax rate of 30%. The after-tax profit of AUD 700,000 is available for distribution.

Case Study 2: A New Zealand Investment Fund

A New Zealand-based diversified investment fund, KiwiInvest Ltd., receives franked dividends from its investments in Australian shares.

Conclusion

Franked dividends are a powerful tool for both investors and corporations within jurisdictions that employ an imputation tax system. By enabling tax credits for the taxes paid at the corporate level, franked dividends help to mitigate double taxation, providing a more equitable and efficient framework for dividend distributions. Strategic management of franked dividends can offer significant tax advantages, promote shareholder satisfaction, and enhance market appeal for issuing companies. Understanding the detailed intricacies of franked dividends, tax implications, regulatory requirements, and practical strategies is crucial for both corporate entities and individual investors aiming to maximize their financial outcomes.

For more information on the implementation and calculation of franked dividends, investors and companies can refer to resources provided by the Australian Taxation Office (ATO) or consult financial advisors specializing in tax and investment strategies.