Franking credits: Here’s how they work and why they have been a contentious political issue for the last 5 years

What are Franking Credits? Those pesky things that allegedly decided the 2019 election after uproars from investors, led by Geoff Wilson. Are they just some kind of rorting mechanism that help the rich get richer? Or are they the things that ‘save the bacon’ so far as investing in particular ASX dividend stocks are concerned? The answer is…it is complicated. We would probably say it is closer to the latter, although we would pour cold water on the idea that no one would invest in dividend stocks without them.

What are Franking Credits?

Franking credits, also known as imputation credits, are a form of tax credit offered to shareholders by Australian companies. These credits represent a portion of the taxes paid by the company on its profits and are passed on to shareholders as an incentive for investing in the company.

How do franking credits work?

When an Australian company pays out dividends to its shareholders, it also attaches franking credits to those dividends. This means that a shareholder who receives a dividend payment will also receive a corresponding amount of franking credits. The value of these franking credits is equivalent to the amount of tax paid by the company on its profits.

It is crucial to note that all investors are eligible for franking credits, they must be an Australian resident for tax purposes. Non-residents and foreign investors are not entitled to claim them. Additionally, the amount of credits received by a shareholder is dependent on their marginal tax rate. This means that shareholders who are in a higher tax bracket will receive a larger benefit.

Why do they exist?

The main purpose of these credits is to avoid double taxation on company profits. In other words, tax being paid twice on the same money. Without them, a company’s profits would be taxed at the corporate tax rate and then again when distributed to shareholders as dividends. But instead, the taxes paid by the company are attributed to the individual shareholders, reducing their tax liability.

Advantages of Franking Credits

Aside from avoiding double taxation, franking credits offer several other advantages to shareholders. These include:

• Higher Returns on Investments: By receiving franking credits, shareholders effectively receive a higher return on their investment as they are able to claim a credit for the taxes paid by the company.
• Encourages Investment in Australian Companies: The use of franking credits incentivizes investors to put their money into Australian companies on the ASX, allowing them to benefit from the country’s economic growth.
• Stability and Predictability: As franking credits are determined based on a company’s profits, they offer stability and predictability to shareholders as they know what to expect in terms of tax liability when receiving dividends.

The 2019 election controversy

The Labor party went to the 2019 federal election proposing to end franking credit refunds. After the defeat, this proposal (along with negative gearing) was commonly attributed to the party’s defeat – or perhaps because it had a policy vacuum without any clear over-riding narrative, causing anxiety amongst lower income, economically insecure voters that the economy would crash and they would lose their jobs.

One of Australia’s most popular fundies, Geoff Wilson, led a campaign against those changes. His company has 6 ASX-listed LICs with 80,000 shareholders between them, arguing these investors would have lost out. Given Wilson’s success in life, many Labor supporters would’ve been resentful, thinking franking credits just hurt the rich. But Wilson said franking credits made such a difference for many investors. He claimed to the AFR, ‘some of the stories simply made me cry’, noting one woman who was a full-time carer for her disabled son and relied on franking credits to pay rent and other expenses. Keep in mind it is not as if the proposal was to cap franking credits, this was an outright prohibition of cash refunds.

Labor ended up winning the 2022 election and promised no changes. However, the party has since pledged to crack down on them, albeit not as significantly as was proposed in 2019. Specifically, payments for off-market buybacks would would be considered capital proceeds rather than a portion being considered a franked dividend. Geoff Wilson has pledged to fight even harder against any such concrete proposals put forward. Only time will tell if he is able to influence another federal election result, it will another 18 months or so.

Conclusion

In conclusion, while we wouldn’t say franking credits are the only thing that encourages investment in dividend stocks, they do play a vital role in reducing double taxation for shareholders in Australian companies. Their use benefits both the company and its shareholders, making it a win-win situation for all parties involved.

Investors should be aware of franking credits and their potential impact on their investments when considering Australian companies as part of their portfolio.

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