Franked Dividend

Definition

A franked dividend is a form of dividend payment that shareholders receive from a corporation on which the corporate tax has already been paid. It’s a common term in Australia, where companies use a system known as dividend imputation to eliminate the double taxation of dividends. This allows shareholders to avoid paying tax on a portion of their dividends equivalent to the tax already paid by the corporation.

Phonetic

The phonetics of the keyword “Franked Dividend” would be: /frænkt ˈdɪvɪˌdɛnd/

Key Takeaways

1. Additional Benefit for Shareholders: Franked dividends are a beneficial feature for shareholders, particularly in countries like Australia. The franking credit system avoids double taxation, meaning that taxes paid by a corporation can be offset by shareholders against their own tax liability. Thus, shareholders receive an additional benefit, the franking credit, along with the dividend.
2. Tax Obligation: The amount of the dividend that a shareholder receives is grossed up to include the tax paid by the corporation. The shareholder’s tax obligation is calculated on this grossed up amount. However, the tax paid by the corporation is then subtracted from their tax obligation, effectively eliminating the double taxation.
3. Tax Refund: For shareholders whose marginal tax rate is less than the corporate tax rate, the excess tax paid by the corporation is received as a tax refund. This feature makes franked dividends particularly attractive to low-income taxpayers and tax-exempt entities such as pension or endowment funds. The franking credit can become a source of income, provided the tax rate of the shareholder is lower than the corporation’s tax rate.

Importance

A franked dividend is important in business and finance as it is associated with tax benefits for corporations and their shareholders. Companies in certain countries like Australia apply this strategy to avoid the issue of double taxation on profits. When a company earns a profit, it pays corporate tax on that income. If the post-tax profit is distributed as dividends, shareholders also have to pay tax on the income they receive. However, with franked dividends, the corporation allocates a tax credit for the tax it has already paid to the shareholder. This ‘franking credit’ can be used by the shareholder to reduce their personal income tax. Hence, franked dividends increase the net return for shareholders, making it a significant element in investment decision-making and corporate finance planning.

Explanation

Franked dividends primarily serve the purpose of preventing the double taxation of corporate profits. They are a significant element in Australia’s dividend imputation system where companies may pass on to their shareholders, along with their dividend payments, a tax credit representing the amount of tax already paid on their income. Essentially, franked dividends ensure that income is taxed only once, at the shareholders’ personal rate, rather than twice – firstly, at the corporate level, and secondly, when dividends are distributed.For shareholders, particularly those within lower income brackets, franked dividends may offer tax benefits. Because these dividends come with a tax credit attached, this amount can be used to offset the income tax that the shareholder would typically have to pay on their dividends. It increases the effective yield of the dividend, making them more attractive to investors and, consequently, potentially providing companies with a broader or more diverse shareholder base.

Examples

1. Australian Company: Franked dividends are notably practiced in Australia. For example, if Company A, which is based in Australia, already paid corporate tax on its profits, it may offer franked dividends. This means shareholders will receive dividends that come with a tax credit. The shareholders can use this tax credit to offset their personal income tax liability.2. UK-based Corporation: The system also existed in the United Kingdom until 1997. A UK-based corporation, say Company B, could have distributed franked dividends to its investors. The shareholders would then only be liable for the difference between the tax credit and their personal tax rate.3. Transition to Unfranked Dividend: In certain cases, a company that previously distributed franked dividends may switch to distributing unfranked dividends due to a change in their profit scenario. For instance, Company C used to pay franked dividends with a 30% corporate tax. However, due to a financial downturn, they incurred losses and didn’t have to pay corporate taxes. In this scenario, they may opt to pay unfranked dividends to their shareholders since they didn’t incur any corporate tax.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Dividend Imputation
• Corporate Tax
• Shareholder
• Grossed Up Dividend
• Tax Credit

Sources for More Information

• Investopedia
• The Balance
• Canstar
• Australian Taxation Office