Before 1 July 1987 corporate profits were subject to two lots of tax. Firstly, companies paid company tax on their earnings. Only the “after tax” earnings were then available for dividend declarations. Secondly, individual shareholders paid personal income tax on any dividends received by them, despite the fact that the companies paying them had already paid tax on the underlying profits. There are some great all seasons dividend stocks on the ASX that individual investors have been taking advantage of for years. This unfair approach to dividend taxation however has now been replaced.
Under the current system, which is called “dividend imputation”, companies still pay tax on their earnings and then declare dividends, if they wish, out of their “after tax” incomes. However, these transactions no longer involve double taxation.
Such dividends are known as “franked” dividends. The company tax which was paid by the company on the portion of the gross profit relating to the dividend is called the “imputation credit”.
With a company tax rate of 30 per cent each $100 gross profit becomes $30 tax and $70 net profit. Each dollar of net profit thus has associated with it 30/70 dollars of imputation credits.
Individuals receiving a franked dividend are then treated, for tax purposes, as having received as assessable income both the dividend and the associated imputation credit, and as having already pre-paid as tax a sum equal to the imputation credit.
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Individuals on marginal tax rates which are less than the company rate of tax thus become entitled to a refund of the amount overpaid. If not required as an offset to tax this refund is now available in the form of cash.
Some dividends are unfranked – for example, when the relevant company profits were earned overseas and did not result in tax payments to the Australian government.
Some dividends are only partly franked. The franked portion divided by the whole is known as the “franking ratio”.