Understanding Franking Credits: A Guide for U.S. Investors

Franking credits are a system of tax credits popular in advanced economies without a standardized capital gains tax system. Notably, Australia uses the system for dividends paid out to investors. U.S. investors with Australian-based investments may also be subject to the Franking credit system. Essentially, this is a way for a corporation to pay taxes on gains prior to paying out dividends and then to add these tax credits to the dividends paid. Ultimately, the investor's individual tax liability is lowered through the Franking credit system.

Franking Credit Example

It is often easiest to understand the complicated Franking credit system through an example. If a company is paying dividends of $200, the company may be subject to a tax of $60, or 30 percent, on the dividends. The company pays this tax up front and then pays its shareholders $140 instead of $200. The investor receives the $140 and owes taxes on face value of this sum plus the $60 Franking credit. Then, the face value is adjusted through the individual's taxable income level, which is typically higher than a corporation's. So, the individual would perhaps owe 40 percent tax on the $200, or $80. The Franking credit of $60 is subtracted from this $80, and the individual owes only $20 in taxes. 

Purpose of Franking Credits

The purpose of Franking credits is to prevent the funds from being taxed twice. Since the business has already paid taxes, the individual needs to pay only the additional taxes he or she is liable for because of an individual income tax. In reality, the individual is benefiting from the credit. If he or she was taxed at the 40 percent rate on the $140, the total owed would be $56. The lower taxable income of $20 is preferable for the individual taxpayer. It is also preferable for the company, which does not have to pay as high of a tax but instead passes the tax onto the shareholder in part.

Benefits of Franking Credits

This system is used to attract businesses to operate in the otherwise high-tax country. The business can pass the tax onto the investor instead of incurring the tax at the business level. In the above example, the business did not actually pay a tax. The business contributed to the Franking credit system, but the amount contributed was deducted from dividends paid to shareholders, making the tax have no real effect on the business. The money is never doubly taxed. In the United States, business income can be doubly taxed. First, a business reports earnings and is taxed on those earnings. Then, it pays dividends to shareholders. The shareholders pay a capital gains tax. The result is the double taxation of the same dollars earned. In order to remain competitive on the international market, the United States needs to offer tax systems that make sense for businesses to operate within its borders. Some economists advocate using the Franking system to attract businesses from foreign countries and to keep businesses from leaving.