Episode Details

Investing in shares can produce tax benefits. But it can also result in tax liabilities too. Terms such as “franking credits” and “imputation credits” (same thing) were frequently used during last year’s federal election (the Labor Party proposed to ban franking credit refunds). However, many people do not understand these concepts. So, this blog seeks to provide a simple overview of the possible taxation consequences resulting from investing in shares.

There are two types of taxes that could result from making an investment (including share market investments) being income tax and Capital Gains Tax (CGT).

Income tax and franking credits

Some shares pay investors an income which is called a dividend. This is typically paid twice per year (interim plus final dividend). The amount of the dividend can vary significantly (this is called the dividend yield – refer to this blog for a basic overview of investing in shares).

A company can declare and pay a dividend from profit after it has paid tax. The dividend imputation system was introduced in Australia in 1987 by the Hawke-Keating Labor Government. Essentially, it sought to avoid the double taxing of corporate profits. This is best explained as an example.

So, how does dividend imputation work?

To avoid the double-taxing of dividends, shareholders obtain a credit for the amount of tax the company has previously paid. Using the example above, the company has already paid $30 in tax so the shareholders will obtain a credit for this amount.

The formula is: cash amount of dividend plus franking credit multiplied by the marginal tax rate minus the franking credits.

Therefore, using the example above, the cash dividend is $70 + $30 of franking credits X 47% - $30 franking credit = $17. So, the shareholder will pay an additional amount of tax of $17 when they lodge their tax return. This means the net dividend retained after all taxes is $53 ($100 - $30 - $17).

Imputation credit refunds

If the shareholder has an effective tax rate lower than the corporate tax rate, then they will receive a tax refund. A good example of this is superannuation funds. A super fund’s tax rate is 15%.

Therefore, a super fund will receive the dividend of $70 plus a refund of $15 (i.e. using the formula above; $70 + $30 X 15% - $30 = refund of $15). If the super fund is in pension phase, its tax rate is zero so it will receive a full refund of all imputation credits i.e. $70 + $30. This is what the Labor Party was arguing against last year i.e. that self-managed super funds shouldn’t be entitled to a refund.

International shares offer limited tax credits

Most foreign countries do not have an imputation system except for New Zealand. That said, you may be entitled to foreign tax credits resulting from receiving dividends. However, any credits will typically be relatively immaterial, and certainly not as g