Franking Credits Explained: How Dividend Imputation Works

Australia is one of very few countries that will write you a cheque for tax somebody else paid. That is, in essence, what a franking credit refund is, and it is why fully franked Australian shares behave so differently in a low-tax-rate portfolio than they do in a high one.

The mechanism is not complicated. Two things around the edges are, and both cost people money: the credit is not always three sevenths of the cash, and holding the shares too briefly can disqualify you from the credit altogether.

The problem it solves

An Australian company pays company tax on its profits, then pays some of what is left to shareholders as dividends. Without franking you would pay tax on that dividend again at your own marginal rate — the same profit taxed twice.

Dividend imputation fixes it by attaching a credit for the tax the company already paid. That credit is the franking credit, and the system treats the company tax as a prepayment of your tax rather than a separate impost.

Gross up, then offset

1. You receive a franked dividend
2. You gross it up by adding the franking credit, which reconstructs the pre-tax profit
3. You pay tax on the grossed-up amount at your marginal rate
4. You subtract the franking credit from the tax owing

If your rate is above the company rate you top up the difference. If it is below, the excess reduces tax on your other income, and anything still left over is refunded in cash.

That last step is the unusual part internationally. Most imputation systems let excess credits reduce your tax to zero and stop there. Australia has refunded the excess since 2000.

The formula, and why the rate matters

The credit is not a fixed fraction of the dividend. It is:

franking credit = cash dividend × rate ÷ (1 − rate)

At the 30% company rate that is 30/70, or three sevenths of the cash. At the 25% base rate it is 25/75 — one third.

This is the first thing that catches people out, because most explanations only ever show the 30% case:

Same cash in your bank account, and the credit differs by 28.6%. A company qualifies for the 25% rate if its aggregated turnover is under $50 million and no more than 80% of its assessable income is passive — so the large caps most dividend portfolios are built on franks at 30%, but smaller holdings may not. Your dividend statement carries the actual credit. Use it rather than assuming three sevenths.

A worked example

Take the $700 fully franked dividend at 30%, grossing up to $1,000. Your outcome depends entirely on your own rate:

• 45% taxpayer: tax on $1,000 is $450, less the $300 credit = $150 to pay
• 30% taxpayer: tax is $300, less $300 = nothing to pay
• 15% taxpayer: tax is $150, less $300 = $150 refunded
• 0% taxpayer: tax is nil, less $300 = $300 refunded

Those four lines use a flat marginal rate for clarity. Stacked on a real salary the answer moves in a way that surprises people — a $1,000 fully franked dividend costs $50.00 in tax on $60,000 of other income but only $28.57 on $100,000, because the low income tax offset is still tapering across the lower band and pushes the effective rate there to 33.5%.

The Franking Credits Calculator runs this on your own dividends, and the Dividends Calculator covers the wider picture. To see the effect alongside your salary, use the Salary Tax Calculator.

Partly franked dividends

Franking is not all-or-nothing. A dividend can be franked to any percentage, and the credit scales with it. A $700 dividend franked to 50% at the 30% rate carries $150, not $300, and grosses up to $850.

Unfranked dividends carry no credit at all and are simply taxed as income. Companies with substantial foreign earnings often pay partly franked dividends for exactly this reason — they have not paid Australian company tax on all of the profit.

The 45-day rule, which very few guides mention

This is the one that quietly disqualifies people.

To claim a franking credit you must be a qualified person, which means holding the shares at risk for at least 45 continuous days — 90 days for preference shares. The days you acquire and dispose of the shares do not count, so 45 days genuinely means 47 days on the register.

"At risk" matters too. Hedging the position so you carry no real exposure can fail the test even if you technically hold the shares.

The rule exists to stop dividend stripping, where someone buys just before a dividend, collects the credit and sells straight after. But it applies to ordinary investors as well, and anyone who buys shortly before an ex-dividend date and sells shortly after can lose the credit without ever intending anything of the sort.

The small shareholder exemption saves most people. If your total franking credits for the year are under $5,000, the holding period rule does not apply to you. At the 30% rate that is roughly a fully franked dividend income of $11,667, so most retail investors are comfortably clear — but a larger portfolio is not, and that is precisely the portfolio where trading around dividend dates is most tempting.

Why this matters for retirees and super

The refund is what makes franking so valuable at low tax rates, and super is where that bites hardest.

A super fund pays 15% on earnings in accumulation phase and nil in retirement phase. A fully franked dividend arrives carrying a 30% credit. In accumulation the credit more than covers the 15%, and the excess reduces tax on the fund's other income. In pension phase there is no tax to offset at all, so the whole credit comes back as cash.

That is the real reason Australian equity income is weighted so heavily in retirement portfolios here, and why the same portfolio structure would make far less sense in most other countries.