Whether you’re an investor or not, you probably have an understanding of what dividends are. Though you may not have heard of franking credits, Australia is one of the few countries that have these provisions for shareholders. Franking credits often go hand in hand with Australian-generated dividends, and they symbolize the tax that a company has already paid on its profits before they’ve been distributed to investors. And also unlike many countries, the United States taxes foreign income, including income from dividends. While it can be a little confusing, especially when you’re a non-resident shareholder, we break down the basics for you below.
What are they?
Dividends, as you probably know, are a portion of a company’s profits that are paid to its shareholders as a form of investment income and a reward for investing in the business. In Australia, the corporate tax system allows certain companies to attribute some or all of the tax paid on their profits to their shareholders by way of a tax credit – or, franking credits.
A dividend is considered “franked” when a company pays its dividends from its after-tax profits. These credits make dividends from shares a tax-efficient source of income for Australian investors. Franking credits become especially handy around tax time because they allow investors to declare those franking credits on their tax return, preventing them from double taxation on those dividends. The whole purpose of these credits and the idea of dividend imputation is to avoid double dipping from the ATO.
How do they work?
If a dividend is considered fully franked, that means that the company has already paid the 30% tax rate. In that case, if your personal tax rate is 30% or less, that dividend income is essentially tax-free. For some, a significant proportion of the return on a share investment can come from the associated tax benefits that come with franking credits and dividends – especially for retirees or others with a low personal tax rate.
As an example, you may receive $1000 in rental income from an investment property. You will need to declare this income on your tax return and pay your full personal rate of tax on that income because that $1000 has not yet been subject to any form of taxation. But let’s say you receive $1000 worth of fully franked dividends. Those dividends will have already been subject to $430 worth of tax, so you will only need to make up the difference between that and whatever your personal tax rate is. So, if your tax rate is 40%, you will only have to pay 10% in tax on that dividend income. But on the flip side, if your personal tax rate is only 19%, you may even receive a refund.
Though not all businesses pay franked dividends, it’s important to know whether your dividends are fully franked, partially franked, or not franked at all.
I want to know more about US taxes abroad
Whether a dividend is considered fully franked or partially franked all comes down to the amount of tax the company has paid. The flat 30% company tax rate on any profits is applicable to most ASX-listed companies in Australia, however, they are not required to pay tax on the profits they distribute to shareholders as dividends.
This creates the difference between fully franked, partially franked, and unfranked dividends. Fully franked dividends have been paid from profits that have already been subject to the full 30% tax rate before they were distributed to shareholders. While partially or partly franked dividends have only had tax paid on a certain amount of the dividend—the franked part.
Unfranked dividends have not been subject to any tax at all, and have been paid directly from the company’s pre-tax profits. This is often the case for shareholders who hold stakes in companies that are exempt from paying tax in Australia, either because they made no profits, are carrying losses forward, or because of their location.
While unfranked dividends may seem less desirable, they do have different advantages that you may need to consider. Sticking to companies that are Australia-based simply because of the tax advantages that franked dividends provide can significantly limit your portfolio. So, before you write them off as a bad investment, it’s a good idea to weigh up your options and consider if the long-term gains might outweigh the tax obligations that come hand in hand with unfranked dividends.
Which is better?
In general, it makes little difference, and there is no clear-cut answer. The amount of tax you pay and the amount of money that ends up in your pocket will pretty much be the same, but it’s definitely something to consider and take into account when considering your investment strategy. In the end, it all comes down to individual financial circumstances and plans. For example, if you have a low personal tax rate, fully franked dividends might be best for you and may even result in a tax refund. Though, active investors may prefer unfranked dividends to use the extra funds in other investments before the ATO takes its cut. There are definite benefits on both sides, and it’s often best to speak to a qualified financial advisor who understands your unique financial situation before making any big decisions.
How does residency status affect it?
For Americans living in Australia who are still required to complete their U.S. tax return, you will be required to report your dividends on both your Schedule B and your FATCA form. The U.S. does not take into account whether your dividends are non-taxable from an Australian point of view—they must still be included on your tax returns. You may be entitled to a Foreign Tax Credit for that income, but otherwise, the dividend income will just be combined with your worldwide income to determine your U.S. tax rate.
Regardless, non-residents can still reap some of the benefits from franking credits, but there are some limitations, and your dividends will be taxed differently from resident investors. Like residents, any franked amount of dividends paid to a shareholder will not be subject to Australian income or withholding tax. However, unless you are an Australian resident for tax purposes, you will not be able to use these franking credits to offset or reduce any tax payable on your other forms of income or receive a refund for your franking credits.
Any unfranked dividends paid to a non-resident will be subject to a final withholding tax and may be declared to be conduit foreign income on your dividend statement. Any unfranked dividends that are declared as conduit foreign income are not assessable income and will be exempt from withholding tax. But any other unfranked dividends, either paid or credited to a non-resident will be subject to final withholding tax on the full amount.
This means no deductions may be made from the dividends, and the flat rate of withholding tax will be applied whether or not you have other Australian-sourced taxable income. Because of the U.S./Australia tax treaty, the withholding tax on dividends is capped at 15% in most cases. If you’re paid dividends that aren’t fully franked and you aren’t declaring them to be conduit foreign income, you should attach a separate schedule to your tax return that shows all of the details on any dividends that you received. This way, the ATO can work out the correct amount of tax you will be required to pay.
Franking credits are an important factor to consider for anyone who is or is thinking of becoming a shareholder in Australia. There are significant tax benefits that these tax credits can provide for both residents and non-residents, and they can be an important part of your investment strategy. Investments and dividends can seem complicated, especially for non-residents or those who still have to consider their U.S. tax return or withholding tax, but there are tax professionals out there who will be able to help you get the most out of your investments.