For many Australians, owning shares is about more than simply hoping the share price goes up. One of the biggest advantages of investing in Australian companies is something called franking credits.
They can sound complicated, but the basic idea is quite simple: franking credits help prevent company profits from being taxed twice.
How do franking credits work?
When an Australian company earns a profit, it generally pays company tax before distributing some of that profit to shareholders as dividends.
For example, imagine a company earns $100 of profit. If it pays company tax at 30%, it is left with $70, which it may then pay to shareholders as a dividend.
Without the franking system, the shareholder could then be taxed again on that same $70 dividend at their personal marginal tax rate.
Franking credits recognise that $30 of tax has already been paid by the company.
If you receive the $70 fully franked dividend, you generally declare both the $70 cash dividend and the $30 franking credit in your taxable income. You then receive the $30 credit against the tax you personally owe.
The outcome depends on your own tax position.
If your personal tax rate is higher than the company tax rate, you may need to pay some additional tax. If your tax rate is lower, the franking credit may reduce your other tax liabilities or, subject to the tax rules applying to you, potentially result in a refund.
Why are franking credits important to investors?
The most important point is that investors should not look at the cash dividend alone when assessing the income generated by an Australian share.
Suppose a company pays a fully franked dividend yield of 4.2%.
Because the company has already paid tax on the profits behind that dividend, the value to an Australian investor can be significantly higher. At a 30% company tax rate, a 4.2% fully franked dividend represents a grossed-up income yield of 6% before the investor’s personal tax position is taken into account.
That can make dividend-paying Australian companies particularly attractive to income-focused investors.
Why Australia is different
Franking credits are also one reason the Australian share market has traditionally had a strong dividend culture.
Large companies such as banks, miners and other established Australian businesses have historically returned substantial amounts of profit to shareholders through franked dividends.
For retirees, superannuation investors and others seeking portfolio income, these credits can therefore form a meaningful part of the overall investment return.
However, franking credits should never be the only reason to buy a share. A high dividend is of little benefit if the underlying company is deteriorating, taking excessive risks or cannot sustain its dividend.
The starting point should always be the quality and value of the investment itself.
But when comparing Australian shares with other investments, understanding franking credits is essential. The dividend you see deposited into your bank account may only be part of the economic benefit you have received.