A franking credit is a tax credit given to stockholders who are paid dividends from companies that have already paid taxes on that dividend. Such credits are available to investors in companies in Australia and New Zealand, which use an imputation system when taxing dividends. This means that the taxes are imputed, or attributed, to the company in question and thus are not attributed to the taxpaying investor. An investor who earns a franking credit for some or all of a dividend must claim the income on his or her taxes but will be refunded the amount of the credit.
If a publicly traded company earns profits, it often passes on some of those profits to its investors in the form of dividends. In most situations, all income from dividend payments is taxable for the investor, even if the company that paid the dividend has also paid taxes on this profit. This is known as double taxation, and Australia, wishing to encourage long-term investment in local businesses, became the first to eliminate this process when it created the franking system in 1987. Companies in New Zealand also allow investors to earn a franking credit.
For an example of how a franking credit is calculated, imagine a company that pays out a $2,000 US Dollars (USD) dividend to an investor and that the company has already paid taxes on that profit at the company tax rate of 30 percent. The credit is equal to the amount of the dividend multiplied by the company tax rate and then divided by the difference between the tax rate and 100. In this situation, $2,000 USD would be multiplied by 30 and then divided by 70. This yields a credit of about $857 USD.
The above example is applicable if the company grants a fully franked credit. In some cases, a company might not have enough credits in its franking account to pay off its investors in this way and, as such, may offer a partially franked credit. Using the example above again, if the company offered only a partial franking credit of 50 percent, that percentage would be taken from the final total of $857 USD, leaving a total of about $428 USD.
When an investor earns a franking credit, he or she is still liable to pay income taxes on the gross amount of the dividend. Once the income taxes are paid according to whatever tax rate the investor holds, the credit is then applied to the amount due in taxes. If the credit is larger than the amount due, then the investor will get a refund. This refund can be collected or immediately reinvested, giving an investor who receives franked dividends the opportunity for long-term opportunities.