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How does a fund pay no tax overall or even get a tax rebate?
By Paul Rickard
The dividend imputation system makes investing in shares that pay franked dividends particularly popular with self-managed superannuation funds (SMSFs). Many funds will pay reduced tax, some will pay no tax, and others will end up with a tax rebate – that is, a cheque back from the tax office!
The system is unique to Australia, and helps to explain why, when compared internationally, Australian superannuation funds tend to be overweight equities as an asset class.
What are franking credits?
Dividend imputation was introduced in 1985 to correct the anomaly whereby company profits were effectively being taxed twice. The company paid tax on the profit it made, and the shareholder then paid tax on the dividend they received. Potentially, profits were being taxed at up to 62.55 per cent.
To address this problem, the dividend imputation system allows companies to pass on to the shareholder a notional amount that represents the tax that the company has paid on its profits. This is called an “imputation credit”, more colloquially referred to as “franking credits”.
The company tax rate is currently 30 per cent. So if a company makes a profit of A$100, it will pay A$30 in company tax. If it then pays a dividend of
A$70, it can pass on imputation or franking credits of A$30 to its shareholders, representing the tax the company has already paid.
How do franking credits work?
Franking credits act like a tax offset. However, to ensure that the actual amount of tax collected by the government is consistent with the shareholder’s marginal rate of tax, a three-step process is applied:
Step 1: The shareholder includes both the dividend in cash and the imputation credit in their assessable income.
Step 2: The gross tax payable is calculated at the shareholder’s marginal rate of tax.
Step 3: The imputation credit is then applied like a tax offset, and deducted from the gross tax payable.
If the imputation credit is greater than the gross tax payable, then the excess is refunded back in cash to the taxpayer. Not only does the taxpayer pay no tax on the dividend, they actually get cash back!
Franked dividends and SMSFs
A superannuation fund in the accumulation phase (when the monies are going into super) pays tax at 15 per cent on its investment earnings. It also pays tax on concessional contributions made by its members at 15 per cent (there is a higher rate for members who earn more than A$300,000). In the pension phase (when monies are coming out), the fund pays no tax on its investment earnings.