Essentially, franking credits provide shareholders with an offset for the tax already paid by the company on the dividend, thereby undoing what would otherwise be a double taxation outcome. That is, tax paid by the company on profits at the corporate tax rate and then tax paid by the shareholder on the dividend income at the shareholder tax rate.
The franking account keeps a running balance of the tax flowing in and out of the company. The balance of the account rolls forward from year to year and is not reset. The account is credited (for tax paid) and debited (for tax received or refunded). In essence, where the credits exceed the debits, the franking account will have a positive balance and where the debits exceed the credits, there will be a negative balance.
A company should generally avoid a negative balance at year end as this can result in liability for franking deficit tax (explained later in this article). It is important to understand what tax events will cause a debit or credit to arise and also the rules concerning the timing of recognition of these debits and credits.
In this article
- Common examples of credits
- Common examples of debits
- How can a company frank a distribution / dividend?
- To what extent can the distribution be franked?
- Over-franking, under-franking and ATO relief
- Franking Deficit Tax
- Concessions related to the franking deficit tax
Common examples of credits
2. Payment of year-end income tax. The credit is equal to the amount paid and is recognised at the date of payment. Note that the liability for the payment generally arises on the date of lodgement of the tax return.
3. The company incurs a liability to pay franking deficit tax ‘FDT’. The credit is the amount of the FDT and is recognised as a credit on 30 June of the income year in which there is a deficit.
Common examples of debits
2. The company receives a refund of income tax. The debit is equal to the refunded amount and is generally recognised on the date received.
Other debits may include where a company under-franks a distribution; is involved in certain linked distributions; is involved in distribution streaming; or is involved in an on-market share buy-back.
How can a company frank a distribution / dividend?
- The company must be a tax resident at the time of distribution;
- The franked distribution must a ‘frankable distribution’; and
- The company must allocate franking credits to the distribution and disclose this to the shareholder by issuing a distribution statement.
Note that the following are examples of distributions which are not frankable distributions:
- A distribution in respect of a non-equity share.
- A distribution sourced from the company share capital account.
- A distribution which is a deemed dividend by operation of Part III Division 7A of the Income Tax Assessment Act 1936.
- A distribution of profit to a shareholder out of certain exempt CGT gains.
To what extent can the distribution be franked?
The first rule is that franking credit on a distribution may not exceed the ‘maximum franking credit’ amount.
The maximum franking credit amount = the amount of the frankable distribution x [1 / the applicable gross-up rate].
In this instance, the ‘applicable gross-up rate’ = [1 – corporate tax rate of company expressed as decimal] / corporate tax rate of company expressed as decimal.
As an example, ABC Pty Ltd makes a distribution of $10,000 to its single shareholder. It is not a base rate entity and therefore pays tax at a corporate rate of 30%. The maximum franking credit amount is calculated as follows:
Applicable gross-up rate = [1 – 0.3] / 0.3 = 2.3333.
Maximum franking credit = $10,000 x [1 / 2.3333] = 4,285.
If the maximum franking credit is exceeded, the company must only recognise a debit to the franking account equivalent to the maximum franking credit. Similarly, the shareholder may only include the maximum franking credit in their assessable income and will only obtain a tax offset for the maximum franking credit amount.
The second rule is the benchmark franking percentage rule which provides that all dividends paid during the franking period (i.e. income year in most instances) are required to have the same franking percentage. Note that certain public companies may have two or more franking periods within an income year. The purpose of this rule is to prevent tax avoidance in instances where certain shareholders are distributed lower franked dividends and other shareholders receive highly franked dividends to take advantage of shareholder tax circumstances.
If the benchmark franking percentage rule is not complied with there will either be an over-franking situation or an under-franking situation. The consequences attached to either circumstance can be quite disadvantageous for the company and shareholders. The company should therefore seek to avoid either situation occurring.
Over-franking, Under-franking and ATO relief
Where the franking percentage for a distribution exceeds the benchmark percentage, the excess triggers over-franking tax. The tax is calculated as follows:
Amount of the frankable distribution x [franking percentage differential / applicable gross-up rate].
‘Franking differential percentage’ = the difference between the franking percentage for the relevant distribution and the benchmark franking percentage for the relevant franking period.
For example, ABC Pty Ltd makes a distribution to a sole shareholder of $7,000 to which 1,200 in franking credits are attached. The benchmark percentage for the remainder of the franking period is therefore set at 40% (i.e. franking credits of 1,200 / maximum franking credits of 3,000).
ABC Pty Ltd later in the same income year makes another distribution to the shareholder of $7,000 and attaches 2,100 in franking credits. The maximum franking credit is 3,000 (i.e. $7,000 x [1 / 2.3333]). The franking percentage is therefore 70% (2,100 being the franking credits attached to the distribution / 3,000 as the maximum franking credit).
Over-franking tax = $7,000 amount of frankable distribution x [30% franking percentage differential / 2.3333 as the applicable gross-up rate ]= $900.
In this instance, despite the company exceeding the benchmark percentage, the entirety of the franking credit attached to the over-franked distribution is valid for the shareholder and the over-franked amount will still be recognised as debit to the franking account. However, the $900 over-franking tax will be payable by the company within one month after income year end (i.e. 31 July). The tax payment will not be credited to the franking account. The tax is also not an offset that can be applied against the company income tax liability, nor is it deductible.
Where the franking percentage for a distribution is less than the benchmark percentage the shortfall will result in an under-franking debit to the franking account. Essentially, this results in ‘wasted’ franking credits rather than a separate penalty tax to be paid. To calculate the under-franking debit refer to the formula used to calculate the over-franking tax.
Note that there are some limited circumstances where the ATO may waive the above-listed penalties related to a departure from the benchmark percentage. For further detail, refer to Section 203-55 of the Income Tax Assessment Act 1997.
Franking Deficit Tax
The consequences of franking deficit tax include the following:
- The company is liable for payment of the tax within one-month of the end of the income year (i.e. 31 July).
- The company will obtain a credit at midnight on 30 June to ensure the franking account is brought to nil for the start of the next income year.
- The franking deficit tax amount will be a non-refundable tax offset for the company. However, the offset entitlement will be reduced by 30% if the amount of the FDT exceeds 10% of total franking credits.
For example, in FY 2023-24 XYZ Pty Ltd has total franking credits of 100,000. The franking account balance was in a debit deficit of $5,000 at 30 June. The tax offset penalty reduction of 30% does not apply here as the deficit is only 5% (5,000 deficit / 100,000 franking credits) of the total franking credits that arose during the financial year.
If, on the other hand, the deficit was $15,000 at year end, the tax offset reduction of 30% would apply as the deficit is 15% (in excess of the 10% threshold). In this second example, the amount of franking deficit tax that could be utilised by the company as a tax offset is reduced by 30% to $10,500 (i.e. $15,000 (deficit) less 4,500 (30% of deficit)). In this scenario, the company is effectively penalised by losing entitlement to a tax offset of $4,500.
Concessions related to the franking deficit tax
- The company is a private company.
- The company will have a tax liability.
- The company has not incurred at tax liability in a previous income year.
- The liability for income tax is greater than 90% of the franking account deficit.
The ATO also retains discretion not to enforce penalties where the 10% tolerance threshold is exceeded due to circumstances outside the control of the company. Relevant circumstances for consideration include:
- The company having a franking account debit that was unexpected and outside the control of the company.
- A franked distribution was not received at the usual time expected.
- The company has a sudden downturn in business leading to reduced PAYG instalments after the company had already distributed franked dividends.
This article is for general information only. It does not make recommendations nor does it provide advice to address your personal circumstances. To make an informed decision, always contact a registered tax professional.