Franked Dividend

Franked Dividend Meaning

The term “Franked dividend” refers to the dividend on which taxes have already been paid by the company issuing it, at the rate which the company is liable to be taxed. In other words, the investors, along with dividend, receive a tax credit equal to the amount of taxes paid by the issuing company.

Explanation

A dividend definitionDividend DefinitionDividend is that portion of profit which is distributed to the shareholders of the company as the reward for their investment in the company and its distribution amount is decided by the board of the company and thereafter approved by the shareholders of the company.read more the distribution of a portion of a company’s profits earned during the period of retained over the earlier years to a particular class of shareholders of the company. The amount of dividends to be distributed is decided by the board of directors and approved by shareholders at the meetings.

At the time of payment of dividends, the company pays taxes on such dividends declaredDividends DeclaredDividend declared is that portion of profits earned that the company’s board of directors decides to pay off as dividends to the shareholders of such company in return to the investment done by the shareholders through the purchase of the company’s securities.read more and paid and provides the shareholder/investor with a tax credit, also termed as “franking credit”.

Such dividend, on which tax is paid and franking credit provided to the investor, is referred to as Franked Dividend.

Franked-Dividend

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How does it Work?

Any person earning income, subject to exemption thresholds, if any, is liable to pay taxes at applicable rates on their annual income. Similarly, the company also has the responsibility of paying the taxes at applicable rates on their annual profits. Post payment of statutory taxes, the balance is available with the company to retain or distribute in full or in part to the shareholders.

As discussed earlier, dividend means the distribution of the portion of profits of the company. Thus, when a company pays dividends, it has already paid taxes on that portion of profits distributed to the investors.

From a shareholders’ point of view, a dividend is a taxable income in his hands and thus added to his annual income and taxed at the personal tax rate. At this juncture, it is highlighted that this dividend has already been taxed at a company level. Now, it may end up being taxed again in the hands of investors, thus leading to double taxation of incomeDouble Taxation Of IncomeDouble Taxation is a situation wherein a tax is levied twice on the same source of income. It usually occurs when the same income is taxed both at corporate as well as at the individual level.read more.

Hence, the concept of franked dividend evolved, thereby allowing to claim a tax credit, that is franking credit, on the dividend amount received by the investor.

How to Calculate Franked Dividend?

When we refer to this type of dividend, we refer to the cash dividendCash DividendCash dividend is that portion of profit which is declared by the board of directors to be paid as dividends to the shareholders of the company in return to their investments done in the company. Such a dividend payment liability is then discharged by paying cash or through bank transfer.read more received by the investor. Thus, it would be right to say that the franked dividend is the net dividend amount paid post considering the payment of applicable taxes by the company.

Franked Dividend = Shares Owned * Net Dividend Received Per Share.

Further, it shall also be important to understand the calculation of franking credit received by the investor.

Franking Credit = (Dividend Received / 1 – Company Tax Rate) – Dividend Amount

Example

Let us take the example of Edwina. Edwina held 100 shares of Hudson Works Ltd., valuing $2300. She received a dividend at the rate of $8 per share. Further, Hudson Works Ltd pays taxes at a rate of 30%. Calculate what will the franked dividend and how much will franking credit be available to Edwina?

Solution

Calculation of Dividend can be done as follows,

Franked Dividend Example 1
  • = 100 * 8
  • = 800

Calculation of Franked Credit can be done as follows,

Franked Dividend Example 1.1
  • = (800 / 1 – 0.3) – 800
  • = 342.86

Thus, Edwina received a dividend of $800 and a credit of $342.86

Franked vs. Unfranked Dividend

The basic difference between the franked and the unfranked dividend is due to tax credit attached to the dividend.

A franked dividend means dividend paid to investors with a tax credit attached to such dividends. This tax credit refers to the extent of corporate taxes paid by the company on such dividend being distributed. The shareholder receiving such a dividend is eligible for tax relief to the extent of tax already paid by the company.

Unfranked dividend refers to dividends with no tax credit attached to it. Thus, the investor will have to bear the additional tax burden liable on the amount of dividend received.

The above is summarized below:

Franked DividendUnfranked Dividend
Tax Credit attached to a dividendNo tax credit attached to the dividend
Taxes already paid at the company level. An investor is eligible to claim tax credit to the extent tax paid by the company.An investor will have to bear the taxes applicable to such dividend income.
Taxes paid by the company at corporate tax ratesTaxes to be computed and paid at personal income tax rates

Advantages

The company is required to pay taxes on its annual income for the financial year. The company declares dividends from a portion of the post-tax profits available with it. In other words, it will be right to say that the company is liable to pay taxes, whether or not it distributes dividends. Thus, the company, as such, does not have the advantage of paying it.

Now, from an investor’s point of view, the main advantage of a franked dividend is that it comes with an attached tax credit. The investors receive the benefit of availing the tax credit while filing his tax return. It may be worthwhile to note that generally, the tax rates are higher for corporates as compared to the tax rates for personal income. Thus, it is possible that the investors may also be eligible for a refund, provided other provisions are complied with.

Disadvantages

It leads to distributing its free cash flowsCash FlowsThe cash flow to the firm or equity after paying off all debts and commitments is referred to as free cash flow (FCF). It measures how much cash a firm makes after deducting its needed working capital and capital expenditures (CAPEX).read more, and therefore, the company has less cash available for its disposal. Lesser liquidity may hinder the company’s growth, or maybe earn higher interest by investing such disposed dividend amount.

Also, wouldn’t invest the amount back into the company’s business help the company achieves a full growth mode?

Conclusion

To summarize all of the above discussions, a franked dividend means a dividend paid by the company to the investors, post-payment of taxes applicable to it, and a franking credit given to the investors.

Further, the credit so given helps in the tax burden of the investor, as he needs to offer the total amount of dividend, i.e., including the taxes paid by the company, as income but simultaneously gets credit for the taxes already paid and hence tax is applicable only on the balance dividend. In effect, franking credit helps reduce the tax burden in investors’ hands to the extent of the franking credit. The concept is designed to avoid double taxation of income.

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