When an Australian company pays company tax, a franking credit is created that the company can pass on to shareholders when paying dividends.
Let’s presume that a company makes a $100 profit and pays $30 in tax. The company now has $70 that it can pay as a dividend and $30 it can pass on as a franking credit. The company decides to pay the $70 as a fully franked dividend to its sole shareholder Dylan. Dylan has other income, and as a result, he will pay personal income tax at a rate of 32% on any dividend he receives. Dylan needs to report $100 of dividend income in his tax return (being the $70 in cash dividend received and $30 in franking credit). The tax on the $100 at 32% equals $32 dollars. The franking credit gets applied against the tax payable and reduces the tax payable by Dylan to $2 ($32 – $30).
Paying dividends at the right time is an important tax planning strategy.