Franked Investment Income

What Is Franked Investment Income?

Franked investment income (FII) is income that is received as a tax-free distribution by one company from another. This income is typically tax-free to the receiving firm and is usually distributed in the form of a dividend. Franked investment income was introduced in the interest of avoiding double taxation of corporate income.

From the perspective of the company that makes the distribution, the FII is referred to as franked payment, and the term is most commonly used in Australia and New Zealand.

Understanding Franked Investment Income

Double taxation of dividends occurs when both a company and a shareholder pay tax on the same income. The company pays taxes on profits and subsequently distributes a dividend out of its after-tax profits. Shareholders must then pay tax on the dividend received. Taxpayers in countries (mostly Oceanic or European countries) with franked investment income will typically claim the appropriate credit when filing their taxes through dividend imputation.

Franked investment income is income distributed as dividends to a company from earnings on which corporation tax has already been paid by the distributing company. If ABC company pays franked investment income to XYZ company, XYZ company does not have to pay tax on the income. This is because the tax was assessed on ABC company before the income was paid. In essence, the tax paid on this income is also attributed to the receiving firm. Once the issuing company has paid corporate tax on the income being distributed, the tax payment is attributed also to the companies who receive the franked dividend.

Through the use of tax credits called "imputed tax credits," the tax authorities are notified that a company has already paid the required income tax on the income it distributes as dividends. The shareholder or receiving entity then does not have to pay tax or pays a reduced tax on the franked dividend income. In New Zealand, for example, full imputation means providing 28 cents of imputation credits for every 72 cents of franked investment income that is received by the shareholder. At this ratio, all resident shareholders who pay income tax at the rate of 28% or less will not have to pay any further income tax.

On the other hand, shareholders who pay the highest tax rate of 33% will be required to pay a further 5 cents for each $1.00 of gross income, leaving them with a net 67 cents of cash.

The dividend recipient grosses up the dividends by adding the imputed tax credits on the FII to the amount of dividend received. The investment tax is applied to this sum to determine the gross tax liability. Finally, the imputed credit is subtracted from the tax liability to derive the actual tax payable.

Types of Franked Dividends

There are two different types of franked dividends: fully franked and partially franked. When a stock’s shares are fully franked, the company pays tax on the entire dividend. Investors receive 100% of the tax paid on the dividend as franking credits. In contrast, shares that are not fully franked may result in tax payments for investors.

Businesses sometimes claim tax deductions, perhaps due to losses from preceding years. That allows them to avoid paying the entire tax rate on their profits in a given year. When this happens, the business does not pay enough tax to legally attach a full tax credit to the dividends paid to shareholders. As a result, a tax credit is attached to part of the dividend, making that portion franked. The rest of the dividend remains untaxed, or unfranked. This dividend is then said to be partially franked. The investor is responsible for paying the remaining tax balance.