Overview

This Parliamentary Budget Office (PBO) explainer provides an in-depth walk through of the dividend imputation part of the tax system, and the franking credits that underpin it. The explainer first provides an intuitive approach to understanding imputation, including using ‘pay-as-you-go’ (PAYG) withholding tax as an analogy, before introducing the complexities of the system.

• Chapter 1 sets out the core concepts of how corporate business income is taxed in Australia in the most common case of company profits being distributed to Australian shareholders as dividends.
• Chapter 2 covers the taxation of company profits which are paid to foreign shareholders or retained by the company.
• Chapter 3 discusses practical outcomes of the dividend imputation system.
• The 3 appendices included provide some historical background and data.

Note to the reader
The taxation of corporate income is arguably the most complex and contested area of tax policy, partly because of the balance between domestic and international considerations.

This explainer introduces imputation from the perspective of Australian shareholders, to show how the dividend imputation system operates and how it relates to other income tax in Australia (an important consideration for the PBO’s costings of company tax proposals). 

Our discussion of corporate tax for foreigners also mainly focusses on mechanisms rather than the economic impacts of imputation or comparisons to alternative tax systems, topics of robust debate among experts.

For readers wishing to delve deeper into the literature on the taxation of corporate income, we suggest as a starting point the Tax and Transfer Policy Institute’s (TTPI) Corporate income taxation in Australia: Theory, current practice and future policy directions, a detailed discussion of Australia’s corporate tax system, including analysis of impacts on foreign and domestic shareholders, the benefits and shortcomings of imputation compared with alternatives, and current policy debates.

1. Dividend imputation concepts

1.1 The basics

Australia’s income tax system recognises that while all taxable income is ultimately earned by individuals, in practice most income flows through a business, typically as wages for employees or profits and capital gains for owners. Accordingly, income tax in Australia is largely paid to the Australian Tax Office (ATO) by businesses on behalf of individuals (the goods and services tax - GST - and excise are also paid by businesses and passed onto consumers through prices).

Businesses ‘withhold’ tax from employees’ wages as a pre-payment of tax on their behalf. Similarly, income tax paid by companies is a pre-payment of tax on behalf of the owners, the shareholders.

When a company pays income tax the ATO provides the company with a credit of the same value, known as an ‘imputation credit’ or ‘franking credit’. Later, this tax credit can be passed on to shareholders when they receive dividends from the company. Franking credits work somewhat like a voucher that was purchased by the company from the ATO, passed on to the shareholder, and accepted by the ATO as payment of tax.

When a shareholder (owner) of a company lodges their own tax return, these franking credits are recognised by the ATO as tax already paid on the owner’s behalf. This may result in a tax refund to the shareholder if the tax already paid is higher than their tax liability, or the shareholder may need to pay an additional amount of tax if their tax liability is greater than the tax already paid.

The diagram shows the various flows for a simple case of a company with one shareholder, whose only income is $100,000 of dividends. The flows of tax (and refunds) are shown by the purple arrows (figure 1). The flows of franking credits are shown by the gold arrows.

Figure 1 – Flows of tax and franking credits 

In the example, the shareholder receives $100,000 of income, being $70,000 of cash dividends and $30,000 of tax credits paid by the company on the shareholder’s behalf, at the company tax rate of 30%. The shareholder’s tax assessment¹ for the income is around $23,000, so the over-payment of tax of around $7,000 is refunded to the shareholder. The refund is for the tax that, in retrospect, should never have been paid because it is the shareholder who ultimately earns the income and pays the associated tax, with the company acting as a conduit.

The example illustrates that, while the tax payments system results in flows of tax to and from the ATO, the end result is that the tax on the profits earned by the company is based only on the shareholder’s individual tax rate.

Most of Australia’s income tax system works like this, with a notional amount of tax being paid close to when the economic activity occurs, followed by a reconciliation later on. The most well-known of these payment mechanisms is PAYG tax, where a business will ‘withhold’ some of its employees’ wages to send to the ATO. These amounts of tax are credited to the employees. This payment system ensures that when employees submit their tax returns after the year ends they don’t find themselves with large tax bills (as they often did before 1942, when pay-as-you-earn tax - as it was then called - was introduced²). In fact, the amount of tax already paid on an employee’s behalf is often slightly more than the eventual tax liability, resulting in a tax refund for the employee.  Sometimes the amounts already paid are less than the eventual tax liability, resulting in the employee needing to pay more – an additional tax bill on assessment.

In a system of dividend imputation, company income tax is a pre-payment by the company of the shareholders’ eventual income tax. A simple parallel is PAYG withholding tax on wages: the business sends tax to the ATO as a pre-payment of tax on behalf of the individual.

Dividend imputation is more complex than PAYG withholding tax because the business’s management may choose to retain profits in order to grow the business rather than distribute the profits to the owners. Another complexity is that many owners of Australian businesses are foreigners who mostly cannot take advantage of tax credits (see Chapter 2 for more on this).

Nevertheless, in an imputation system the tax paid by companies is not on their own behalf but on behalf of their owners. From this perspective companies in Australia are not actually taxed at all and company tax can be thought of simply as another withholding tax.

Dividends that are paid together with franking credits are referred to as ‘franked dividends’. If the company did not distribute franking credits with the dividends, they would be ‘unfranked’. In less common cases, the company may distribute franking credits with the dividend but of a lower value than the company tax rate allows. For example, the company may distribute a $700 dividend with only a $100 franking credit. In this case, the dividends are ‘partly franked’ (see Chapter 3 for more on this).

1.2 Imputation across marginal tax rates

Because the shareholders ultimately pay the tax on company profits, the eventual tax rate applied will depend on the shareholder’s total income. The shareholder may earn other income, such as wages, in addition to the dividends.

The example shown in the next diagram shows how the Australian corporate income that results in dividends paid to Australian resident shareholders is ultimately only taxed once, at the individual tax rates of the various shareholders. 

In the example, an Australian company earns income and pays tax, which generates franking credits. Three shareholders of the company each receive a $700 cash dividend and a $300 franking credit. 

Each of the three shareholders also receives varying amounts of other income that puts each of them into different tax brackets. The difference between the company tax rate (which has already been paid, signified by the franking credit) and their marginal income tax rate including the Medicare levy (ML) will determine if the shareholder receives some of the tax back or needs to pay more.

Figure 2 – Franking credits at different marginal tax rates

This means that shareholders with low incomes (such as retirees) can receive a cash refund from the ATO through refunding franking credits that they have received on dividends. 

High income earners must still pay tax on dividends, but because the company has already paid some of the tax on their behalf, they only have to pay the difference between the company tax rate and their individual income tax rate.

1.3 Franking credit refundability

Central to the imputation system for Australians with low taxable incomes or low tax rates is that franking credits can be refunded. This means that if the individual does not have a tax liability large enough to absorb all the franking credit on a dividend, the excess franking credit is paid to the individual as a cash refund, as illustrated in the simple example above.

The system of taxing wages works in the same way, where employees receive a tax refund after it is clear, in retrospect after the end of the year, that too much tax has been withheld.

One aspect of a dividend imputation system is that no special tax arrangements are needed for dividend income. Dividends are included with other income into the individual’s end of year calculations. If you have paid too much, once everything is factored in, you get a refund. As discussed later, tax systems in other countries often involve separate arrangements for different sources of income. In Australia, individuals are ultimately taxed on the basis of their combined income from all sources.

There are three common cases where franking credits result in refunds. The first case is for organisations including charities and government investment entities such as the Future Fund, which pay no income tax so any franking credits received will be refunded to the entity. 

The second common case is self-managed superannuation funds (SMSF), which operate differently from large superannuation funds due to their smaller client pools. This is explained in detail in the next section.

The third case is for individuals with low taxable income. For instance, if the individual shareholder’s income is below the tax-free threshold ($18,200 as of 2022-23), with an assessment of zero tax, then the shareholder receives a cash refund of the tax previously paid by the company on the dividends.³

Prior to 1 July 2000, any franking credits in excess of a shareholder’s tax assessment were not eligible to be refunded and were simply lost. This led to several effects on individuals:

• While high-income individuals generally received the full value of their franking credits, because their tax bill was higher than their franking credits, low-income individuals received only part of the value of franking credits, and those whose income was below the tax-free threshold received none of their franking credits because they paid no tax;
• Incentives to invest in assets other than shares, because non-refundable franking credits meant that the overall after-tax return would be lower for shares, all else being equal; 
• Incentives for small businesses to remain unincorporated, such that the profits for a sole owner was taxed at the owner’s tax rate, however low that was; and
• Incentives towards investing through large superannuation funds, which have sufficient contributions and other earnings income to absorb franking credits, rather than self-managed super funds (see the next section).

The impact of these effects increased over the 1990s with the increase in the superannuation guarantee rate to 9%, leading to a rapidly increasing stock of assets in super funds looking for tax effective investments.

The refundability amendment⁴ of 1 July 2000 removed these effects.

Refundability of franking credits has been the subject of debate over recent years, particularly in the context of self-managed superannuation funds, which will be discussed in the next section. 

1.4 Superannuation funds and refundable franking credits

The extent to which franking credits are refunded to superannuation funds is related to the size of the fund. Funds with thousands of members and many assets under management will receive relatively small refunds of franking credits or none at all, while funds with up to 6 members, usually SMSFs, will often receive significant refunds of franking credits. The reason for the difference is explained here, and it relates to the fact that income tax on superannuation is not levied on each member individually but on the fund as a whole.⁵

Super funds pay tax on their total income from member contributions and from investment earnings. A flat tax rate of 15% is applied to the fund’s total income except for that earned on behalf of those who are retired and drawing a pension. Investment earnings for retired members with assets below the ‘transfer balance cap’ (currently $1.9 million) are exempt from tax.

Large super funds have thousands or millions of members either working and contributing or retired and drawing a pension. Around half of all large fund income is from contributions and half from investment earnings. These funds invest in a wide range of asset types, receiving income through different streams such as rent, interest, capital gains and dividends. Large funds need a ‘balanced’ investment strategy owing to the mix of members contributing and drawing a pension. Around 20% of large fund investment income is dividends with franking credits.

Given that large funds receive much more income (approximately 90%) from member contributions and other earnings, the value of franking credits are unlikely to exceed the funds’ total tax liability, such that these funds rarely receive refunds of franking credits.⁶

An example of how franking credits operate for a large super fund is shown in the box below.

On the other hand, the 1 to 6 members of a self-managed superannuation fund are often at similar stages of life and likely to be either all employed and contributing, or all retired and drawing a pension. In this case, franking credits are more likely to be refundable, as shown in the illustrative example below of a retired couple.

The significant refund of the franking credits in the example reflects both that the fund has no income (and no associated tax) from employed, contributing members, and that the fund’s assets are strongly weighted towards dividends. When the members are retired, self-managed funds tend to invest in assets which provide a steady cash flow, such as interest and dividends, rather than those that provide capital growth.

If there was no refundability, the impact on government revenue would depend on how affected individuals responded.⁷ As shown above, very large funds receive sufficient contributions and diversified earnings which generate sufficient tax to absorb franking credits without resulting in refunds. Members of SMSFs could continue to receive franking credits simply by rolling their fund balances into a large fund. In this case, removing refundability may generate relatively little additional tax revenue.

An alternative response by SMSFs may be to diversify assets away from Australian shares (with an associated fall in share prices) and towards other assets such as foreign shares, fixed interest or rental housing. In this case, removing refundability would also result in a relatively small amount of additional tax revenue.

Public debate on refundability sometimes involves  concerns that the tax concessions available for super funds have resulted in the use of self-managed super funds as a preferred tax-minimisation vehicle for high-wealth individuals.

Funds were able to accumulate very high balances during the years up to 2006, when there were fewer limits to concessionally taxed contributions. Since 2006, individuals have been limited in the amounts they can contribute to funds, which are currently⁸ a maximum of $27,500 before incurring additional tax. The ‘transfer balance cap’ introduced from 2017-18 means that funds with high balances will continue to pay 15% tax on earnings even after retirement. From 1 July 2025, an additional 15% tax rate will apply on superannuation fund earnings from assets above a value of $3 million, regardless of if the fund is in the retirement phase or not.

These policies limit the building of new concessionally taxed super fund balances of many millions of dollars. They reduce the previous advantages from the zero tax rate on earnings after retirement for high-wealth individuals and hence the impact of refundability of franking credits. Policies based on the size of superannuation fund balances preserve the benefits to retirees in general while reducing the incentives to use superannuation as a high-wealth investment vehicle. However, the changes add further complexity to the superannuation tax system.

2. Profits paid to foreigners or kept by the company

2.1 'There is no such thing as company tax'

So far, this explainer has drawn a parallel between the PAYG withholding system, where a company remits tax to the ATO on behalf of its employees, and the imputation system, where a company remits tax on profits on behalf of its shareholders. In both cases an individual’s income is eventually taxed at a rate determined by their total income from all sources, resulting in additional tax or refunds.

Considered this way, the company does not actually pay ‘company tax’ on its own behalf, but always on behalf of its shareholders, which can lead to a conclusion that there is effectively no such thing as company tax.

However, accounting standards in Australia treat the tax paid by companies on behalf of shareholders as ‘company tax’, drawing on international standards. The international standards assign the PAYG withholding tax on wages to individuals even though it is paid to the ATO by businesses on the individuals’ behalf.⁹ A key difference between the PAYG system and the imputation system is that while all PAYG withholding tax will eventually be credited to Australian individuals in the same year, this is often not the case for tax paid by companies.¹⁰

The two most important exceptions are:

• Companies are not required to distribute dividends to shareholders, but may retain earnings and accumulate franking credits for distribution in a later year, or perhaps never; and
• Companies may distribute dividends to shareholders unable to utilise franking credits, particularly foreigners.

Sections 2.3 and 2.4 will explain these cases in more detail.

So, while there is such a thing as ‘company tax’, it is important to recognise different perspectives in assigning tax to entities within an imputation system, and that allocating taxes to ‘heads of revenue’, which is done for budget accounting purposes, uses a method which cannot account for these nuances.

For example, the government’s 2020-21 Final Budget Outcome reports tax revenue from companies of $99 billion and superannuation fund tax revenue of $13 billion. However, superannuation funds had received franked dividends, out of which $7 billion of tax had already been paid by the companies.

On the basis of the entities which eventually bore the tax liability, total tax revenue from superannuation funds would be $20 billion, including the $7 billion paid by companies on behalf of shareholder funds, and total company tax would be $7 billion less. The Government Finance Statistics (GFS) standard reflects the amounts that the entities paid to the ATO. The amounts do not reflect which entities eventually bore the tax assessments.

2.2 Is the company tax rate in Australia irrelevant?

So far, this explainer has focussed on the case of companies being owned by Australian shareholders. Being in a small and open economy, the impact of Australia’s tax system on foreign shareholders is also important.¹³

Franking credits can be used as a tax credit only by Australian residents. The tax treatment of dividends paid to foreign (non-resident) shareholders is therefore less favourable than that for their Australian counterparts. International investors therefore face different incentives for investing in Australian companies for the purpose of receiving dividends as an income stream, all else being equal.

The inability to utilise Australian franking credits means dividends paid to foreigners are subject to ‘double taxation’, meaning that both the Australian company and the foreign shareholder pay tax on the same corporate profits separately at their own tax rates. In the United States, for example, the shareholder pays 15% tax¹⁴ on dividends received. Dividends paid to an American shareholder from an Australian company are therefore taxed at a combined rate of 40.5%.¹⁵

In contrast, the American corporate tax rate is 21%. When combined with the 15% tax rate on dividends, American shareholders pay a combined tax rate of 32.85%, lower than if the dividends had originated in Australia.¹⁶ The ‘double tax’ system is explained further in Appendix A.1.

The higher overall tax rate for American shareholders in this example is because of the higher company tax rate in Australia compared to the United States, not because of the imputation system itself. For domestic shareholders on high marginal tax rates, the after-tax return on dividends may be similar to some foreign shareholders, depending on their own marginal tax rates.

Given that foreigners cannot use Australian franking credits to offset their tax in their own country, companies operating in Australia with largely foreign shareholders may decide to arrange their affairs to reduce their tax and distribute only unfranked dividends. In a case like this, a company would distribute only unfranked dividends, which attract a 30% dividend withholding tax when paid to a foreign shareholder (between 5% and 15% for around 40 countries with tax treaties with Australia). The dividend withholding tax reduces (but does not eliminate) the incentive for such companies to minimise their tax paid in Australia.

Income paid to Australian shareholders from overseas is taxed less favourably than Australian source income because it has been taxed already in the ‘home’ country. The foreign source income is subject to taxation in both countries – ‘double taxation’ – when distributed to Australian resident shareholders (although in some cases the foreign tax is recognised in Australia as a tax offset).

International companies need to outperform Australian companies to generate similar returns as a result of this favourable tax treatment, and domestic investors may prefer to invest in domestic companies as a result.¹⁷

Note, however, that the reverse is not necessarily the case. For investors residing in countries which maintain a ‘double taxation’ system, the incentive to invest in Australia will in part depend on the Australian corporate tax rate compared to other countries. The fact that Australia maintains an imputation system is largely irrelevant to the foreign investor. Unlike the domestic investor, who may be indifferent to the corporate tax rate, the foreign investor will consider the relevant tax circumstances.

Importantly, the corporate rate is not the only determinant of the tax impact on profits. While the corporate tax rate in Australia was relatively high in the 1980s, companies could benefit from several significant tax arrangements which narrowed the company income tax base, such as investment allowances and accelerated depreciation. After allowing for the net effect of these impacts, the average ‘effective tax rate’ on corporate income in Australia has fallen by less than the reduction in the statutory rate from 49% to 30%.¹⁸

A further consideration for non-residents looking to invest is a range of less tangible aspects such as political and economic stability, potential exchange rate volatility, other tax treaties, economic specialisation and the regulatory environment. As such, a simple comparison of statutory tax rates is unlikely to paint a complete picture of incentives for foreign investment.

In addition to Australia, other nations have had full or partial imputation systems, including New Zealand and some European nations, such as Austria, Italy, Finland, France and Spain. However, in 2003 the European Court of Justice determined that dividend imputation breached European tax treaties because the different corporate tax systems in different countries could distort investment decisions. 

Within Europe, where nations are relatively close geographically and relatively similar economically (including a single currency), differences in taxation may affect investment flows as foreign investors rapidly move funds between countries in search of the best returns. The Court summarised:  “Where, in applying their systems, Member States differentiate between the tax treatment of domestic and inbound or outbound dividends this can be a restriction on cross-border investments and it can result in fragmented capital markets in the European Union (EU).”¹⁹

Most of these European nations returned to a system of double taxation during the following 15 years, leaving only New Zealand and Malta as countries maintaining a full imputation system.

The different political, geographic and economic contexts for Australia compared to Europe may not lead to similar impacts.

As a nation with significant natural resources, a key role for the Australian tax system is in ensuring that income generated from Australian activity is taxed within Australia, before the income leaves its shores. In the context of mining companies being significantly foreign owned, Tilley (2024) notes “the importance of company tax in ensuring an adequate community return for natural resource extraction”.

2.4 Retained earnings and accumulated franking credits

In practice, companies often do not distribute all their profits. For example, a company may retain its profits in order to grow the business. In this case the franking credits accumulated by the company may never be distributed to shareholders and are effectively lost (see Chapter 3). Compared to other systems of taxing corporate profits, dividend imputation encourages companies to distribute profits through dividends so the shareholders can get the full value of the franking credits.²⁰

Retaining profits may still be beneficial to shareholders. When a company retains earnings then the value of the company will increase, all else being equal. The increase in value will result in capital gains tax when the shares are eventually sold.²¹

Despite the lost franking credits and the additional capital gains tax, the company retaining its profits will still be advantageous to some shareholders. Box 3 (below) shows a simple illustrative scenario of a company either choosing to distribute or retain all of its post-tax earnings for a single year. Chart 1 summarises the results from the same calculation over a 10 year period. The after-tax return for the shareholder varies according to the percentage of corporate profits distributed and the shareholder’s own marginal tax rate.
 

Chart 1: Investment returns over ten years depend on 
the percentage of profits distributed and the shareholder’s marginal tax rate²²

Shareholders with low tax rates get the best return if the company distributes all its profits, otherwise the franking credits have no value. When the shares are sold at the end of the decade, there will be a capital gain (solely from inflation) which is subject to capital gains tax.

Shareholders with high marginal tax rates will lose the value of the franking credits if the company retains its profits (assuming the credits are never distributed) but benefit from the increase in value of the company when the shares are sold at the end of the decade. Given the shares were held for at least 12 months, the shareholder is eligible for the capital gains tax discount, meaning that only half the capital gain is taxable, an advantage for those subject to high tax rates. The tax advantage from the capital gains tax discount outweighs the disadvantage from the ‘lost’ franking credits.

Therefore, while the imputation system encourages companies to distribute profits to shareholders and discourages strategies to minimise tax, the incentive is somewhat counterbalanced by the significant tax advantage from the capital gains tax discount for those shareholders subject to high tax rates.²³

In practice company managers do not make decisions solely on the basis of tax advantages to shareholders. They strive to balance the need to grow the business with the after-tax benefits to shareholders in general.

3. Dividend imputation in practice

3.1 The franking account balance and 'trapped' franking credits

As described earlier, for operational reasons companies sometimes don’t issue dividends even if they made a profit, paid company tax and received franking credits. In order to allow companies discretion to distribute or retain profits, unimpeded by tax considerations, the imputation system allows companies to maintain a running stock of franking credits in a ‘dividend franking account’. Any ‘left over’ franking credits are added to the dividend franking account balance and carried forward to future years, when they may later be distributed.

This process is illustrated in Figure 3, where a company earns $1,000 profit and pays $300 tax, receiving franking credits from the ATO of the same value. The company distributes only $100 of the franking credits to shareholders, making the dividends ‘partly franked’, leaving the remaining $200 to be carried over for distribution in a later year.

Figure 3 – Dividend franking account

The franking credit a shareholder receives therefore may have originally been earned from company tax paid years prior.  This means that comparisons of company tax paid and franking credits distributed and/or claimed can be misleading.

Companies may attach franking credits to dividends only up to the value corresponding to the company tax rate. For example, if the company tax rate is 30% and a company distributes $700 of dividends then up to $300 of franking credits may be attached, such that the franking credits are worth 30% of the $1000 total distributed to shareholders. A company cannot reduce its franking account balance by attaching, for example, $2000 of franking credits to a $700 dividend.

In order to reduce the size of its franking account in a later year, the company must pay shareholders more dividends than its profit for that year. In practice, companies’ franking credit accounts tend to accumulate over time. Should a company keep accumulating franking credits, the  account may reach a level which the company is practically unable to ever reduce. These may be referred to as ‘trapped’ franking credits.²⁴

Companies which do not distribute dividends may therefore accumulate a large franking account balance which is difficult to reduce. If a company generates a profit and pays tax but retains the earnings to expand the business, the franking credits will remain in the franking account balance. If the company is successful in expanding the business and generating twice as much profit in a later year, for example, the company will pay twice as much tax and generate twice as many new franking credits. Even if the company distributes all these new earnings and franking credits to shareholders, the originally retained franking credits remain.

Because trapped franking credits are effectively value lost to shareholders, the imputation system tends to encourage companies to pay out dividends rather than accumulate profits and associated franking credits within the company. As explained earlier, however, the capital gains tax discount can offset this incentive. 

Companies may seek to reduce their franking account balance by raising funds through methods unrelated to the operation of the business. One method is to raise funds (through issuing shares or borrowing) solely for paying out special franked dividends, on the basis that the benefit to shareholders of receiving the franking credits is greater than the cost (a reduced share price resulting from the capital raising or interest repayments).

Another method is for the company to buy its own shares back from shareholders but making the payment partially or wholly in the form of franked dividends. This would enable the company to buy their shares for less than market value, with shareholders keen to accept on the basis that they are also receiving franking credits. These and other related mechanisms are the subject of past and recent legislation intended to curb their usage.²⁵

At the end of 2020-21, companies’ total franking account balance was around $450 billion. It is unknown how much of this balance is effectively trapped, unlikely to be ever paid. An overview of the balance of franking credits over time is included in Appendix A.2.

Chart 2 shows company tax and franking credits distributed over recent history. Over the last decade, companies have distributed franking credits worth 77% of the company tax paid over the same period.  Given that there may be a gap of a year or more between the tax being paid and the associated franking credit being distributed, the percentage of company tax eventually distributed is higher.  For example, distributed franking credits were worth around 85% of the average company tax over the previous 3 years.

The gap between company tax paid and franking credits distributed will result in an increasing franking account balance over time.