If a company earns a profit for the year it may choose to distribute this profit to its shareholders by way of a dividend.

Consider an example where a company has a net taxable income of $1,000 for the year.  The company will pay income tax at 30% (ie $300) leaving an after tax income of $700 available for distribution by way of a dividend to shareholders.

To prevent taxing this same income twice (ie once as company profits and again as a dividend to shareholders) we have an imputation (or franking) system that allows the shareholder a credit for the company tax already paid.  In our example, the company could pay a fully franked dividend of $700.  The shareholder(s) would include this amount in their taxable income as well as the $300 of company tax already paid (called a franking or imputation credit), meaning that they include the same $1,000 of taxable income that the company had (even though they only received $700 in cash).  This dividend is then added to the shareholder’s income from other sources and their total tax payable is determined.  The $300 of tax paid by the company is then deducted from the tax payable by the shareholder.  If the shareholder’s tax rate is more than 30% they will pay the difference, and if their tax rate is less than 30% they will receive a refund.

Superannuation funds are also able to take advantage of the imputation system.  Superannuation funds currently pay tax at 15% on contributions and earnings.  If part of the fund’s income is made up of franked dividends there is an excess of franking credits and these can be offset against other tax payable or even result in a refund of tax.

Many small business clients operate with a company structure and it is a good idea to include dividends as part of the reward to owners.  This can be more effective than paying out profits by way of salary to the owners as dividends are not included in the calculation of workers’ compensation insurance.

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