What it means
Without imputation, the same dollar of profit is taxed twice. The company pays corporate tax on it, then the shareholder pays income tax on the dividend paid out of what is left, which is why the arrangement is often called the classical system.
Imputation fixes this by treating company tax as a prepayment of the shareholder's tax. The dividend is grossed up to the pre-tax profit it came from, the shareholder is taxed on that grossed-up amount, and the credit for company tax already paid is subtracted from the bill.
The result depends entirely on the shareholder's own tax rate. Someone whose marginal rate is above the company rate pays the difference, someone at the same rate pays nothing further, and someone below the company rate ends up with an excess credit.
What happens to that excess credit is where systems differ. In Australia the excess is refundable in cash to many shareholders, including pension funds and low-income individuals, which makes fully franked dividends unusually attractive to those investors.
The nuance for anyone reading foreign accounts is that credits generally do not cross borders. A shareholder in a country without imputation who receives a franked dividend usually gets the cash and no usable credit, which is why franking credits mostly influence domestic investor behaviour and domestic share prices.
In practice
Real-world examples.
Example
An Australian self-managed superannuation fund in pension phase, taxed at 0%, holds shares in three fully franked banks. Every franking credit attached to those dividends comes back as a cash refund, meaningfully raising the fund's effective income.
Example
A high-earning consultant on the top marginal rate receives $14,000 of fully franked dividends. She grosses the amount up to $20,000 in her return, claims $6,000 of credits, and pays the difference between her marginal rate and the 30% company rate.
Example
A New Zealand company pays a partially imputed dividend because some of its profit was earned overseas and never taxed domestically. Shareholders receive credits covering only part of the payment and pay more tax on the unimputed portion.
Formula
Calculation
Franking credit = cash dividend x (company tax rate / (1 - company tax rate)). Grossed-up dividend = cash dividend + franking credit. Tax payable = grossed-up dividend x shareholder's marginal rate, minus the franking credit.
Take an Australian company taxed at 30% that pays a fully franked cash dividend of $700. The franking credit is $700 x (0.30 / 0.70) = $300, and the grossed-up dividend is $700 + $300 = $1,000, which is exactly the pre-tax profit the dividend came from.
A shareholder on a 45% marginal rate is taxed on the grossed-up $1,000, giving $1,000 x 0.45 = $450. Subtracting the $300 credit leaves $150 to pay, so the net cash retained is $700 - $150 = $550.
A retiree on a 19% marginal rate is taxed $1,000 x 0.19 = $190 on the same dividend. The $300 credit exceeds that bill by $300 - $190 = $110, and where excess credits are refundable, the retiree receives $700 in cash plus a $110 refund, for $810 in total from a $700 dividend.Case study
Seen in the real world.
Kanga Regional Bank is a fictional bank invented purely as an illustrative example of dividend imputation. In the scenario the bank earned $1,000 million of pre-tax domestic profit, paid company tax of 30%, or $300 million, and distributed the remaining $700 million as a fully franked dividend.
Two shareholders received identical $700 dividends per parcel of shares. A partner at a law firm on the 45% marginal rate grossed the dividend up to $1,000, faced $450 of tax, applied the $300 credit and paid $150, retaining $550. A retired teacher on a 19% rate grossed up the same $1,000, faced $190 of tax, applied the same $300 credit and received a $110 refund, ending with $810.
The illustrative point is that the company paid tax once, at 30%, and imputation then adjusted each shareholder to their own rate rather than layering a second tax on top. It also explains why, in this fictional market, income-focused domestic investors bid up shares in companies like Kanga that pay fully franked dividends from domestically taxed profits.
Watch out
Common mistakes.
- Comparing a franked dividend yield with an unfranked one directly. A 5% fully franked yield at a 30% company rate is worth about 7.1% grossed up, so ignoring the credit understates the return to a domestic investor.
- Assuming every dividend from an imputation-system company is fully franked. Profits earned overseas or sheltered by deductions carry no domestic tax, so the dividend may be partly franked or unfranked.
- Expecting franking credits to be usable abroad. Foreign shareholders generally cannot claim them, so the credits mainly affect domestic investors' after-tax returns.
Questions
People also ask.
Which countries use dividend imputation?
Australia and New Zealand are the main full-imputation systems today. Several European countries used similar schemes historically and have since moved back towards a classical or partial-relief approach.
What is the difference between franked and unfranked dividends?
A franked dividend carries a credit for company tax already paid; an unfranked dividend does not, so the shareholder is taxed on the full amount at their own rate with no offset.
Does imputation mean dividends are tax free?
No. It means company profits are taxed once, at the shareholder's marginal rate overall, rather than twice, so a high-rate shareholder still has tax to pay.
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