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If you own an ASX stock that pays dividends, franking credits will keep more money in your pocket come tax time. What are franking credits? When companies pay net profits out as dividends to shareholders, they will have already paid corporate tax on those profits. Franking credits are a tax credit that shareholders receiving dividends can use if dividends are "franked" - when corporate tax has already been paid on them. The legislation governing franking credits was introduced to avoid or reduce the incidence of 'double taxation' on listed company profits -- once for the company itself, and once for the investor receiving dividends. Susan Franks, Senior Tax Advocate at Chartered Accountants Australia and New Zealand, also notes it can be positive for companies as well. "Some commentators have argued that the introduction of dividend imputation has made Australian companies manage their capital more efficiently," she said. How franking credits work Just how do franking credits operate in practice? "If an Australian individual investor was to earn $100 of interest income, they would pay tax on the $100 at, say 45% -- so the total tax paid would be $45," Franks explained. "If you earned that $100 as dividends from a large company which pays Australian tax, then without the franking credit system, that company would pay tax at 30% ($30 of tax) and would then be able to distribute $70 as a dividend." If those shareholders pay income tax at the example rate above of 45%, additional tax payable on the $70 dividend will amount to $31.50. "The total tax paid under this scenario would be $61.50 - $30 by the company and $31.50 by the shareholder. The more layers between the shareholder and the investment, the higher the overall tax burden," Franks says. "Under Australia’s franking credit system, the company would still pay $30 of tax, but the $70 dividend paid to the shareholder has a $30 franking credit imputed to the shareholder (hence the name ‘dividend imputation’)." Here's how it's applied: "The shareholder will include $100 of income (being the $70 cash dividend and the $30 franking credit) in their tax return and pay tax at 45% on the grossed-up amount of $100 (i.e. $45). But they also get a franking credit of $30, which reduces their tax payable to $15," Franks said. "The overall tax paid under the franking credit system is $45; $30 by the company, and $15 by the shareholder." Do companies have to frank their dividends? No they don't. There are several reasons when they may not frank their dividends, the most obviously of which is if they do not pay tax in Australia. As Franks explains, there are several scenarios why this may be the case. "Some cannot frank dividends, or fully frank dividends, as they may not have paid Australian tax," she said. "This could occur where for example they earn tax exempt income (e.g. income from overseas) or their tax depreciation deductions are a lot higher than their accounting depreciation deductions. Another example is if they have been utilising prior year tax losses." Franks said that during COVID-19, which saw many businesses fall into the red, the latter reason will be particularly relevant. "This year companies may not be paying franked dividends because they want to make use of the loss carry-back provisions," she said. Loss carry-back provisions allow a company to carry back a current-year loss to a previous year. The move allows them to obtain a tax offset equal to the amount of tax that is no longer payable, due to the carry back of the loss. However, "the amount of the tax offset is also limited by the surplus in your franking account on the last day of the income year in which you are claiming the tax offset", Franks said. History of franking credits Franking credits were first bought in by the Hawke government in 1987, with the intent of helping retail investors pay less tax on the shares they owned. But for the first 14 years, although you could get a "tax credit", you could not get a tax refund for franking credits above and beyond when your income tax payable was reduced to zero. The Howard government amended the system in 2001 so that excess franking credits were a refundable offset for individuals and super funds - even to the point where the government would be giving you a refund you otherwise wouldn't get. Australia's system is not unique. A handful of other countries have dividend imputation systems, including New Zealand and Canada. But some other countries that used to have it, ended up scrapping the system including the UK, France, Germany, Ireland and Singapore. Systems these countries replaced them with vary substantially, ranging from no taxation on dividends in Malaysia to a flat 57% tax rate in Finland. Reasons why countries removed them included views that it discourages companies reinvesting profits, as well as allegations that the system discriminated against companies and residents of other countries that lacked tax treaties with the host country by denying them benefits residents of countries with tax treaties could enjoy. An academic paper by then University of Sydney Business School scholar in 2016 Andrew Ainsworth noted that almost all countries lowered the corporate tax rate at or around the time the imputation was removed. Could franking credits change in the future? Franking credits have been a highly publicised issue in recent years. The Federal Labor party went into the last federal elections with a pledge to reverse those 2001 changes by the Howard government (outlined above) on excess franking credit refunds. It estimated such a move would raise $10.7 billion over four years, but ultimately dumped the policy after its shock loss in the 2019 election. When asked if we could still see changes to franking credits Susan Franks simply told Stockhead, "there is no indication that the Coalition government would curtail franking credit refunds". Nonetheless, ever since the Morrison government's COVID-19 stimulus package was unveiled there has been continual speculation as to how it will eventually be paid for -- and franking credits have been named as an easy target. Most recently, an OECD economic survey released just a fortnight ago named changes to franking credits as a tax reform that Australia could undertake. Even one of the biggest supporters of franking credits in 2019, Wilson Asset Management boss Geoff Wilson, acknowledged last year something may have to give eventually to help fund the deficit but hoped it would still be "done equitably and fairly and logically". While debate might increase in the months ahead, the work by Ainsworth back in 2016 sets out a useful framework. It said the critical questions to answer before making any changes are: What system would we replace franking credits with; And Whether any potential unintended consequences to shareholders from different tax systems -- including any that might leave investors with lower incomes worse off -- are well understood.