Dividend imputation

Double taxation of corporate dividends ceased to exist in Australia in 1987 after the introduction of Dividend Imputation. The rules are complex, and while the core is in the 1936 Income Tax Assessment Act other elements of the system are to be found in the 1997 Income Tax Assessment Act.

Introduction

Under the Australian system, corporations still pay tax on their profits and dividend recipients must still pay income tax upon their receipts, but along with the payment and receipt of these dividends are what are called franking credits. A corporation generates one franking credit for each dollar it pays in corporate income tax. These franking credits are then passed on to shareholders, at varying proportions. Australian taxpayers must then include in their own income tax assessments not the amount of dividends received but their share of the corporation's entire assessable profits, via an accounting process called "grossing up". It is upon this share of pre-tax corporate profits that shareholders must pay tax. After the tax payable is calculated along with the normal income tax upon other income sources, the shareholders then claim the franking credits they have received against this gross tax payable to arrive at a net tax payable. The net result of the process is that the corporate pre-tax profits are treated in tax (as they are in justice) as those of the shareholders, where the corporation simply pays part of the income tax payable on behalf of the shareholders.

For this simple exposition the effect of retaining profits is ignored and the corporation is assumed to pay out all post-tax profits as dividends. The grossing-up calculation is fairly simple: a real taxpayer and shareholder in the corporation begins with the dividend received and then divides that amount by (1 minus the corporate tax rate). As of 2005 the corporate tax rate was 30%, so real taxpayer's dividend is grossed up by dividing it by (1–0.3) = 0.7, meaning for example that a real shareholding taxpayer who received a $2,100 dividend must divide that amount by 0.7 to arrive at an assessable amount of $3,000, which represents that taxpayer's proportionate share of the corporation's pre-tax profits. From the perspective of the shareholder, if the corporation had fully paid tax at the prevailing tax rate then it would have paid $900 in corporate income tax and generated 900 franking credits to match. If the corporation made the dividend distribution "fully franked" (see below) this means it forwarded all 900 credits to the shareholder. If our tax-paying shareholder was in the 42% marginal tax bracket (see progressive income tax), his tax payable upon the $3,000 would be $1,260. However, the taxpayer also received 900 credits that may be used to offset the tax payable, meaning that our shareholder now only has to pay $1,260 – 900 = $360. The end result is exactly the same had no corporate income tax existed: the corporation would have not paid any tax on its $3,000 profits and passed all of it to the shareholder who then paid tax at his current 42% marginal rate. This shareholder would then have to pay the full $1,260 in income tax but would have received $900 more from the corporation.

If a shareholder is in a marginal tax bracket lower than the corporate tax rate, that shareholder has effectively paid more tax than the law requires. For example, a recipient in the 17% marginal bracket receiving the same $2,100 dividend (again from $3,000 corporate pre-tax profits) and 900 credits would have a tax payable of $510 on the $3,000, which only needs 510 credits to offset to zero. The remaining 390 excess credits may be claimed as a tax refund at the normal dollar per credit rate that generated them in the first place. In this way shareholders who are low-income earners are not disadvantaged by the system.

The corporate tax rate has changed a few times since dividend imputation was introduced, all of which were small reductions. These reductions had the effect of rendering existing franking credits still held by corporations as less valuable than before the change. Thus along with the reduction in tax rates (except for the last one) the existing credits held by corporations were increased using formulae to restore the system to effective net-zero corporate income tax.

If a corporation owns shares in another corporation and receives franking credits, then quite simply these received credits are added to the receiving corporation's own stores and are duly passable on to that corporation's own shareholders, whether real or corporate. This ability to pass on of credits from one corporation to another made the 'intercorporate rebates' allowances redundant. These rebates acted so that a corporate shareholder in another corporation did not itself pay double tax upon dividends, meaning that all the franking system has done is expand the elimination of double taxation to real persons as well as corporations. The intercorporate rebates were part of the original 1936 act (section 46), meaning that the principle of eliminating double taxation has been present to some degree in Australian income tax law for a very long time.

The system is now non-controversial in Australia, and the only significant political party objecting to the system (The Australian Democrats) was effectively destroyed at the 2004 Australian Federal Election, and even then they did not draw much attention to this element of their policies. As a result, Australian shareholders effectively have not paid corporate income tax or dividend tax for almost a generation and this may be expected to continue for the foreseeable future.

Abuses of the system

A corporation is not required to pass on all credits to shareholders. The degree of passing-on is the percentage of franking, eg a 75%-franked dividend is one upon which only 75% of the maximum possible attachable credits have in fact been attached to that dividend. It is not permitted, however, to exceed 100% franking, which at the present corporate tax rate means 0.3 credits for every 70 cents in dividend. A corporation may pay out more credits than it actually has, but there are limitations and penalties attached to this.

Only Australian residents paying tax to the Australian Federal Government may use franking credits, as the credits are not offsettable against withholding taxes. Accordingly, foreign investors in Australian equity are keen on directors maximising unfranked dividends. Australian residents, naturally, want the opposite. Initially, it was permissible for corporations to direct the flow of franking credits preferentially to one type of shareholder over than another so that each may benefit the most as fits their tax circumstances. This practice, known as 'dividend streaming,' became illegal in 2002, whereafter all dividends within a given time frame must now be franked to a similar (but need not be identical) degree irrespective of shareholder location or which class of shares held.

A lesser known abuse is 'dividend stripping,' and appears to be intended to claim double-deductions via both the franking system and capital gains tax rules. The definition of 'dividend stripping' in Australian income tax law is both spartan and circular. However, tax law study texts suggest that the essence of the process is this: a stripper fully takes over a company at a given cost, then declares a dividend payable to the stripper so large that the value of the equity drops considerably, distributes to itself all franking credits along with that dividend, claims these credits against gross tax liabilities, and then sells the equity at that lower price. This sale generates a capital loss, which is then used to offset the realisation of capital gains made elsewhere and thereby lowering net assessable capital gain. No real loss is actually made since it was generated by the dividend. How workable and common such a scheme actually was is questionable, and Australian tax texts do not much discuss it other than to point out that the anti-stripping sections exist.

Elimination of tax-incentivised corporate behaviour?

It is also interesting to note that it was soon realised that the system eliminated to a considerable extent the effectiveness of tax incentives for corporations. If a corporation was given a tax break then its incomes thus released from taxation would not generate franking credits precisely because no tax was paid. In turn, this meant that the shareholders received fewer credits along with their dividends, meaning in turn that they had to pay more tax. The net result is that each tax break a corporation itself got was countered by a matching increase in the tax burden of shareholders, leaving shareholders in exactly the same position had no tax break been received by the corporation. Thus, to the extent that corporate directors acted so as to increase shareholder wealth, tax incentives would not influence corporate behaviour.

It could be argued, however, that a residual bias in favour of obtaining the credits may exist through it being cheaper for the corporation to retain more profits and pay less tax than to ignore the tax break and obtain the same funds from shareholders at some future date. How significant such an inclination to use corporate tax breaks for this purpose is debatable.

Overseas systems

Australia is not the only country to employ dividend imputation, another example being in New Zealand, but few other countries do so completely such that double taxation of dividends is in fact eliminated.