Tuesday, September 02, 2014

A note on dividend imputation

I hadn’t realised that New Zealand, Malta and Australia are apparently the only countries to have dividend imputation built into their tax systems. For those who don’t know dividend imputation, it is intended to reduce double taxation on the same profit stream.

Prior to dividend imputation, a company would pay tax on its Australian earnings. If it then paid a dividend to shareholders on post tax profits, that dividend was taxable in the hands of shareholders. So every dollar of company profits distributed as dividends was taxed first at the company tax rate and then the personal tax rate.

This was seen as having certain negative effects. To begin with, it was inequitable. It provided an incentive for the the use of tax structures such as trusts designed to avoid double taxation. It also arguably created a market distortion by skewing investment returns against dividends in favour of interest bearing securities.

The system that Australia introduced allowed shareholders to effectively claim an income tax credit on dividends paid from Australian profits. Tax was now payable only on the difference between the company tax paid and the shareholder’s marginal tax rate. For example, if the company tax paid represented 28% but the individual’s marginal tax rate was 40%, the dividend was taxable at 12% in the hands of that shareholder.

There is now pressure to remove dividend imputation as part of possible tax changes targeting taxation “concessions”. As with all these things, the immediate effect of removal is likely to be greater than the original introduction. 

I do not have the knowledge to track the detailed effects since these depend in part on the varying tax positions of individuals and entities. However, on the surface, the removal of dividend imputation is likely to have considerable impact on the return from shares for certain classes of investors. There are also likely to be differential impacts on share prices. The impact here would be greatest for shares and dividends in companies earning the majority of profits in Australia since dividend imputation only applies to dividends paid to Australian shareholders from Australian profits.

Interest rates were relatively high at the time dividend imputation was introduced. In these circumstances, dividend imputation had a considerable impact on dividend versus interest returns, encouraging a rise in share prices. Interest rates are now so low that the immediate asset price impact of the removal of imputation is likely to be muted. However, as interest rates rise (and they will), there are likely to be considerable asset price effects.     


Evan said...

That's interesting, I hadn't heard about it.

Do you know if there are different patterns of investment in Malta, NZ and Aus?

Winton Bates said...

Dividend imputation is a good thing in terms of removing double tax on dividends and removing a disincentive that would otherwise discourage distribution of profits to shareholders in the form of dividends. If it is removed I guess firms and investors will just alter their behaviour to take returns in the form of capital gains rather than dividends.
However, dividends serve a purpose. They help individual investors to budget - to live off their income, without fear of consuming their capital. They may also help investors to assess corporate performance, but I suspect that benefit is illusory given the tendency for some companies to go into debt to maintain dividends.

Jim Belshaw said...

I don't know, Evan. It also bears upon Winton's point.

I support imputation because, to my mind, it removes a distortion affecting one form of funding compared to another. However, I simply haven't thought through all the economics.

As an example, since dividend imputation only applies to Australian profits, it effectively increases the value of companies with Australian earnings vs overseas earnings. Then to the degree it increases share prices, it makes it easier for firms to use equity rather than debt to raise capital.

As more and more Australian firms invest overseas, the proportion of profits available for dividend imputation declines.

I need to sit down quietly at some point and think some of this through.