What Is Dividend Imputation?
Dividend imputation is a taxation system that seeks to eliminate or mitigate the double taxation of company profits. In a traditional system, a corporation's earnings are taxed at the corporate tax level, and then again when distributed to shareholders as dividends, subject to personal income tax. Dividend imputation addresses this by allowing shareholders to receive a tax credit for the tax already paid by the company on those profits. This credit effectively attributes, or "imputes," the corporate tax paid to the individual shareholder, reducing their personal tax liability on the dividend income.
History and Origin
Before the introduction of dividend imputation, many countries operated under a classical taxation system where corporate profits were taxed twice. Australia pioneered the dividend imputation system in 1987 under the Hawke-Keating Labor Government, aiming to create a more level playing field and eliminate the disincentive for companies to distribute profits. Prior to this reform, companies and their shareholders often had an incentive to retain taxed income within the company rather than paying it out as dividends, because distributed profits would face a second layer of taxation. This change fundamentally altered how equity distributions were treated for tax purposes in Australia and subsequently influenced other nations.
Key Takeaways
- Dividend imputation aims to prevent the double taxation of corporate profits distributed as dividends.
- Shareholders receive a tax credit for the company tax already paid on those profits.
- The system allows distributed corporate income to be effectively taxed at the shareholder's marginal income tax rate.
- It is most commonly associated with Australia and New Zealand.
- If a shareholder's tax rate is below the company's tax rate, they may receive a tax refund.
Formula and Calculation
The core of dividend imputation revolves around calculating the "franking credit" (or imputation credit), which represents the tax already paid by the company on the distributed profits. For a fully franked dividend, the franking credit is calculated such that the grossed-up dividend (cash dividend + franking credit) reflects the company's pre-tax profit that underlies the cash distribution.
The formula for the franking credit ($FC$) can be expressed as:
Where:
- $CD$ = Cash Dividend received by the shareholder
- $CTR$ = Corporate Tax Rate (expressed as a decimal)
This formula determines the amount of pre-paid company tax that corresponds to the cash dividend paid out, ensuring the shareholder's income includes both the cash dividend and the attached tax credit. The grossed-up dividend, which is the amount subject to the shareholder's personal income tax, is ( Grossed\text{-}Up\ Dividend = CD + FC ).
Interpreting the Dividend Imputation
Dividend imputation effectively means that the tax paid by a public company on its profits acts as a prepayment of its domestic shareholders' tax liability on those profits. When interpreting dividends received under an imputation system, shareholders consider the "grossed-up" amount, which includes both the cash dividend and the attached franking credit. This grossed-up amount is then included in their taxable income. The franking credit then acts as an offset against their total personal income tax liability. If the shareholder's marginal tax rate is lower than the company's tax rate, they may receive a refund for the excess franking credits. Conversely, if their marginal tax rate is higher, they will pay additional tax on the grossed-up dividend. This system aims to ensure that the total tax paid on distributed company profits aligns with the individual shareholder's marginal tax rate.
Hypothetical Example
Consider Company ABC, an Australian company, which earns $100,000 in company profits and pays a corporate tax rate of 30%.
- Company Tax Paid: Company ABC pays $30,000 in corporate tax ($100,000 x 30%).
- After-Tax Profit: This leaves $70,000 ($100,000 - $30,000) as after-tax profit available for distribution or retained earnings.
- Dividend Distribution: Company ABC decides to distribute the entire $70,000 as a cash dividend to its shareholders.
- Franking Credit Calculation: For each shareholder receiving a portion of this $70,000 cash dividend, a franking credit is attached. Using the formula for a cash dividend of $70 (representing a share of the total):
So, for every $70 of cash dividend, there is a $30 franking credit. - Shareholder's Taxable Income: A shareholder receives $70 in cash. Their taxable income from this dividend is grossed up to $100 ($70 cash dividend + $30 franking credit).
- Shareholder's Tax Liability:
- If the shareholder's marginal tax rate is 19%: Tax payable would be $100 x 19% = $19. Since they have a $30 franking credit, they receive a refund of $11 ($30 - $19).
- If the shareholder's marginal tax rate is 30%: Tax payable would be $100 x 30% = $30. With a $30 franking credit, their net tax is $0.
- If the shareholder's marginal tax rate is 45%: Tax payable would be $100 x 45% = $45. With a $30 franking credit, they pay an additional $15 ($45 - $30).
This example illustrates how the tax credit ensures that the total tax paid on the profit, from initial earning by the company to final receipt by the shareholder, aligns with the shareholder's individual tax rate.
Practical Applications
Dividend imputation is primarily applied within national taxation systems to integrate corporate and individual income taxes. Its most prominent application is in Australia and New Zealand, where it significantly impacts how dividends are treated for domestic shareholders. For companies, the system encourages the distribution of profits that have already been taxed at the corporate level, as these can carry franking credits. For investors, understanding dividend imputation is crucial for evaluating the true after-tax return on their investment in companies that operate under such a system. The New Zealand Inland Revenue provides guidance on how companies manage their imputation credit accounts to track and pass on these credits to shareholders.6 This mechanism ensures that the company's tax payments are effectively attributed to its owners, preventing the same dollar of profit from being fully taxed twice. This can influence corporate financial decisions regarding dividend payouts versus retained earnings and may impact the attractiveness of domestic versus foreign equities in financial markets.
Limitations and Criticisms
Despite its benefits in addressing double taxation, dividend imputation faces several limitations and criticisms. One significant drawback is its limited utility for foreign investors, who typically cannot utilize franking credits against their home country's tax liabilities, making domestic companies less attractive compared to those in countries with classical tax systems.5 This can potentially deter foreign investment and affect capital flows.
Furthermore, academic research suggests that while dividend imputation mitigates double taxation and can induce more saving and investment, it can also raise the cost of investment for firms that are not fully imputed.4 The system can amplify frictions in the reallocation of capital across firms, and different tax treatments for resident and foreign investors may prevent foreign capital inflows from fully offsetting domestic savings shortages.3 Another criticism revolves around potential complexities and administrative burdens for companies in managing franking credit accounts and ensuring compliance with the rules. While some studies suggest that dividend imputation may lead to less corporate tax avoidance, its overall impact on economic growth and capital accumulation is a subject of ongoing debate among economists.2
Dividend Imputation vs. Double Taxation
The primary distinction between dividend imputation and double taxation lies in how they treat the tax paid on corporate profits. Under a classical double taxation system, corporate profits are taxed first at the company level through corporate tax. When the remaining after-tax profits are distributed to shareholders as dividends, these dividends are then taxed again at the individual shareholder's personal income tax rate. This results in two distinct layers of taxation on the same earnings.
In contrast, dividend imputation aims to integrate these two tax layers. It does so by providing shareholders with a tax credit for the corporate tax already paid on the profits underlying their dividends. This credit essentially offsets, or partially offsets, the shareholder's personal tax liability on the dividend income, thereby mitigating or eliminating the second layer of taxation. The objective of dividend imputation is to ensure that the total tax burden on distributed company profits more closely aligns with the shareholder's marginal tax rate, rather than being a combined rate of both corporate and personal taxes. The Organisation for Economic Co-operation and Development (OECD) frequently analyzes different approaches to taxing dividend income across its member countries, highlighting various methods including imputation systems, which contrast with classical double taxation.1
FAQs
How does dividend imputation benefit shareholders?
Dividend imputation benefits domestic shareholders by providing them with a tax credit for the corporate tax already paid on the dividends they receive. This reduces or eliminates their personal tax liability on that dividend income, effectively lowering the overall tax burden on the distributed company profits.
Are all dividends franked under dividend imputation?
No, not all dividends are necessarily "franked" (meaning they carry imputation credits). Companies may pay fully franked, partially franked, or unfranked dividends, depending on their tax position and the amount of tax they have paid. The dividend statement received by shareholders will specify the franked amount and the associated credits.
Does dividend imputation apply to foreign investors?
Generally, no. Franking credits are typically only valuable to domestic shareholders who can use them to offset their local [personal income tax](https://diversification.com/term/personal income tax) liability. Foreign investors usually cannot claim these credits, which can make investments in companies operating under an imputation system less appealing compared to those in countries with different tax regimes, especially for capital gains or direct dividends.
Which countries use dividend imputation?
Australia and New Zealand are the most well-known countries that operate comprehensive dividend imputation systems. Some other countries may have partial imputation systems or have had them in the past.
How does dividend imputation affect a company's decision to pay dividends?
Dividend imputation can incentivize companies to distribute profits that have already been subject to corporate tax, as these distributions can carry valuable franking credits for domestic shareholders. This can influence a company's dividend policy, potentially leading to higher payout ratios for taxed profits compared to a classical taxation system.