Question

Answer in ~ 600-700 words

Explain the Australian dividend imputation credit system and how it applies in Australia. Include an analysis of how the receipt of franking credits will result in differing returns for Australian resident and international investors.

Answer 1

The Australian dividend imputation system is a corporate tax system in which some or all of the tax paid by a company may be attributed, or imputed, to the shareholders by way of a tax credit to reduce the income tax payable on a distribution. In comparison to the classical system, dividend imputation reduces or eliminates the tax disadvantages of distributing dividends to shareholders by only requiring them to pay the difference between the corporate rate and their marginal rate.

The objective of the dividend imputation system is to eliminate double taxation of company profits, once at the corporate level and again on distribution as dividend to shareholders. More specifically, it is intended to create a "level playing field" by taxing the same activity in the same way, irrespective of the business structure being used, namely a company or trust, sole trader or partnership. Under the previous system, the company and shareholders had an incentive for the taxed income of the company to be retained by the company.

Non-resident shareholders are not entitled to claim a tax credit or refund of imputation credits. Unfranked dividends received by non-residents are subject to a withholding tax, which does not apply to franked dividends.

Say, a company makes a profit of $100 and pays company tax of $30 (at 2006 rates) and records the $30 in the franking account. The $30 is paid to the tax office. The company now has $70 left to pay a dividend, either in the same year or later years. When it does so, it may attach a franking credit from its franking account, in proportion to the tax rate. So if it pays a $70 dividend it could attach $30 of franking credits. When the dividend is paid, the franking account is debited by $30.

An eligible shareholder receiving a franked dividend declares the cash amount plus the franking credit as income, and is credited with the franking credit against their final tax bill. The effect is as if the tax office reversed the company tax by giving back the $30 to the shareholder and had them treat the original $100 of profit as income, in the shareholder's hands, like the company was merely a conduit.

Thus company profits going to eligible shareholders are taxed just once. Profits are either retained by the company and taxed there at the corporate rate, or paid out later as dividends and instead they're taxed at the shareholder's rate.