Question

The imputation system encourages payment of high dividend. Companies that pay significant dividend may be left short of cash. Comment on this statement.

Answer 1

Imputation system encourages payment of high dividend as it eliminates double-taxation on dividends. Dividend is paid from the net income of a company, which is already net of taxes. If the dividend income of shareholders is taxed again, then it becomes the case of double taxation. For example, a company paying 20% tax rate will pay 20% of its all pre-tax earnings as taxes. From the earnings after tax, the company pays out dividends. Now, if the dividend is taxed at, say 10%, then total tax on the dividend amounts to 20% + 10% = 30%, hence double taxation.

Countries such as Australia, Canada, Chile, Korea, Mexico, and New Zealand follow imputation system. Taxes on dividend distribution reduces the net dividend income of the shareholders. So, in the imputation system, companies pay higher dividend as a cost-effective means of wealth transfer to shareholders.

However, the flipside to high dividend is its impact on cash flow. Since dividend is a direct cash outflow, unless its a stock dividend, high dividend payment can reduce the net available cash for a company. This in turn may require to rework the working capital requirements of the company so as to ensure sufficient free cash flow to the firm.