Is the future of dividend imputation in doubt?

Does dividend imputation still have a place in the Australian tax system?

Imputation systems have decreased in popularity, so should Australia follow Asia's example and get rid of the idea altogether?

It’s a common problem in tax systems: company profits are taxed once as company income, and then a second time as shareholders’ dividend income. Imputation eases this problem by attributing (“imputing”) tax on profits to a shareholder, who can then claim some offset against their other taxes.

Australia introduced imputation in 1987, and New Zealand brought in a similar system in 1989. But since then imputation systems have fallen out of favour. Malaysia, Singapore and other countries have done away with it. Australia’s Financial System Inquiry questioned its usefulness. So is dividend imputation still a good idea?

Nicholas Gruen

Chief executive
Lateral Economics

Nicholas GruenFew cases in economics are as strong as the one against dividend imputation. At the margin, imputation encourages Australian investors to increase their investment in Australian shares. But Australians already have a strong domestic market orientation and will retain it for the foreseeable future. The additional funds that imputation attracts to Australian companies are slight.

By contrast, foreigners get nothing from imputation. Yet foreigners, who invest little of their money in Australian equities, are the very people who will be most responsive to our tax favours.

Abolishing imputation could fund the reduction of company tax to around 20 per cent. If this one-third cut in tax induced one-third more foreign investment – not an implausible estimate – then total share investment would surge by around 10 per cent.

“Abolishing imputation could fund the reduction of company tax to around 20 per cent.” Nicholas Gruen

Experience backs up this simple theory. Removing imputation privileges from UK pension funds in the 1990s didn’t harm UK share prices. And the only study I know of concludes that imputation’s Australian introduction in 1987 did not inflate our share prices. Since then other countries – such as Germany and Ireland – have swapped imputation for lower company tax, to their great good fortune. 

Swinging tax incentives away from domestic investors towards foreigners makes sense because foreigners will far more readily invest as tax falls. To add icing to the cake, 10 per cent share price rises would offer fine compensation for any Australian shareholders selling to rebalance their portfolio.

Kate Howitt

Portfolio manager
Australian equities, Fidelity

Kate HowittTo judge a tax, you must look at its wider impacts. Tax settings can change behaviours in surprising ways. The unforeseen magic of dividend imputation is that it makes Australian companies better manage their capital, which has made them sounder investments. In fact, franking credits might explain much of the outperformance of Australian stocks since 1988.

Dividend imputation boosts returns in two ways. The first is that it leaves Australian managers with only enough money to invest in the best projects – for they have paid out an average 70 per cent of their earnings under dividend imputation, versus 42 per cent in the five years before it appeared.

“Imputation makes Australian companies better manage their capital, which has made them sounder investments.” Kate Howitt

The other boost comes from how franking credits promote “scrutinised reinvestment”. Because companies must get outside equity and debt investors to agree to major reinvestment decisions, the investment dollar is allocated more effectively. 

Can we prove Australian companies invest only in the finest projects? We could use the cash flow return on investment (CFROI) measure devised by Credit Suisse HOLT. By this yardstick, Australian companies under the dividend imputation stand out.

Australia’s CFROI was 4.2 per cent per annum from 1982 to 1987, not far below the rest of the world’s CFROI of 4.8 per cent per annum over those years. The measure for Australia soared to 8.6 per cent per annum between 1988 and 2014, well above the rest of the world’s 6.2 per cent outcome. When the distorting sectors of IT, metals and minerals are excluded, the results show the same outperformance by Australia. Why cast a spell on that?

Paul Drum FCPA

Head of policy
CPA Australia

Paul DrumThe debate around the income tax treatment of dividends in Australia seems to take an all-or-nothing course – that is, if a government was to do away with our so-called full imputation system, then Australia would return to the bad old days of double taxation on dividends.

Such a radical approach would inevitably lead to investors – individuals, corporates and super funds – all rethinking their investment strategies, as investment yields would be threatened.

Further, some argue that the reason Australian companies pay as much income tax as they do is so they can reward their shareholders with franked dividends. It follows then that if dividend imputation was scrapped, without an alternative, companies may be disinclined to pay as much income tax as they currently pay. That would not be good for government tax revenues.

“What if dividends were treated as exempt income for Australian residents?” Paul Drum

Australia is one of the last countries left with a full imputation system. But that is not to say we’re wrong and everyone else has got it right.

The Australian Government’s tax white paper process needs to explore, among other things, if there are better alternatives regarding the tax treatment of dividends that could be introduced to encourage investment in Australian companies. Would they be preferable to the current full imputation system? For example, what if dividends were treated as exempt income for Australian residents?

It is reasonable to argue that increasing taxes does nothing for encouraging investment. We need to ensure the tax system does not discourage investment in Australian businesses and encourages productivity, job creation and enhanced standards of living for all Australians.

The experts

Nicholas Gruen

Dr Nicholas Gruen is founder and CEO of consultancy Lateral Economics, as well as the chairman of the Australian Centre for Social Innovation.

An economic adviser to Australia’s Hawke and Keating Governments, his 2006 paper for the Committee for Economic Development of Australia, Tax Cuts to Compete, was the first significant publication to argue that scrapping Australia’s dividend imputation system in favour of a lower corporate tax rate would boost economic growth.

Kate Howitt

Kate Howitt is a portfolio manager in Fidelity Worldwide Investment’s successful Australian equities team and manages a retail fund and institutional mandates. She has been with Fidelity’s Australian team in Sydney since it was set up in 2004, and has managed S&P/ASX 200-benchmarked portfolios since 2007.

Paul Drum FCPA

Paul Drum has worked in the tax and business policy arena for more than 30 years, principally in Australia, but also in Hong Kong, Malaysia, Singapore and New Zealand.

As CPA Australia’s policy head, he is involved in member representation and advocacy with various levels of governments, and is CPA Australia’s media spokesperson on tax policy issues. He is the past chairman of the Association of Accounting Technicians, AAT (Australia).

September 2020
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