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Dividend Imputation – is it an obsolete tax distortion?

Dividend Imputation – is it an obsolete tax distortion?

July 15, 2014 3:32 PM | Posted by Payne, Karen | Print this page
Dividend Imputation - Intentional or Obsolete Tax Distortion?

The Financial System Inquiry Interim Report (the Report) has identified taxation as one of three main sources of distortions which hamper the operation of price mechanisms that would otherwise promote an efficient allocation of funding and risk (the other two being regulation and market imperfections). The Report is somewhat restrained in its comments on specific tax reforms:

It is not this Inquiry’s role to make recommendations on tax issues; however, the Inquiry will provide its observations to the Government’s forthcoming Tax White Paper

One area where it does venture a comment is dividend imputation. The Report suggests that the case for retaining imputation is now less clear than it was in the past and may act as a subsidy to domestic equity. Dividend imputation is thought to affect corporate funding decisions in two main ways:

• the amount of debt financing to seek, and
• the share of earnings to distribute to shareholders, which affects the amount of equity financing used.

The degree to which dividend imputation may act as a subsidy to domestic equity holders, making equities relatively more attractive as a savings vehicle, may contribute to a number of characteristics of the broader financial system. These include:

• The propensity of domestic investors, particularly superannuation funds, to hold more domestic equity relative to foreign equity and other asset classes than otherwise would be the case, which encourages less diversified portfolios;
• The lack of a deep, liquid domestic corporate bond market;
• Low demand for annuities, which are largely supported by fixed-income securities, relative to a retirement income strategy based on high-yield domestic equity

Australia’s Future Tax System Review (the Henry Review) argued that the benefits of dividend imputation, particularly in lowering the cost of capital, have declined as Australia’s economy has become more open. However, the Henry Review also acknowledged that the integrity benefits of imputation include:

• compensating Australian shareholders for Australia's relatively high rate of company tax;
• encouraging companies to set up in and retain profits in Australia;
• discouraging companies to shift profits and/or residency offshore; and
• fewer anti-avoidance rules (simpler taxation)

That is, some tax distortions are intentional and by design. It was for these reasons that the Henry Review recommended that the dividend imputation regime be retained in its present form, at least in the short to medium term.

Dividend imputation is fundamentally a model of company and shareholder integrated taxation. Other considerations (in addition to bond market implications) will be relevant to any internationally competitive model of integrated taxation, including:

• the possibility of lower rates of taxation for dividends; and
• the introduction of deductions for equity funding.

Although the benefits and role of dividend imputation should be reconsidered given global developments since its introduction (in 1987) and the opportunity for simpler taxation, these broader tax policy considerations will need to be considered, suggesting that any final recommendations will be delayed, at least until the Tax White Paper is complete in 2015.