Australian investors appear to have dodged a bullet, with the government's first paper on tax reform discussing the dividend imputation system but falling short of attacking it outright as an idea that has outlived its usefulness.
David Murray's inquiry into the Australian financial system concluded that the case for retaining dividend imputation was "less clear than in the past".
It received submissions from groups including PricewaterhouseCoopers arguing that imputation, or franking, created a local bias towards share investment, and favoured local shareholders over overseas ones.
The new paper's discussion of imputation and the questions it raises don't suggest that a wholesale attack on imputation is in the wind, however.
The paper begins where it should, by pointing out that when it was introduced in 1987, dividend imputation was a response to the double taxation of income.
Imputation treats tax that a company pays as a downpayment on tax paid on dividend income that is assessed at the marginal rate in the hands of a shareholder. Shareholders including super funds, which pay tax at a lower rate than companies, are also entitled to a tax refund on any excess tax paid at the company level.
Big numbers
Imputation generates big tax numbers. The discussion paper estimates that the value of imputation credits claimed by individuals, superannuation funds and charities has been around $19 billion a year in recent years. Credits claimed by other Australian companies have been around $10 billion per year, taking the total to about $29 billion.
Company tax has been running at about $65 billion. The $36 billion gap between that and imputation credits claimed mainly represents after-tax earnings that companies retain for balance sheet strength and investment, and imputation credits worth about $12 billion that are received by overseas shareholders but not claimed.
The discussion paper notes that imputation raises the rate of return for Australian share investors, and says several things flow from that fact.
It gives local personal investors and corporate investors an incentive to invest locally and a disincentive to invest overseas, for example. Imputation does not give overseas investors a tax incentive to invest in Australia, because they cannot claim imputation credits. It gives local investors a reason to prefer shares over fixed interest investments, which do not offer credits for corporate tax already paid.
As the Murray report did, the discussion paper also notes that the dividend system has some important virtues, however.
Cost effective
By raising the rate of return on equity, imputation makes equity issues a more cost-effective way for Australian companies to raise money.
It helps make their choice between tax-deductible debt funding and equity funding more neutral, the discussion paper says.
It also encourages companies to pay dividends instead of hoarding their earnings, and encourages them to pay tax and create credits that can be passed on to shareholders.
Given that high levels of debt are a way to reduce tax, it therefore encourages lower gearing. The discussion paper agrees with the Murray report that imputation in that way tends to to improve the stability of the economy.
There was an example of these effects during the global financial crisis, when a slew of companies rapidly repaired their balance sheets by making well-supported share issues that in 2009 topped $100 billion.
The discussion paper goes on to say that companies that have tax breaks of their own, for research and development, for example, will pay less tax and therefore generate less tax credits for domestic shareholders. On that measure, they will be relatively less attractive to local investors than Australian companies that pay full tax and generate fully franked dividends.
Overseas investors who do not get dividend imputation credits might in contrast be biased towards investing in Australian companies that benefit from other tax breaks they can access, such as R&D.
Globalised economy
Such biases "may be undesirable in an increasingly open and globalised world economy", the discussion paper states, adding that imputation also increases the complexity of the tax system.
Its survey of what the rest of the world is doing does not show that imputation is generally considered to be a thoroughly bad idea, however.
Germany, Austria, Belgium, the Czech Republic, Iceland, Greece, Ireland, Israel, Netherlands, Slovenia and Sweden still double-tax dividends the way Australia did before 1987.
Australia, New Zealand, Chile and Mexico are also the only countries that give shareholders a dividend tax credit that reflects the underlying corporate tax rate.
There are however many countries that recognise that double tax is undesirable, and have systems in place to at least dilute its impact.
Canada, an economy with similarities to Australia, gives a tax credit for all tax paid, wherever it is paid. The United States, Denmark, Japan, Poland, Portugal, Spain and Switzerland tax post-corporate tax dividend income again, but at a preferential rate.
The UK and South Korea provide a dividend tax credit at a lower rate than the corporate rate. France, Finland, Italy, Luxembourg and Turkey only double tax a portion of the dividend. Norway does not tax the risk free return, and Estonia and the Slovak Republic do not tax dividends at all.
No consensus against imputation there: and despite the divergent treatment of dividends around the world, the overall taxation of dividends is very similar. Australia's overall taxation rate of close to 50 per cent on dividends paid to top marginal rate shareholders is "comparable with many other OECD countries", the discussion paper states.
'Revenue concerns'
The report does say that imputation credit refunds to low-tax paying investors cost about $4.6 billion in 2012-13 and raise "revenue concerns". It says they also create an incentive for closely held companies to defer dividends until their shareholders are on a lower tax rate, and says imputation as it is configured isn't creating a magnet for foreign investment.
It raises only a few questions for discussion and submissions in the months ahead, however. Is imputation "continuing to serve Australia well" as the financial system becomes more open? Could the taxation of dividends be improved? Should there be dual recognition of imputation credits in Australia and New Zealand?
Imputation certainly hasn't been let off like the family home. There is a "strong consensus" that it would not be appropriate to either tax imputed rent or tax capital gains on the sale of owner-occupied housing, the discussion paper says, "given the central importance of the home for Australian families".
Its question about whether dividend imputation is "serving Australia well" will probably result in some calls for the tax concession to be scrapped or heavily pruned.
The imputation refund for low-tax investors may be in the tax review's sights, and the discussion paper is wary about ironing out the imputation "distortion" by extending it to fixed interest investments.
A lower corporate tax rate is also up for discussion and that would cut franking credits.
The discussion paper doesn't seem to be the harbinger of an all-out attack on imputation, however, and that's welcome. Given the structural benefits it produces, dividend imputation deserves to survive.
