Australia's Future Tax System

Final Report: Detailed Analysis

Chapter B: Investment and entity taxation

B2. The treatment of business entities and their owners

B2–3 The future of dividend imputation

International trend away from imputation

Australia and New Zealand are now the only two OECD countries to operate dividend imputation systems.

Countries that have abandoned dividend imputation systems include the United Kingdom (in 1999), Germany (in 2001), Finland (in 2005) and Norway (in 2006). While the move away from imputation for European countries can be partly explained by European Union legal issues, the trend has also been evident in Asian countries. Both Singapore (in 2003) and Malaysia (in 2008) have abolished their imputation systems.

Notwithstanding the move away from imputation, there has been no clear trend to reduce or remove shareholder level tax relief (see Table B2–3). The United States, whose federal company income tax rate has remained at 35 per cent since 1993, introduced dividend tax relief in 2003. While some countries that have low company income tax rates (such as Ireland and Switzerland) also have classical company income tax systems, other countries exempt resident shareholders from further tax (for example, Singapore and Hong Kong).

Table B2–3: International approaches to shareholder and company interactions

  Dividend received by resident from domestic company Dividend received by resident from foreign company
New Zealand Operates imputation system. Imputation credits are not refundable. Taxed at shareholder's marginal tax rate, imputation credits not available.
United Kingdom Dividend tax credit provided. Tax rates on dividends are lower than tax rates on other income. Same treatment for foreign dividends.
United States 'Qualified' dividends taxed at 15% for high rate taxpayers; 0% for low rate taxpayers.(a) Same treatment for foreign dividends if paid from a company resident in a country with which the US has a comprehensive tax treaty.
Germany Substantial shareholders (interest greater than 25%) taxed on 60% of dividends at marginal rates (only 60% of expenses deductible). Other shareholders subject to final withholding tax of 26.38% on gross dividends. Same treatment for foreign dividends.
Hong Kong Exempt. Same treatment for foreign dividends.
Singapore Exempt. Same treatment for foreign dividends.
Ireland Classical taxation — taxed at shareholder's marginal tax rate without credit for company income tax paid. Same treatment for foreign dividends.
  1. These arrangements are legally due to expire on 31 December 2010, when, absent further legislative changes, dividends will be taxed at normal marginal rates.

Source: Treasury.

Most developed countries fall in between the extremes of classical and full exemption systems, providing partial dividend exemption, partial tax credit, lower rates of tax for dividends, or a combination of these. Unlike dividend imputation, these approaches do not depend on company income tax having been paid on the profits from which the dividend is paid.

More radical forms of shareholder tax relief have been adopted in Belgium and Norway. Belgium operates a classical tax system but avoids double taxation largely by applying a business level expenditure tax — the allowance for corporate equity. Norway provides shareholder tax relief through an allowance for shareholder equity. This is similar to the allowance for corporate equity, except that relief is provided at the shareholder rather than the company level.

Companies are not always taxed as separate entities. For example, the United States operates a special regime for 'S corporations', which are legally companies but taxed as flow-through entities if certain conditions are met. The United States also operates a 'check the box' regime, under which a limited liability company that is not publicly traded can elect for either partnership or company treatment.

While the Australian and New Zealand imputation systems do not provide tax relief for dividends received from foreign companies, many other countries provide equal treatment for dividends received from domestic and foreign companies. For example, a United States taxpayer receiving a dividend from an Australian company would receive the same shareholder relief — a reduced tax rate on that dividend — as for a dividend received from a United States company.

Dividend imputation provides benefits

Australia's imputation system provides a more neutral treatment of incorporated and unincorporated domestic businesses and has less impact on company financing and distribution choices than the classical company income tax arrangements that applied before dividend imputation was introduced in 1987.

Dividend imputation may also encourage domestic business investment by reducing the cost of capital for domestically owned companies. This depends on the extent to which domestic rather than foreign providers of capital set the cost of capital for these companies. To the extent that domestic providers set the cost of capital, imputation may bias Australian companies owned by residents towards investing in Australia rather than overseas.

Dividend imputation and the cost of capital

In general, a company will only make an investment where the expected return on that investment at least covers the rate of return required by the providers of the company's capital, both debt and equity. In a closed economy, it could be expected that imputation would reduce the cost of capital, at least for new equity. However, where an economy is open to foreign capital and such capital is readily available, the cost of capital will be influenced by international capital markets.

Imputation is likely to have a more positive effect in reducing the cost of capital for smaller and unlisted Australian companies, particularly when they are starting up or raising new equity. These companies typically have more limited or indirect access to international capital and, therefore, a higher reliance on residents' savings. However, although they may not have direct access to foreign capital, the cost of capital for larger firms that do have access will also influence that of smaller firms. Hence, even for smaller and unlisted Australian companies, international capital markets matter.

One way to gauge the impact of imputation on the cost of capital for larger, listed companies is through studies of the market value of imputation credits (see Table B2–4). While these studies report varying estimates, taken together they support the conclusion that imputation has a real but muted impact on the cost of capital for listed companies, and that the availability of foreign equity capital influences the cost of capital and market valuation of listed Australian companies.

Table B2–4: Empirical estimates of the value of distributed franking credits

Study Method Study period Estimated value of distributed credits
(cents in dollar)
Cannavan, Finn and Gray 2002 Options analysis(a) 1994–1999 ≈ 50
(pre-45 day rule(b))

≈ 0
(post-45 day rule(b))
Hathaway and Officer 2004 Dividend drop-off(c) 1986–2004 Post-2000 50
Beggs and Skeels 2006 Dividend drop-off(c) 1986–2004 57
Strategic Finance Group 2007 Dividend drop-off(c) 1998–2006 20–40
  1. The value of the imputation credit is inferred from the relative prices of futures contracts and the individual stocks on which they are based.
  2. The 45 day rule requires that ordinary shares must be held for at least 45 days around the date of dividend entitlement otherwise the shareholder is not entitled to any imputation credits. The shares must be held 'at risk' so if the shareholder removes a substantial part of the price risk (for example, through hedging), imputation credits may be disallowed.
  3. The value of the imputation credit is inferred from the amount by which the price of a share changes when it goes ex-dividend.

Source: Australian Energy Regulator (2008).

Table B2–4 shows the market valuation of one dollar of imputation credits distributed by listed companies. By way of comparison, such studies typically find that one dollar of distributed cash is valued at 80 cents in the dollar (Australian Energy Regulator 2008). That the estimated values for imputation credits are less than for cash suggests that imputation has less of a beneficial impact on domestic investment than could be assumed, but is more relevant than an application of a simple open economy perspective would imply.

The study by Cannavan, Finn and Gray (2004) estimates that the market value of imputation credits was reduced to zero when rules preventing franking credit trading (the '45 day rule') were introduced. These rules prevent non-resident shareholders from effectively obtaining a benefit from imputation credits by selling them to resident shareholders who can use them. The fall in the value of imputation credits with the introduction of the 45 day rule (which reduced the benefits of franking to non-residents) is consistent with an open economy perspective under which international capital markets set the cost of capital and value of shares for Australian companies.

Another way of testing the impact of imputation credits on the cost of capital for Australian companies is to look at survey evidence about how companies make decisions. A 2004 survey of Australian listed companies found that only 13 of the 77 companies that responded to the survey made adjustments for imputation credits in project evaluation, including in respect of company estimates of their cost of capital (Truong, Partington & Peat 2005). Only three respondents attached a value of more than 50 per cent to imputation credits.

For those companies that did not take account of imputation credits in their investment decision-making, reasons included: difficulties in setting an appropriate tax credit value for all shareholders; that the value of imputation credits was already factored into the share price; and irrelevance to non-resident shareholders.

Dual-listed companies

Differences in the valuation of the Australian and non-Australian companies in a dual-listed company structure may also reflect the impact of imputation, and may suggest that imputation reduces the cost of capital for Australian companies. For example, Bedi, Richards and Tennant (2003) showed that for BHP-Billiton, a dual-listed company, the Australian shares traded at a 5 to 10 per cent premium to the United Kingdom shares. Such a premium may suggest that the market does value imputation credits.

However, the evidence is not clear cut. Not all dual-listed companies have traded at a premium on the Australian arm. Empirical studies have struggled to explain the observed long-term premiums for dual-listed companies, even taking account of tax factors. Further, dual-listed structures in effect allow for dividend streaming, and so may not provide conclusive evidence that imputation credits are generally valued.

Dividend imputation provides integrity benefits

Dividend imputation also provides integrity benefits. For Australian companies with largely resident shareholders, company income tax acts as a prepayment of the personal income tax liabilities of shareholders on future dividends. The benefit to companies and their shareholders of avoiding or deferring company income tax is therefore reduced. This can increase company income tax revenues and reduce the need for anti-avoidance rules in general.

Tax administration and compliance costs are also reduced as companies spend fewer resources on trying to minimise tax paid. There is anecdotal evidence that some Australian companies bring forward tax obligations and eschew avoidance activities to generate franking credits. This appears particularly true of companies with a history of paying fully franked dividends.

For companies with foreign operations and a significant proportion of resident shareholders, imputation provides an incentive to shift foreign profits into Australia. This allows them to pay dividends from creditable Australian company income tax rather than non-creditable foreign tax. Similarly, imputation discourages domestically owned companies from shifting profits offshore.

The integrity benefits of imputation may partly explain why Australia's company income tax collections are high compared to other countries (see Section B1 Company and other investment taxes). While evidence of these integrity benefits is largely anecdotal, a recent quantitative cross-country study estimated that the presence of a dividend imputation system in a country gave rise to increased company income tax (Markle & Shackelford 2009).

The revenue outcomes discussed above reflect changes in gross company income tax paid. However, in looking at the benefits of imputation it is also necessary to consider the net gain to revenue. As increased company income tax payments generate more imputation credits that in turn reduce personal income tax collections, the net gain to revenue from imputation will be less than the gross gain. The net gain to the revenue from the integrity benefits includes:

  • the time value of bringing forward tax from the personal to the company level;
  • the absolute gain arising when imputation credits generated from the gross company income tax revenue gain are wasted (for example, because some shareholders are non-residents); and
  • the revenue gained from taxable income increasing as foreign tax expenses are reduced (as Australian multinationals allocate more profits to Australia).

In considering the overall efficiency of the tax system, the net revenue gain from imputation is only of benefit if it is a relatively efficient source of revenue. It is difficult to assess whether this is the case, though the revenue and national income gains from encouraging the minimisation of foreign taxes are beneficial.


Dividend imputation provides a number of benefits to Australia, including improved neutrality around financing and entity choices. It also has integrity benefits that have allowed for fewer anti-avoidance rules.

Dividend imputation may create biases

Biases from the non-creditability of foreign taxes

Under dividend imputation, resident shareholders in an Australian company that invests offshore generally do not receive imputation credits on dividends paid out of the profits from that investment. Dividends and capital gains from such investments are generally exempt from tax in the hands of Australian companies, and imputation credits are not provided for any foreign company income or withholding tax paid.

As imputation credits are not permitted for foreign company income tax and other taxes such as foreign dividend withholding tax, resident shareholders in an Australian company receive the equivalent of a deduction, rather than a credit, for foreign taxes paid. Dividends paid out of net company profits (after deducting foreign taxes) are taxed in full without credit. The same is true for residents who hold shares in a foreign company, though they may receive a credit for foreign dividend withholding tax.

From the perspective of Australian companies, the non-creditability of foreign taxes may increase the required return for offshore investment, discouraging such investments and encouraging a domestically-orientated investment focus. From the perspective of Australian shareholders, the tax benefit of franked dividends may encourage them to invest more of their savings in Australian companies that invest domestically in preference to other Australian or foreign companies or other assets (a savings portfolio bias).

An assessment of the consequences of these tax biases depends on whether a more traditional view of dividend taxation is adopted or whether more weight is placed on the increasing openness of the economy (see Table B2–5). In practice, given the evidence on the effect of imputation on the cost of capital of Australian companies, the actual effects are likely to fall somewhere in between the consequences suggested under each perspective and to depend in part on firm-specific characteristics.

Table B2–5: Biases created by the non-creditability of foreign taxes and their potential consequences

Nature of potential bias Consequences under traditional or new view Open economy perspective

Bias against offshore investment by an Australian company

Cost of capital for an Australian company investing offshore may be increased, encouraging domestic over foreign investment.

Bias may be optimal from a national efficiency perspective.

Cost of capital for Australian company for investments offshore is unaffected, as it is determined by international capital markets.

Bias of no consequence to the allocation of investments between countries and, hence, the level of investment in Australia.

Portfolio bias against investment, by Australian resident or superannuation fund, of their savings in an internationally orientated Australian company or in a foreign company

Return to shareholder affected by company and shareholder-level taxes.

Bias in favour of investment of savings in domestically focused Australian companies, but the bias is reduced the lower are foreign taxes on the offshore investment. Depending on financial policies of a company, the bias may be reversed.

Return to shareholder affected by shareholder level tax.

Bias in favour of investment of savings in domestically focused Australian companies. Reduces gross inbound and outbound flows of capital; net capital flows remain unchanged.

According to the traditional or new view

To the extent that the tax bias against offshore investment actually has an effect, it may be beneficial from a national perspective. This is because paying foreign tax does not benefit Australians. Rather, it reduces the net return to Australians of the offshore investment of domestic savings. In contrast, paying Australian company income tax on a domestic investment helps fund transfers and public services. By restricting imputation to Australian company income tax and not giving a credit for foreign taxes, Australian companies treat foreign tax as a cost, so aligning their private interests with the national interest.

One qualification to this national interest argument is that it assumes there are no potential spillover benefits from offshore investment by Australian companies. It also assumes that direct investment offshore is a substitute for, rather than a complement to, domestic investment, whereas there is evidence that for some industries or types of firm this is not always the case (Desai, Foley & Hines 2009).

The non-creditability of foreign taxes also gives rise to a potential portfolio bias for resident savers against owning shares in companies that invest offshore. However, whether there is actually a bias against holding shares in a foreign company or internationally focused Australian company depends on the level of foreign taxes applying to the company and its financial and distribution policies. Where the level of foreign taxes is low, and shareholder taxation is deferred, the bias against offshore investment may actually be reversed.

According to the open economy perspective

These results do not hold to the extent that the cost of capital (in Australia and overseas) is set by international capital markets. In that case, resident shareholder tax relief has no impact on the firm's cost of capital. Hence, the non-creditability of foreign taxes does not give rise to a bias against offshore investment by Australian companies. The portfolio savings bias becomes more evident, however, as differences in company income taxes between countries are offset by differences in company profitability.

Biases from restricting imputation to shareholders of Australian companies

Imputation is, for the most part, limited to Australian companies. Shareholdings in foreign companies, even those that conduct business in Australia and pay Australian company income tax, do not give rise to imputation credits. As well as creating the savings portfolio bias discussed above, this feature of the imputation system may discourage Australian companies from shifting their residence offshore.

The extent to which companies have an incentive to remain resident for tax purposes depends on the proportion of resident shareholders to total shareholders, and of domestic income to total income. As the proportion of non-resident shareholders or foreign income rise, the benefits of maintaining residence in Australia fall. For example, a resident entrepreneur with an internationally focused company could have an incentive to shift the residence of both themselves and their company offshore.

An exception arises in the case of Australian shareholdings in New Zealand companies with Australian operations. In this case, the New Zealand company is able to provide imputation credits to Australian shareholders for Australian company income tax paid, in proportion to the shareholders' ownership of the company. The same applies in the case of New Zealand shareholders of an Australian company with New Zealand operations. This rule provides neutrality in company location decisions between Australia and New Zealand.

Complex rules have been adopted in response to the biases

As different types of shareholders are taxed differently on their dividend income, the value they ascribe to imputation credits will vary. This sets up incentives for franked dividends to be paid to those shareholders that value them the most.

In particular, as non-resident shareholders cannot directly benefit from imputation credits (other than to avoid dividend withholding tax), there is an incentive for companies to stream unfranked dividends to non-residents and franked dividends to resident shareholders.

Non-residents who would otherwise receive franked dividends also have an incentive to enter into arrangements (franking credit trading) that see those dividends paid to resident taxpayers, in return receiving compensation in a tax-effective way for the loss of the cash dividend and for allowing the use of the imputation credit.

As a consequence of these incentives, the imputation system requires its own complex anti-avoidance rules to prevent dividend streaming and franking credit trading. These rules apply inconsistently; they do not prevent streaming through the use of dual-listed companies.


The benefits of dividend imputation have declined as the Australian economy has become more integrated into the global economy. In particular, benefits in relation to financing neutrality have fallen, while the bias for households to over-invest in certain domestic shares has increased. Furthermore, imputation has its own complex integrity rules.