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The pros and cons of scrapping dividend imputation

by Matthew Smith | 14 Apr 2016

In a low-growth economy — which we are in — any barrier to future growth is fair game to be considered for removal, so it should come as no surprise that Australia’s beloved dividend imputation system is the target of some debate.

John McIntosh, a private investor and doyen of the finance industry, makes the case for scrapping dividend imputation along these lines:

If companies are incentivized to pay dividends it takes money away from what they might otherwise use to invest to deliver future earnings.

An already high corporate tax rate relative to the rest of the world means multinationals are using every trick in the book to avoid paying tax here, he adds. The government could reduce corporate tax by as much as 20 per cent if it was to do away with franking credits, he reckons.

McIntosh also says the dividend imputation system is harbouring a dividend paying culture which is distorting the decision making of our corporate executives.

“If you have the confidence in a corporate executive, surely you’d rather have them manage the money rather than leave it in the hands of a funds manager who makes money from fees,” McIntosh, who was the founding partner and chairman of McIntosh Securities before it was sold to US investment bank Merrill Lynch in 1996, says in an interview with FINSIA’s InFinance.

McIntosh joins finance luminaries including Bill Ferris, a veteran venture capitalist and chairman of Prime Minister Malcolm Turnbull’s innovation and science advisory committee, along with other prominent VC investors who have been beating the drums for a review of the dividend imputation tax system.

But if push ultimately comes to shove, it will be very difficult for Australians to wean themselves off the imputation tax system, which was introduced in 1987 by then Treasurer Paul Keating.

Furthermore, it is far from clear whether scrapping dividend imputation in favor of lower corporate tax is in the best interests of the country and the welfare of

Australians, particularly among those saving for their retirement.

In the first issue of JASSA for 2016, FINSIA’s Journal of Applied Finance, senior thinkers from the University of Sydney Business School weigh up the positives and negatives of dividend imputation and conclude that its removal would have both positive and potentially negative implications for the economy and the country generally.

Dividend imputation in essence removes double taxing — that is, the tax paid at the corporate level as well as taxes paid by the investor themselves, the JASSA paper, penned by Andrew Ainsworth and Graham Partington from University of Sydney Business School Department of Finance and Geoffrey Warren from the Centre for International Finance and Regulation, explains.

The system allows the corporate taxes to effectively be distributed as a tax credit attached to the dividend — thereby reducing the amount of tax the individual has to pay.

The imputation incentive ensures investors will be willing to pay a higher price to invest in listed company if they are, indeed, getting access to what ends up being higher net income at the end of the day.

The benefit to the company, the JASSA paper highlights, is a lower cost of capital. That is, the company needs to generate a lower income from its operations in order to generate the returns investors require.

Superannuation funds and superannuats generally love the current system because imputation credits can be used to create a rebate stemming from the difference between the corporate tax rate (30 per cent) and the super income tax rate (15 per cent).

Individuals like it because they use the credits to offset their personal income tax.

Meanwhile foreign investors get little or no benefit because tax can only be recouped in the home country.

One thing we know for sure, the JASSA article explains, is the imputation system has encouraged higher dividend payouts – there’s a stark divergence in the dividend payout ratios for the Australian and world equity markets after imputation was introduced.

Dividend payout ratio

"There are strong signs that imputation has influenced the behaviour of companies and investors." — Andrew Ainsworth, Graham Partington and Geoffrey Warren assess the impact of dividend imputation.

Making generous dividend payments is a bit of a no-brainer for many Australian companies under the current system — doing so allows them to demonstrate they have shareholders’ interests at heart.

The Ainsworth article highlights the cost associated with distributing imputation credits is often relatively minor. It can also create capital discipline, which is good for both shareholders and the economy at large.

“Before you take something apart you have to go back and think, why was it created in the first place? Are the reasons for it to be created still relevant today? And I say they are,” says Jack Lowenstein, a founding partner of Australian-based global hedge fund, Morphic Asset Management.

“It was designed to remove the unfairness of double taxation, to encourage investors to invest in Australian shares, and to create disincentives for excess leverage at the company level. These are all good reasons and they all happened and they are still relevant today,” Lowenstein says in support of the current tax system.

Supporters of dividend imputation argue that encouraging companies to give money back that would otherwise “burn a hole” in the company’s pocket and potentially lead to bad investment decisions is a good thing.

The tax system also ensures Australian companies trade at a valuation premium to their overseas peers.

But because the consideration of dividend imputation differs from person to person, depending on the individual tax circumstance and also depending on the respective motivation for owning shares, the JASSA paper concludes that it remains impossible to tease out how imputation actually impacts prices of listed companies.

Other countries have shifted away from imputation systems in the past, but those examples are unique to those countries.

Still, McIntosh’s view echoes the voices of others calling for the dividend imputation system to be reviewed, saying it was right when it was introduced but we’re now faced with a different set of circumstances.

“I liked it when it first came in, but I also think the time and place has passed. We want growth. We have some good corporate executives and we want them to invest,” he says.

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