Australia looks again at discontinuing imputation credits
07 April, 2015
Australia is looking at whether it should scrap the franking credit system for dividends. So, change is possible for Australian share investors as the Government looks again at imputation credits. What's this all about Mark?
Occasionally we do report on things that are going on in Australia that are likely to influence New Zealand investors, and here is another one.
Recently the Australian Government released a discussion paper which amongst other things, questions whether Australia should continue having a dividend imputation regime (they call it franking credits). This is an important issue that has been raised before in Australia, which is very relevant to New Zealand because we are the only other OECD country that has such a system. We introduced the system two years after Australia did in the late 1980s.
The way it works is a share investor receives a tax credit for tax that the company has paid, which can be used in the tax return of the investor — this prevents the double taxation of company profits.
It means investors in Australia and New Zealand can own high dividend paying shares and don't need to worry much about tax implications on that income, provided the company is paying these dividends out of tax paid profit.
It certainly influences investor preferences. There are some Australian companies that will deliberately pre-pay tax that they don't actually have to, in order to have the credits to pay out with dividends. It appears that very few countries other have such a system — the only ones that I know, of other than Australian and New Zealand, are Mexico and Chile. The UK used to, it abandoned such a system in 1999, as did Germany in 2001 and Singapore in 2003.
What are the pros and cons of this kind of system?
People say the good things are that you have a neutral tax treatment of incorporated and unincorporated businesses — which is important for small businesses. Also, if you have mostly a domestic shareholder base, it acts as a kind of prepayment of tax and reduces the need for anti-avoidance rules. But the problem is that this is not really the cash in an open economy.
The disadvantages are that studies show that it does very little to reduce the cost of capital for corporations, because foreign investors require a rate of returns that compensates for the fact that they can't use imputation credits. It creates distortion in capital allocations because there's never been any arrangement giving recognition between Australia and New Zealand, so New Zealanders are better off investing in NZ companies and Australian investors are better off investing in Australian companies.
The other big thing is that it creates a home country bias. For example, a typical KiwiSaver scheme has about a third of its share allocation in New Zealand shares — which has been trending up since the start of KiwiSaver. No doubt imputation tax credits play a part in this.
Finally, there is tax revenue issues developing because as baby boomers in New Zealand retire and go onto lower marginal tax rates, they may receive excess imputation credits which can be used to reduce their tax on other sources of income (such as new Zealand superannuation). This means that a retiree may get a refund of tax deducted from other income and Inland Revenue will be missing out.
What would be the implications of changing it?
There are big implications if Australia decided to scrap it.
It means that this home country bias, the tendency to have more investment portfolios in your home country, would be hard to argue. The typical investment portfolio in New Zealand would not need a third of their shares in New Zealand stocks. Depending on what it is replaced with may affect preference for high dividend paying stocks. And it would certainly affect appetite for local market relative to overseas markets and international diversification would become more appealing.
So keep an eye on developments in Australia. If they do scrap imputation, we could be the only OECD country left with such a scheme.