Dividends. What’s all the fuss?

In the last few days Opposition Labor Leader Bill Shorten has proposed a radical transformation of dividend imputation. Putting aside his mistaken belief that his voters are “Aussie Battlers”- when in fact they are hard-working small business owners and contractors, many of whom receive franked dividends from their business endeavors – it’s worth looking at what all the fuss is about…

Prior to 1987, when a company paid tax on its profits of 49 per cent (as it was in 1986) any AFTER TAX profits that were distributed again to shareholders in the form of dividends, were also taxed in their hands. In other words, the profits were taxed twice, once in the company’s hands and then again in the shareholder/owners’ hands.

Double taxation is neither fair nor reasonable and in 1987 the double taxing of dividends was abolished by Hawke and Keating with the introduction of dividend imputation. We understand Finland, Italy, Mexico and New Zealand also have a form of dividend imputation.

Through the use of tax credits called “franking credits” the ATO was notified that a company had already paid tax on the income it distributed as dividends. The shareholder then did not have to pay tax on the dividend income unless their tax rate was higher. If their tax rate was higher they paid a top-up, amounting to the difference between the company tax rate and their personal rate…

And if their tax rate was lower than the company tax rate they paid nothing extra, but they DID NOT receive a refund of any difference either.

That was until July 2000 when the rules were changed by Howard & Costello and shareholders received a cheque from the ATO for the difference between their lower rate and the higher company tax rate.

Budget Impact

With a generational avalanche of retired baby boomers now on zero tax rates the cost of this difference amounts to the ATO sending cheques of about $5 billion to shareholders annually.

(Of course, lowering the corporate tax rate, would also lower the amount of the refunds.)

Capital Allocation Weirdness

The cash refund from dividend imputation means franking credits have no value to a company but enormous value to shareholders on lower tax rates.

As a result, we see lots of suboptimal capital allocation decisions.

A company able to generate very high rates of return on incremental capital should keep the money rather than pay dividends (and then be forced to replace the payments with dilutive equity issues or risk-increasing debt). We have written about this constantly here at the blog and it forms the foundation of our valuation approach. Companies are today forced by shareholders to distribute their franking credits, which have no value to the company, by paying dividends. In other words, a dollar paid is worth more than a dollar retained but look….

Look at the ASX 200 – it is exactly where it was a decade ago, Why? Because the dividend payout ratio is about 80 per cent meaning companies are only keeping 20 per cent for growth including employing more people. Shareholders are worse off under this system in the long run.

 One Solution

Unlike Shorten’s suggestion, one solution might be to introduce progressive tax rates to all post retirement incomes grossed up for franking credits. These tax rates can be much more lenient than pre-retirement and some fairness can still be introduced.

By that I mean that if someone is only managing to pay the bills, put food on the table and go on a domestic holiday once or twice a year then no tax should be paid by them…

But if someone or some entity is earning 10 million dollars in tax free income or more annually, including cheques from the Australian Taxation Office, that is something that should be examined.

Another possible solution was my friend Hamish Douglass’s optional system where companies can choose to pay 15 per cent tax but have to give up tax credits on their dividends.

Ultimately this country needs to earn more from its exports, everything else is just tinkering.