Limited Time Offer: Save 10% on all 2022 Premium Study Packages with promo code: BLOG10

Tax Systems and Dividend Policy

Tax Systems and Dividend Policy

Double Taxation System

Under the double taxation system, earnings before tax (EBT) are taxed at a corporate level and then taxed again as dividends after the earnings are distributed to shareholders. Let us illustrate this in the table below.

$$ \textbf{Double Taxation of Dividends at Different Personal Tax Rates} $$

$$\small{\begin{array}{l|c|c} \textbf{Personal tax rate} & \bf{39.6\%} & \bf{15\%} \\ \hline\text{Net income before taxes} & \$ 300 & \$ 300 \\ \hline\text{Corporate tax rate} & 30\% & 30\% \\ \hline\text{Net income after tax} & \$210 & \$210 \\ \hline\text{Dividend}\ (\text{assuming 100% payout}) & \$210 & \$210 \\ \hline\text{Tax on dividend} & \$ 83.16 & \$31.5 \\ \hline\text{Net dividend to shareholder} & \$ 126.84 & \$178.5 \\ \hline\textbf{Double tax rate on dividend distributions}^{1} & \bf{57.72\%} & \bf{40.5\%} \\  \end{array}}$$

$$ \text{Double tax rate on dividend distributions}^{1}=\frac{($300-$126.84)}{$300}=0.5772=57.7\% $$

In a double taxation system, the investor gets taxes twice—at the coporate level and then at the individual level.

Dividend Imputation System

The dividend imputation tax system ensures that corporate profits are distributed as dividends are taxed once, at the shareholder’s level. When the dividends are distributed, the shareholders get a tax credit known as a franking credit for the tax paid on the dividends. Corporate taxes are attributed to the individual shareholder. If the company’s marginal tax rate is lower than that of the shareholder, the shareholder pays the difference between the two rates.

$$ \textbf{Taxation of Dividends with the Tax Imputation System} $$

$$\small{\begin{array}{l|c|c} \textbf{Marginal shareholders’ tax rate} & \bf{15\%} & \bf{47\%} \\ \hline\text{Pretax income} & \$ 300 & \$ 300 \\ \hline\text{Less taxes at}\ 30\%\ \text{corporate tax rate} & (\$90) & (\$90) \\ \hline\text{Net income after tax} & \$210 & \$210 \\ \hline\text{Dividend assuming 100% payout} & \$210 & \$210 \\ \hline\text{Shareholder tax on pretax income} & \$45 & \$141 \\ \hline\text{Less tax credit for corporate payment} & (\$30) & (\$30) \\ \hline\text{Tax due from shareholder} & \$15 & \$111 \\ \hline\text{Effective tax rate on dividend} & \$15/\$100 = 15\% & \$47/\$100 = 47\%\\  \end{array}}$$

In a dividend imputation system, shareholders get a tax credit for the amount paid at the corporate level.

Split-rate Tax System

A split rate tax system taxes corporate earnings distributed to shareholders at a lower rate than retained earnings, and the dividends are taxed as normal income at the shareholder’s level.

$$ \textbf{Taxation of Dividends based on Split-Rate System (per \$100)} $$

$$\small{\begin{array}{l|c}  \text{Pretax earnings}&$200\\ \hline\text{Pretax earnings retained}& $100\\ \hline40\%\ \text{tax on retained earnings} & $40 \\ \hline\text{Pretax earnings allocated to dividends} & $100 \\ \hline20\%\ \text{tax on earnings allocated to dividends} & $20 \\ \hline\text{Dividends distributed} & $80 \\ \hline\text{Shareholder tax rate} & 40\% \\ \hline\text{After-tax dividend to shareholder} & {[}(1 ˗ 0.4) ×$80{]} = $48\\ \hline\text{Effective tax rate on dividend}&{[}20\%+ (80×0.4)\%{]} =52\%\\  \end{array}}$$

In a split-rate tax system, earnings distributed as dividends are still taxed twice. However, the corporate rate used is lower, 20% in this case instead of 40%.

Question

JC Corporation is a company located in a country with a double taxation system where the corporate tax rate on income is 39.6%, and personal tax on dividends is 25%. JC pays out 100% of all its after-tax income as dividends to its shareholders.

The effective tax rate on JC pretax income distributed as income is closest to:

  1. 40%.
  2. 57%.
  3. 55%.

Solution

The correct answer is C. 

$$\begin{align*}\text{Effective tax rate}&=1-(1-\text{Corporate tax})(1-\text{Tax on dividend})\\&=1-(1-0.396)(1-0.25)\\&=0.547=54.7\%\end{align*}$$

Reading 16: Analysis of dividends and Share Repurchases

LOS 16 (f) Calculate and interpret the effective tax rate on a given currency unit of corporate earnings under double taxation, dividend imputation, and split-rate tax systems

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep


    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.
    Nyka Smith
    Nyka Smith
    2021-02-18
    Every concept is very well explained by Nilay Arun. kudos to you man!
    Badr Moubile
    Badr Moubile
    2021-02-13
    Very helpfull!
    Agustin Olcese
    Agustin Olcese
    2021-01-27
    Excellent explantions, very clear!
    Jaak Jay
    Jaak Jay
    2021-01-14
    Awesome content, kudos to Prof.James Frojan
    sindhushree reddy
    sindhushree reddy
    2021-01-07
    Crisp and short ppt of Frm chapters and great explanation with examples.