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III. Split-Rate and Imputation Systems

16.32. It is thus clear that income tax must continue to be imposed both on companies and on shareholders, above all for international reasons and to prevent the company from being a tax shelter for high-income shareholders. But the unfair incidence upon the individual shareholder of the existing system needs remedying. To this end consideration must be given to a system that makes some allowance at either the company level or the shareholder level for company tax on distributed profits.

16.33. Where an allowance is made at company level, the system is generally referred to as split-rate. For example, if dividends paid are allowed as a deduction in computing profits subject to company tax, there are in effect two rates of tax: a positive rate on undistributed profits and a zero one on distributed profits. Initially, this was the way the Commonwealth company tax operated. Split-rate systems more often,


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however, impose a positive rate of company tax on distributed profits, though a rate lower than that on undistributed profits.

16.34. Alternatively, the shareholder may be permitted a credit against personal income tax on dividends received to allow for all or some of the tax paid by the company on the profits distributed. This is generally referred to as the imputation system. The system involves adding to the cash dividend received by the shareholder an amount representing tax paid by the company. The shareholder is taxed on the dividend so ‘grossed up’ and is allowed credit of the amount representing the company tax against his personal income tax liability. The mechanism of imputation is illustrated later in Tables 16.D and 16.E.

16.35. The differences between split-rate and imputation systems are not significant at the domestic level: if a withholding tax on dividends paid to residents is added to a split-rate system, it will be virtually indistinguishable in its consequences from a corresponding imputation system. But the differences are by no means insignificant in the international field. Thus a split-rate system imposing a zero rate of tax on distributed profits would tax non-resident shareholders only to the amount of withholding tax on such profits—in other words, to a maximum levy of only 15 per cent where the shareholder is resident in a country with which Australia has a double taxation agreement. This difficulty is shared by the split-rate system with all the one-tax systems at the shareholder level.

16.36. It is therefore assumed in what follows that some form of imputation is needed and that this should allow, with as much precision as is administratively possible, for all or some of the company tax on distributed profits.

16.37. The effect on shareholders with various incomes of full imputation is shown in Table 16.C. Clearly, the full imputation system is not wholly neutral between retention and distribution: low-income shareholders will prefer distribution, while high-income shareholders will prefer retention. But this is to be contrasted with the existing ‘separate’ system in which all shareholders, if they consider only tax consequences, have reason to favour retention. However, the full imputation system, coupled with the 1973–74 personal income tax rate schedule, would leave the shareholder on $12,000 a year more or less indifferent between distribution and retention, and in so far as this is the income position of the ‘average’ shareholder neutrality will be very nearly achieved.

TABLE 16.C: COMBINED RATE OF COMPANY AND PERSONAL INCOME TAX UNDER FULL IMPUTATION (A) AND PRESENT ‘SEPARATE’ SYSTEM (B), BY SIZE OF SHAREHOLDER’S INCOME AND PROPORTION OF PROFITS RETAINED

                     
Shareholder's notional income (a)  Shareholder's marginal rate of personal income tax (b)  Combined company / personal tax expressed as a percentage of company profits, assuming proportion of profits retained is: (c) 
per cent  0 per cent  25 per cent  50 per cent  75 per cent  100 per cent 
2,000 A   15.4  15.4  23.4  31.4  39.5  47.5 
B   55.6  53.6  51.5  49.5  47.5 
5,000 A   33.3  33.3  36.8  40.4  43.9  47.5 
B   65.0  60.6  56.3  51.9  47.5 
12,000 A   48.2  48.2  48.0  47.8  47.6  47.5 
B   72.8  66.5  60.2  53.9  47.5 
50,000 A   66.7  66.7  61.9  57.1  52.3  47.5 
B   82.5  73.8  65.0  56.3  47.5 
note  




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16.38. One conspicuous feature of Table 16.C is that for shareholders on incomes up to $12,000 a year the over-taxation of income derived through the company is substantially reduced vis-a-vis the separate system. On the other hand, shareholders with incomes over $12,000 will continue to be under-taxed to the extent that profits are retained, ignoring for the moment any tax levied on capital gains to which those retained profits give rise. In fact, this latter group of shareholders will be more under-taxed than under the separate system.

16.39. It seems clear that under full imputation (Table 16.C) equity will be better served the higher the proportion of profits distributed. A requirement, were it feasible, of full distribution of profits would thus achieve equity for all domestic shareholders. But such a requirement would offend notions of neutrality. Where the company tax is levied at a rate lower than the maximum marginal rate of personal income tax, it may nevertheless be desirable in the full imputation case to impose, in the interests of equity, a minimum distribution requirement, thereby limiting the extent to which the company can be used as a tax shelter by high-income shareholders.

Choice of an Imputation System

16.40. There are three main kinds of imputation system to choose between:

  • A. One that taxes the company at the maximum rate of personal tax and allows full imputation.
  • B. One that taxes the company at a rate less than the maximum marginal rate of personal tax and allows full imputation.
  • C. One that taxes the company at a rate less than the maximum marginal rate of personal tax and allows partial imputation.

16.41. While the maximum marginal rate of personal tax continues at the present level, system A involves a company tax rate out of line with rates of company tax in other countries. One might, however, envisage in the long term a lowering of the maximum marginal rate of personal tax to a level which, adopted as the company rate, would not be out of line internationally.

16.42. The system would have the advantage that it would no longer be necessary to require minimum distributions by private companies.

16.43. The prospect of capital gains tax on the realisation of shares, together with a rate of tax on retained profits equal to the maximum marginal rate on personal income, would give an incentive for companies to make maximum feasible distributions. This is so because undistributed profits, in so far as they give rise to capital gains, would bear total company and capital gains tax at a higher rate than would apply to distributed profits. The resultant pressure towards maximum distributions would operate in the interests of equity as Table 16.C indicates, but would be far from neutral between retention and distribution.

16.44. To overcome this problem the Canadian Royal Commission, which favoured system A, proposed that there should be means of allocating profits by companies. The profits allocated would be taxed to individual shareholders with credit, and added to the shareholder's cost of his shares for capital gains tax purposes. The Committee has already dismissed universal allocation as impracticable.




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16.45. Without such allocations provisions, the lack of neutrality in the treatment of company retentions would be too severe. The Committee accordingly rejects system A.

16.46. System B, whereby the company is taxed at a rate less than the maximum marginal rate of personal tax and the shareholder is allowed full imputation, need not involve a company rate out of line with other countries and could ensure adequate taxation of non-residents. It would also reduce the extent of non-neutrality in the choice of form of organisation and in the choice between equity and loan capital. It could be neutral, in the sense explained in paragraph 16.37, between retention and distribution.

16.47. If existing levels of company distributions continue, system B will mitigate inequity towards the bottom of the scale. However, it is likely to create a tax shelter for high-income controlling shareholders, a shelter that could not be completely corrected by any minimum-distribution requirement. With anything less than full distribution, the high-income shareholder has the advantage of a tax deferral which would continue until full distribution or realisation of the shares. If full distribution were required, the system would be open to the non-neutrality and impracticality objections already raised to such systems.

16.48. A minimum-distribution requirement would, nevertheless, reduce the tax shelter possibilities of the system, particularly if the gap between the company rate and the maximum marginal rate for individuals were reduced so that it was not more than, say, 10 per cent. Closing the gap between the company rate and the maximum marginal rate for individuals, given a continuance of existing levels of distribution, will mean that the mitigation of inequity towards the bottom end of the scale will be less but there will be a gain in equity at all levels of income compared with the present system. Full imputation and a narrowing of the gap between company tax and the maximum marginal rate of personal tax are likely, as already explained, to cause an increase in distributions. The effect of any increase must be to improve the equity of the company tax system at all levels of income.

16.49. System B might then be regarded as the appropriate long-term target. Admittedly, there would be difficulties stemming from the need to limit the gap between the maximum marginal rate of personal tax and the company tax rate; but in the long term it may be possible to envisage a lowering of the maximum marginal rate of personal tax that will make this feasible. The system would be costly to revenue and would need to be associated with changes in the tax structure generally.

16.50. The changes required, were system B to be implemented, would be considerable. And, as a matter of principle, such a system of company tax would need to be introduced slowly: if it were not, there would be a distinct danger that much of the benefit of imputation would be capitalised immediately into the value of shares, with haphazard distributional consequences unrelated to the aims of allowing imputation. For these reasons, any such approach to system B should be gradual, for example via a partial imputation system like system C. This system provides a company rate that need not be out of line internationally, yet would ensure adequate taxation of non-residents. It would mitigate the inequity and the non-neutralities of the present system. The extent of mitigation would depend on the rate of company tax adopted, the measure of imputation allowed and the rate of tax on capital gains.

16.51. In the Committee's view, a company tax at less than the maximum marginal rate of personal income tax coupled with a partial imputation of company tax at the


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shareholder level (system C) is the appropriate immediate step. It therefore recommends a system of this kind.

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