Dividend imputation

Dividend imputation

Dividend imputation is a corporate tax system in which some or all of the tax paid by a company may be attributed, or imputed, to the shareholders by way of a tax credit to reduce the income tax payable on a distribution. In comparison to the classical system, it reduces or eliminates the tax disadvantages of distributing dividends to shareholders by only requiring them to pay the difference between the corporate rate and their marginal rate.

Australia and New Zealand have imputation systems. The United Kingdom has a modified imputation system. France had a dividend imputation system until 2004.



The Australian tax system allows companies to attach franking credits to dividends paid. A franking credit is a nominal unit of tax paid by companies using dividend imputation. Franking credits are passed on to shareholders along with dividends. Shareholders include in their assessable income not the dividends received but the grossed-up amount back-calculated from that dividend and the current tax rate, then have their income tax payable calculated thereupon, then use franking credits to offset tax payable at the rate of a dollar per credit. In Australia & New Zealand the end result is the elimination of double taxation upon company profits.

Franking Credit Formula

Div * tc / (1 - tc) * fp

* tc = company tax rate. * fp = franking proportion.

For a company that pays tax on all its income in Australia, the franking proportion is usually 100% (or 1.0). However, some companies (particularly those paying tax outside of Australia) have a lower franking proportion. Some companies pay only unfranked dividends (i.e. fp=0).


Dividend imputation was introduced in 1987, one of a number of tax reforms by the Hawke/Keating government. Prior to that a company would pay company tax on its profits and if it then paid a dividend, that dividend was taxed again as income for the shareholder, i.e. a part owner of the company, a form of double taxation.

In 1997 the eligibility rules (below) were introduced, with a $2000 small shareholder exemption. In 1999 that exemption was raised to the present $5000. In 2000 franking credits became fully refundable, not just reducing tax liability to zero. In 2002 preferential dividend streaming was banned. And in 2003 New Zealand companies could elect to join the system for Australian tax they paid.


The present operation of the system is as follows. The actual law is complex, the core is in the Income Tax Assessment Act 1936 and other elements are in the Income Tax Assessment Act 1997.

When a company makes $1.00 of profit (profit for tax purposes) and pays $0.30 as income tax (30% rate for 2006) it records the $0.30 in a franking account. The $0.30 is paid in cash to the tax office, the franking account is only a record of what was paid.

When the company pays a dividend, either in the same year or later, it may attach a franking credit from its franking account, in proportion to the tax rate. So each $0.70 of dividend may have $0.30 of franking credit attached. The franking amount is again just a record, only $0.70 of cash is paid. Such a dividend is called a franked dividend.

An eligible shareholder receiving a franked dividend declares the cash amount plus the franking credit as income, and is credited with the franking credit against their final tax bill. The effect is as if the tax office reversed the company tax by giving back the $0.30 to the shareholder and had them treat the original $1.00 of profit as income, in the shareholder's hands, like the company was merely a conduit.

Thus company profits going to eligible shareholders are taxed just once. Profits are either retained by the company and taxed there at the corporate rate, or paid out later as dividends and instead they're taxed at the shareholder's rate.

Dividends may still be paid by a company when it has no franking credits (perhaps because it has been making tax losses), this is called an unfranked dividend. Or it may pay a franked portion and an unfranked portion, known as partly franked. An unfranked dividend (or the unfranked portion) is ordinary income in the hands of the shareholder.


Franking credits are (as of the 2000-2001 year, ie from 1.7.00) "refundable" in the sense described in the tax credit article. This means that not only can they reduce a taxpayer's total tax liability to zero, but any excess is refunded. For example an individual with income below the tax-free threshold ($6000 in 2006) pays no tax at all and can get franking credits back in full as cash, at the end of the year.

Prior to 1 July 2000 franking credits were "wasting", any excess over one's total tax payable was lost. For example an individual at that time paying no tax could get nothing back, they merely kept the cash part of the dividend received.


The easiest way for an investor to value a franked dividend is to think of the franking credit as part of the income they receive. The investor doesn't get it in cash, only as a kind of IOU from the tax office, but nonetheless it and the cash portion make up pre-tax income. Thus a franked dividend of $0.70 plus $0.30 credit is exactly equivalent to an unfranked dividend of $1.00, or to bank interest of $1.00, or any other ordinary income of that amount. (It's exactly equivalent because franking is fully refundable, as described above.)

Franked dividends are often described as a "tax effective" form of income. The basis for this is that the cash $0.70 looks like it's taxed at a lower rate than other income. For example, for an individual on the top rate of 48.5% (for 2006) the calculation is $0.70 plus $0.30 credit is $1.00 on which $0.485 tax is payable, but less the $0.30 credit makes $0.185 net tax, which is just 26.4% of the original $0.70. Conversely, an individual on the 20% marginal tax rate actually gets a $0.10 rebate. In this latter case, the rebate looks very much like negative tax.

There's nothing inherently wrong with the latter way of thinking about franked dividends, and it is frequently made to demonstrate how franking benefits the investor, but it can be argued a grossing-up like the former is better when comparing yields across different investment opportunities.


There are restrictions on who can use franking credits. Those who cannot must simply declare as income the cash dividend amount they receive. . The restrictions are designed to prevent the trading of franking credits between different taxpayers. An eligible shareholder is one who either

  • Owns the shares for a continuous period of 45 days or more (not counting purchase and sale days); or 90 days in the case of certain preference shares. This is the "holding period rule". Shares must be "at risk" for the necessary period, ie. not with an offsetting derivatives position for instance.

Or who

  • Has total franking credits for the tax year of less than $5000 (the "small shareholder exemption") and has not arranged to pass-on the benefits to someone else (the "related payments rule").

Thus franking credits are not available to short-term traders, only to longer term holders, but with small holders exempted provided it's for their own benefit.

The small shareholder exemption is not a "first $5000", but rather once the $5000 threshold is passed the rule is inoperative and all one's shares are under the holding period rule.

For the holding period rule, parcels of shares bought and sold at different times are reckoned on a "first in, last out" basis. Each sale is taken to be of the most recently purchased shares. This prevents a taxpayer buying just before a dividend, selling just after, and asserting it was older shares sold (to try to fulfill the holding period).

This "first in, last out" reckoning may be contrasted with capital gains tax. For capital gains the shareholder can nominate what parcel was sold from among those bought at different times.

Company Matters

If a company owns shares in another company and receives franking credits on dividends, those franking credits are added to the receiving company's accounts, and can be paid out in the same way as franking credits generated from taxes.

This transfer of credits has made the previous "intercorporate rebates" allowances redundant. Those rebates had avoided double taxation on dividends paid from companies to other companies. Those rebates were part of the original 1936 taxation act (section 46), meaning that the principle of eliminating double taxation has been present to some degree in Australian income tax law for a very long time.

The company tax rate has changed a few times through the life of dividend imputation. In each case transitional rules have been made to maintain the principle of reversing the original tax paid, even if the tax rate has changed. This has been either by separate franking accounts for separate rates (eg. class A 39%, class B 33%), or making an adjusting recalculation of the credits (eg. into class C 30%).

Trans-Tasman Imputation

New Zealand companies can apply to join the Australian dividend imputation system (from 2003). Doing so allows them to attach Australian franking credits to their dividends, for Australian tax they have paid. Those credits can then be used by shareholders who are Australian taxpayers, the same as dividends from an Australian company.

There are certain anti-tax-avoidance rules to prevent New Zealand companies deliberately streaming Australian franking credits towards their Australian shareholders; credits must be distributed on a pro-rata basis.

Note that it is only Australian franking credits which can be used by an Australian taxpayer. New Zealand imputation credits on dividends paid to an Australian shareholder cannot be used against that shareholder's Australian taxes.

Abuses of the system

A company is not obliged to attach franking credits to its dividends. But it costs the company nothing to do so, and the credits will benefit eligible shareholders, so it is usual to attach the maximum available. It's actually possible for a company to attach more than it has, but doing so attracts tax penalties that mean this is not worthwhile.

In the past it was permissible for corporations to direct the flow of franking credits preferentially to one type of shareholder over another so that each may benefit the most as fits their tax circumstances. For example foreign shareholders cannot use franking credits (they can't be offset against withholding tax) but Australian shareholders can. This practice, known as dividend streaming, became illegal in 2002, whereafter all dividends within a given time frame must now be franked to a similar (but need not be identical) degree irrespective of shareholder location or which class of shares held.

Elimination of Tax Incentives

It is also interesting to note that it was soon realised that the system eliminated to a considerable extent the effectiveness of tax incentives for corporations. If a corporation was given a tax break then its incomes thus released from taxation would not generate franking credits precisely because no tax was paid. In turn, this meant that the shareholders received fewer credits along with their dividends, meaning in turn that they had to pay more tax. The net result is that each tax break a corporation itself got was countered by a matching increase in the tax burden of shareholders, leaving shareholders in exactly the same position had no tax break been received by the corporation. Thus, to the extent that corporate directors acted so as to increase shareholder wealth, tax incentives would not influence corporate behaviour.

It could be argued, however, that a residual bias in favour of obtaining the credits may exist because it is cheaper for the corporation to retain more profits and pay less tax than to ignore the tax break and obtain the same funds from shareholders at some future date. How significant such an inclination to use corporate tax breaks for this purpose is debatable.

Politics and economics

Dividend imputation has been uncontroversial over most of its lifetime. Investors and their advisors recognise the benefits and are supportive.

In October 2006, the Committee for Economic Development of Australia released a report, Tax Cuts to Compete, concluding that dividend imputation had proved an inefficient means of reducing Australia's cost of capital. The report, authored by prominent economist Dr Nicholas Gruen, argued that the elimination of imputation would allow the funding of a substantial corporate tax cut. This would attract foreign investment and thus increase economic growth, it said.

New Zealand

New Zealand introduced a dividend imputation system in 1989. It operates on similar principles to the Australian system. A shareholder receiving a dividend from a company is entitled to an "imputation credit", which represents tax paid by the company, and is used to reduce or eliminate the shareholder's income tax liability.[1]

United Kingdom

From 1973 to 1999, the UK operated an imputation system, with shareholders able to claim a tax credit reflecting advance corporation tax (ACT) paid by a company when a distribution was made. A company could set off ACT against the company's annual corporation tax liability, subject to limitations.

In 1999 ACT was abolished. Shareholders receiving a dividend are still entitled to a tax credit which offsets their tax liability, but the tax credit no longer necessarily represents tax paid by the company, and cannot be refunded to the shareholder.


See also

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