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Hidden bias in the corporate tax system – is imputation hindering New Zealand and Australian business from offshore expansion?

22 April 2008

The imputation system of corporate taxation is successful in levelling the tax rate between companies and unincorporated business vehicles, and is undoubtedly good at achieving tax equity for domestic investment.

However, the system has always contained an implicit bias against outbound foreign investment. Over the last five years, this bias has led most countries with imputation systems to abandon them.

It is critical that the Government’s review of the system considers alternatives which avoid this bias. In this issue of Counsel we outline the issue and some possible solutions.

The imputation system of corporate taxation is successful in levelling the tax rate between companies and unincorporated business vehicles, and is undoubtedly good at achieving tax equity for domestic investment. However, the system has always contained an implicit bias against outbound foreign investment. Over the last five years, this bias has led most countries with imputation systems to abandon them.

It is critical that the Government’s review of the system considers alternatives which avoid this bias. In this issue of Counsel we outline the issue and some possible solutions.

Twenty years ago, when the imputation system of corporate taxation was introduced in Australia and then in New Zealand, it was leading edge fiscal technology. The “classical” double taxation system it replaced, where tax was levied first on corporate earnings and again on dividends with no credit for the corporate tax already paid, seemed self-evidently antediluvian. It resulted in punitively high theoretical tax rates on distributed earnings, created a huge bias in favour of debt financing, and had lasted in New Zealand for 30 years only because the definition of a dividend was subject to a series of exceptions which well-advised companies could drive a truck through.

Under the imputation system, the corporate and personal income tax regimes were integrated. The effective tax rate on distributed earnings became the individual shareholder’s marginal tax rate. This levelled the tax rate as between companies and unincorporated business vehicles, and allowed corporate financing decisions to be based on economic, rather than fiscal, considerations.

Imputation systems now a rarity

When imputation was introduced to Australia and New Zealand, it was already widespread in European countries. After its adoption here, it was also taken up by Singapore, Malaysia and Taiwan. However, events in Europe have led to its complete abandonment there. Singapore and Malaysia have also abandoned it, in favour of a dividend exemption for shareholders so that there are now very few countries which have an imputation system of corporate tax. An understanding of why this has happened is useful in considering the future direction of our own corporate tax system. This is particularly relevant in light of the impending Government Discussion Document on the imputation system. This will be the first time since its inception that the imputation system in New Zealand has been fundamentally reviewed.

Bias against foreign investment

Imputation systems are undeniably good at achieving tax equity for domestic investment. The tax rate on income earned through a company is the same as it is investing directly or through a partnership (at least once the corporate earnings are distributed) and investors generally end up paying tax at the appropriate marginal rate (though the non-refundability of imputation credits in New Zealand means this is not always achieved).

However, the imputation system always contained an implicit bias against foreign investment. Only New Zealand income tax gives rise to an imputation credit for New Zealand tax purposes (and in Australia, only Australian income tax gives rise to a franking credit for Australian tax purposes). This means that:

  • there is a tax bias against New Zealand individuals investing in foreign companies. The foreign income tax paid by those companies does not give rise to an imputation credit for resident shareholders. The classical double taxation system is alive and well in this scenario;
  • there is a similar tax bias against New Zealand companies with New Zealand shareholders investing overseas. As a result of the imposition of foreign taxes on the income from that investment, the income is likely to be subject to no, or reduced, tax at the level of the New Zealand parent company. However, if the foreign-sourced income is ever distributed by the New Zealand company to its New Zealand shareholders, that tax preference is lost. The shareholders are subject to full income tax on the amount distributed, with no credit for the foreign taxes previously imposed.

Because the law in New Zealand and Australia allows companies to choose to distribute fully taxed income first, in this second situation, the timing of this shareholder level tax liability depends on the New Zealand company’s percentage of foreign earnings and its payout ratio. Companies such as SKYCITY, with a higher percentage of foreign earnings or a higher payout ratio, already face this issue. In Australia, the banks with higher proportions of foreign activities are facing the prospect of being unable to fully frank their dividends.

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