The Effects of a Dividends Paid Deduction

While corporations cannot take tax deductions for dividends paid in any country in the world as of 2011, several countries offer tax credits to corporations, trusts and shareholders. Since tax credits reduce owed taxes on a dollar for dollar basis, and tax deductions lower taxable income, organizations and investors can receive significant benefits from doing business in and investing in these countries.

Considerations

Corporations in most countries pay income tax on retained profits before distributing them to shareholders. Shareholders will then pay capital gains tax on dividends received. While corporations can use other deductions to minimize their taxable income, they cannot take a deduction for dividends paid out to shareholders. The net effect on double taxation of corporate profits results in the reduction of available capital for business investment.

Geography

A few Commonwealth nations, including Australia, Canada and New Zealand, minimize double taxation by allowing certain organizations to take a tax credit for dividends paid to shareholders. In Canada, income trusts typically invest in infrastructure and energy projects, retain few earnings and distribute most earnings to investors. Australia and Canada allow corporations and trusts to use tax credits to prevent double taxation.

Process

Corporations and trusts in Australia and New Zealand and income trusts in Canada receive a credit for every dollar in tax they pay. They can retain these credits and offer them to shareholders on paper. For example, a corporation or trust that owes 30 cents in taxes per dollar can transfer this 30 cent tax liability to a shareholder who receives a $1 dividend at a 25 percent personal income tax rate. The shareholder reports $1.30 in income on his tax return and will owe 32.5 cents in tax. The tax credit will leave him with 2.5 cents in income tax liability.

Benefits

Without a dividends paid credit, the corporate and dividend tax rate combined would greatly exceed the personal income tax levels of investors, making investments in those countries less attractive to investors. Since investors pay less tax on dividends under this scheme, a corporation can pay out smaller dividends.

Considerations

Smaller dividends leave corporations and trusts with extra retained profits to expand their business operations. The decreased revenue going to governments adds additional capital to the markets, creating economic growth on a national scale. The Canadian Department of Finance reported that the market capitalization of income trusts has grown exponentially from 1995 to 2006.

References

• BDO Canada LLP: Taxation of Dividends -- The New Rules
• Australian Taxation Office: Simplified Imputation -- The Tax Effect of Receiving a Franked Distribution
• Australia Taxation Office: Simplified Imputation -- Overview of the Imputation System
• Canada Department of Finance: Canada’s New Government Announces Tax Fairness Plan