Dividend Imputation

In some countries, dividends are distributed to shareholders under dividend imputation system. The purpose of this system is to avoid imposing tax “2 times” on the same income is first generated by companies (taxed the first time when the income is reported by companies), which is then distributed to shareholders as dividends (taxed the second time when the dividend income is reported by individual shareholders).

Example

Company A has 2 shareholders – Mr Big and Mr Small, each holding 50% of the shares in Company A. The details of the share capital of Company A are shown below: –

$

Authorised Share Capital:

100,000 ordinary shares or $1.00 each

100,000

Issued and Fully Paid-up Share Capital:

100,000 ordinary shares or $1.00 each

100,000

For the financial year ended 31 December 2007, Company A made $25,000 profit before taxation and declared and paid a dividend of 25 cents per share to its shareholders.

Based on the profit of $25,000, assume a corporate income tax rate of 20%, and there are no adjustments required to be made to the $25,000 accounting profit to arrive at the taxable profit, the corporate income tax paid by Company A is therefore $5,000 ($25,000 x 20%).

The summarised income statement of Company A for the year ended 31 December 2007 is shown below:-

$

Profit before taxation

25,000

Taxation

-5,000

Profit after taxation

20,000

Retained profits brought forward (Assume $10,000)

10,000

Profits available for appropriation

30,000

Dividends

-25,000

Retained profits carried forward

5,000

The $25,000 is the dividend distributed to both Mr Big and Mr Small in the following manner:-

$

Mr Big – 50% 12,500
Mr Small – 50% 12,500
TOTAL 25,000

In a simplified scenario and assuming there is no dividend imputation, both Mr Big and Mr Small would need to declare this dividend received as a source of income to the tax authority and be taxed accordingly. Assuming a personal income tax rate of 10%, and no other source of income, and no other deductions or rebates, Mr Big and Mr Small would need to pay $1,250 each as income tax to the tax authority.

The following table shows clearly that based on the same source of profit, originally the $25,000 profit before taxation made by Company A, and subsequently distributed to the shareholders as dividends – $12,500 to Mr Big and $12,500 to Mr Small, the total amount of income tax collected by the tax authority is $7,500 ($5,000 from Company A, $1,250 from Mr Big and $1,250 from Mr Small):-

$5,000

—–> on $25,000 profit reported by Company A

+

$1,250

—–> on $1,250 profit reported by Mr Big

+

$1,250

—–> on $1,250 profit reported by Mr Small
TOTAL TAX COLLECTED

$7,500

There is an argument that it is unfair for the tax authority to impose tax twice on the same income and therefore the dividend imputation system is introduced.

Under the dividend imputation system, the amount of tax paid by companies, in this example, the $5,000 tax charged on Company A, will be recorded in a tax credit account. This tax credit account is not an account created and maintained in the general ledger, it is just a memorandum account used to keep track of the income tax on companies which can be used to frank the payment of dividends to shareholders.

Based on the $5,000 tax charged on Company A (some countries require that the tax must be paid by companies before it is eligible to be used as tax credit to frank the payment of dividends), and assume it is eligible to be used as tax credit to frank the dividends, Company A would need to perform a calculation check to know the maximum amount of profits that can be distributed to its shareholders, WITHOUT additional tax to be paid as follows:-

Tax credit = $5,000
Maximum amount of profit that Company A can declare as dividend without incurring additional tax
= $5,000 X

(100% – income tax rate)

income tax rate

= $5,000 X

(100% – 20%)

20%

= $5,000 X

80%

20%

= $20,000

This $20,000 represents the profit of Company A that can be distributed as net dividend to that shareholders without paying additional tax and if Company A were to decide to declare its profit to the maximum without paying additional tax, the dividend is usually described as follows: –

“Company A declared and paid a gross dividend of $25,000 less tax of $5,000 (tax rate at 20%) amounted to $20,000 to its shareholders”.

Refer to the summarised income statement of Company A:-

$

Profit before taxation

25,000

> This is NOT the maximum amount of profit that Company A can distribute as dividends without incurring additional tax
Taxation

-5,000

> This is the tax credit available to be utilised to frank the payment of dividends
Profit after taxation

20,000

> This IS the maximum amount of profit that Company A can distribute as dividends without incurring additional tax

Assume now Company decided to declare $20,000 net dividends to its shareholders, instead of $25,000 (as described earlier where there is no dividend imputation)

In the books of Company A

The double entry for the recording of the dividends paid is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Retained profits – dividend*

20,000

Cash at bank

20,000

*Take note that dividend is not an expense. It is a distribution of profits to shareholders and therefore is shown as a deduction against retained profits.

In the books of Mr Big

The double entry for the recording of the dividend income is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Tax recoverable

2,500

Dividend income

12,500

In the books of Mr Small

The double entry for the recording of the dividend income is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Tax recoverable

2,500

Dividend income

12,500

Assume a personal income tax rate of 10% and both Mr Big and Mr Small have no other source of income, no other deductions and rebates, the tax computation prepared for tax purposes is as follows:-

Mr Big Mr Small

$

$

Dividend income

12,500

12,500

A
Tax @ 10%

1,250

1,250

B = A X 10%
Tax credit available for set-off

-2,500

-2,500

C = from the $5,000 tax credit in Company A split into 50% for Mr Big and 50% for Mr Small
Tax recoverable

-1,250

-1,250

D = B + C

As shown above, the $5,000 ($2,500 each for Mr Big and Mr Small) tax credit available for Mr Big and Mr Small to set off against the tax payable calculated on the dividend income, is from the tax credit of Company A on the $25,000 profit reported to the tax authority.

In the hand of the shareholders, Mr Big and Mr Small, as the amount of tax on the dividend income is only $1,250 each for Mr Big and Mr Small, both Mr Big and Mr Small are eligible to apply to the tax authority for the refund of the “excess” tax paid amounted to $1,250 each for Mr Big and Mr Small. This $1,250 of “excess” tax paid is therefore shown as tax recoverable.

The double entry to record the amount of tax payable of $1,250 calculated above is:-

In the books of Mr Big

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,250

Tax recoverable

1,250

In the books of Mr Small

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,250

Tax recoverable

1,250

The income statement of Mr Big and Mr Small after taken into account of the two adjustments is as follow:-

Mr Big Mr Small

$

$

Profit before taxation (Assume only dividend income. No other income or expenses)

12,500

12,500

Taxation

-1,250

-1,250

Profit after taxation

11,250

11,250

The extract of the balance sheet of Mr Big and Mr Small showing the tax recoverable is as follow:-

Mr Big Mr Small

$

$

Current Assets
Inventories

xxxx

xxxx

Trade receivables

xxxx

xxxx

Other receivables, deposits and prepayments

xxxx

xxxx

Tax recoverable ($2,500 – $1,250)

1,250

1,250

Cash at bank

xxxx

xxxx

A word of caution, I have seen many mistakes on the recording of dividend income in the books of the recipients when the dividend imputation system is applied. The mistakes done usually is because the following double entry is used to record the dividend income:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Cash at bank

10,000

Dividend income

10,000

The tax computation prepared is as follows:-

$

Dividend income

10,000

Tax @ 10%

1,000

The journal adjustment to record the tax payable is:-

Balance Sheet

Income Statement

DR

CR

DR

CR

Taxation

1,000

Tax payable

1,000

Can you see the mistakes made?

  1. Instead of showing a tax recoverable of $1,250, a tax payable of $1,000 is shown.
  1. Taxation amount shown in the income statement of $1,000 instead of $1,250
  1. The tax of $1,000 not set off against the tax credit of $2,500.
  1. Dividend income shown in the income statement is $10,000 instead of $12,500

What if Company A decided to declare a net dividend of $25,000 to its shareholders?(i.e. $5,000 in excess of the $20,000 calculated where no additional tax liability required). Under the tax law and regulations in respect of dividend imputation, Company A is required to pay the tax on the excess of $5,000 ($25,000 – $20,000) for distributing the profit as dividend to its shareholders, i.e. $1,000 ($5,000 x 20%). I have seen many companies declared and paid dividends to the shareholders in excess of the maximum amount without realising that this is the case and attracted unnecessary tax penalties.

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