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: –

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:-

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

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):-

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:-

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:-

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:-

*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:-

In the books of Mr Small

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

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:-

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

In the books of Mr Small

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

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

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:-

The tax computation prepared is as follows:-

The journal adjustment to record the tax payable is:-

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.