Learning about shares: Tax credits a welcome bonus with dividends

Olympic champion BARBARA KENDALL gets some help from Dan Dividend

Q. Barbara Kendall asks: Can you explain the imputation credits shown on my dividend statements? What's behind them and how do they work?

A. Dan Dividend responds: I'm no expert in the tax field, but I can cover the basics for you. Companies attach imputation credits to their dividend payments to avoid "double taxation" of company profits. Sounds ominous I know, but it's a simple concept to grasp.

Let me explain. You already know that companies usually pay dividends out of their profit. You also know that companies' profits are subject to tax.

When you receive a dividend, the company has already paid tax on that money.

However, dividends are also subject to tax, payable by the shareholders who receive the dividends. Before the dividend imputation system was introduced in the late 1980s, shareholders were required to pay tax on dividend money that had already been taxed in the hands of the company.

Imagine a company in pre-imputation days. Let's say the company makes a profit of $1000 and pays tax on that profit at the company tax rate of 33 per cent. After tax, it has $670 left to distribute to shareholders as dividends.

The dividends then become taxable in the hands of shareholders, who we'll assume all pay tax at 33 per cent. The $1000, reduced first to $670 is again chopped to around $450 in shareholders' hands - a 55 per cent effective tax rate at the end of it all.

The dividend imputation system solved this problem. Where the company has already paid tax, shareholders now receive a tax credit, called an imputation credit, attached to their dividends.

You can put that credit toward your annual tax bill.

I'll call on Carmel Fisher of Fisher Funds Management to explain imputation credits in more detail and discuss what you should do with them.

Carmel says:

As Dan has mentioned, the dividend imputation system ensures company profit is taxed only once. Shareholders who receive a share of the company's profit as a dividend generally do not have to pay tax on that money.

What was the impact on the sharemarket?

When the government introduced the dividend imputation system it meant good news for the sharemarket, as more people were encouraged to invest in New Zealand companies. Companies that paid fully imputed dividends became more attractive as investment possibilities.

Some dividends are only partly imputed, or not at all. This is usually to do with the company's tax status. Shareholders must pay tax on the non-imputed part of the dividend. Your NZX adviser should be able to give you more information.

Claiming your imputation credit

When you receive a dividend, instead of just detaching the cheque and running to the bank, have a look at the information on the statement that comes with it.

You'll see a box labelled "dividend amount", "net dividend" or something similar. This is the after-tax dividend amount that ends up in your hands.

Then look for a box that says "gross dividend" or "total dividend for tax purposes".

This figure is the pre-tax dividend amount. The imputation credit is the difference between the gross dividend and the net dividend.

It's up to you to file an income tax return with the IRD to claim your imputation credit. When filling in your tax return, you'll be asked to quote the imputation credit amount shown on your dividend statement. So it's important to hold on to these statements until tax time.

Imputation credits may have different effects for investors with a marginal tax rate of 19.5 per cent or 39 per cent. You should talk to an accountant, tax consultant or your NZX adviser for more information on the effect of imputation credits for your tax.

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