You may think that the tax rate in other countries doesn’t affect you, but you couldn’t be more wrong. In this modern globalized world, corporation tax rates and systems of various countries will have differing effects on your investment portfolios. Nearly all people, both living in the U.K and abroad, have their investments and pensions spread across a number of different countries and thus it is important to get a basic understanding of the differing tax systems.
Tax systems have a very important role to play in a company deciding on whether to pay-out dividends or not. As you will see, certain tax systems encourage dividend pay-outs whilst other discourage it. This article is especially important to those people looking to build their wealth through divided payments. (I have written a separate article on the effectiveness of using dividends as an income stream and you can find it here ).
The three main types of tax systems are the Classical system, Imputation system and the Split-rate system. Below I will give an overview of each of these systems, give the countries that use these systems and the affect these systems have on your portfolio.
1) Classical System – Tax on both the Companies Profits and Dividends Paid out (Double Taxation)
In the classical system, the company’s profits are first taxed (Corporation Tax) and then Income Tax is charged on the shareholder’s dividends. Thus, profits are essentially taxed twice.
Example: If Company A has profits of £1,000,000 and the CT rate is 25%, the company company will pay tax of £250,000. Thus, the company has £750, 000 to retain or pay-out as dividends.
If the company were to pay-out £500,000 of the remaining profits as dividends, the dividends would be charged separately at a rate of 10%. Thus, this adds another £50, 000 to the tax burden.
Less CT (£250,000)
IT on Distribution (£50, 000)
Profits after Overall Taxation £700, 000
Thus as you can see from the above, if the company had paid out no dividend, it’s shareholders would have avoided the £50, 000 tax liability. Hence you can see, this can deter a company from paying out dividends.
Classical System used by: USA.
Effect on Your Portfolio: Companies based in countries that use the Classical System have an incentive to retain profits rather than pay them out as dividends because of the double-taxation effect.
2) Imputation System – Gives Dividend Relief to Shareholders.
The imputation aims to avoid the the double taxation of profits as above. The system does this by giving relief to shareholders for all, or part, of the tax paid by the company. The company’s tax is essentially credited to the shareholders as when they receive their dividend, they also get a tax credit. The tax credit is 1/9 of the dividend to ensure only the ordinary rate is covered.
Example: If Company B has profits of £1,000,000 and the CT rate is 25%, the company company will pay tax of £250,000. Thus, the company has £750, 000 to retain or pay-out as dividends.
But unlike the classical system above, shareholders receiving the £500,000 dividend are entitled to a tax credit of £55 555.55 (£500, 000 * 1/9 ). Unless the shareholders pay tax at a higher rate, shareholders pay income tax on the £555,555 gross dividend at the dividend ordinary rate of 10%
Less CT (£250,000)
IT on Distribution (£55, 555)
Tax Credit £55, 555
Profits after Overall Taxation £750, 000
Imputation System used by: UK
Effect on Your Portfolio : The imputation system is not a disincentive for a company looking to pay-out dividends. Companies in the UK are far more likely to pay a higher rate of divided than those in the US.
3) Split-Rate System – Incentivises Dividend Payments
In the split-rate system, relief is given to the company. As with the classical system, shareholders are charged income tax quite separately from the company’s CT. However, the rate of Corporation Tax on distributed Profits is less than the rate on retained profits.
Split-Rate System used by : Most EU countries
Effect on Your Portfolio: With this system, companies are more likely to give large dividend pay-outs because the tax rate on dividend payments is less than the rate of the company retaining profits.
So you can see, your investment decisions are affected significantly by Corporation Tax Systems. If you are looking for companies that pay high dividend yield, purchase shares in companies that are based in countries that use the Split-Rate System. If you are a higher or additional rate taxpayer, my advice to you would be to buy shares in USA (Classical System) as companies in this country tend to retain profits and thus you will increase your wealth by the share price increasing. If you are an ordinary-rate taxpayer, purchase shares in countries in the UK (Imputation System) as you will benefit greatly from dividend tax credits.