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Tax Assignment: Exploring Imputation Tax System of Australia

Question

Task: Australia operates an imputation tax system in which dividends paid out of profits that have been taxed at the Australian corporate tax rate carry tax credits known as franking credits (also known as imputation tax credits). Franking credits allow Australian resident shareholders to reduce their personal tax paid on dividends while these credits do not benefit non-resident investors in the same way. The fact that franking credits are valued differently by different groups of investors makes it difficult for academics and practitioners to determine their market values. A consensus estimate of the market value of franking credits is yet to be obtained in the academic literature.
Requirements
a. You are required to search for academic journal articles which have examined the market value of dividends and franking credits in Australia and conduct a literature review.
b. Your aim is to write a review of literature which attempt to obtain a reliable estimate of the market value of dividends and franking credits with a particular focus on a method employed.
c. You are required to find and evaluate at least 8 journal articles on this topic.
d. This is a group assignment and one group (of 2 people) is expected to produce one essay.

Answer

Introduction
The present tax assignment deals with the imputation tax system of Australia. The imputation tax system of Australia is a system under which the amount, which is paid out as the tax is, levied over the shareholders, as a result, it reduces the cost of income tax for the dividend imputation. The main purpose of this imputation tax system outlined in the tax assignment is to avoid the payment of the double tax from the profit of the company. Before the introduction of the Imputation tax system, the classical system was implemented in the organization thus to understand the organizations. Under the classic system, the organizations pay tax on their profits; however, they again pay tax at the time of the distribution of dividends to the shareholders. Thus, the organizations were paying double tax over profits and distribution of the dividends. The imputation credits are also called as franking credits. Under the imputation tax system, the taxes, which are levied over the dividends, are termed as franking credits. Franking tax is paid by the organization for reducing the double taxation in the system. Franking credits helps to allocate the credit tax to shareholders for which the tax has been already paid by the organization.

Discussion
Rise in dividends payments
The tax assignment examines the readings of Cannavan and Gray (2017) which signifies that dividends are the amount that is paid to the shareholders from the profit, which has been earned the organization. These amounts, which are given as dividends to the shareholders, are the choices of the company instead of keeping the earrings as their retained earnings for many other purposes. Internationally Australian dividends are considered as higher since it reflects the effect of the tax policies. Usually, organizations make the ordinary dividends payments but in some cases, they also provide the cash dividend payments to their shareholders.

What are the theories of Dividend Policy used in the case of tax assignment?
As per Ainsworth, (2016) there is a range of theories that have been advanced to describe the concept of corporate dividend payments, but there are no such agreements about how the companies should implement these options. There are two major trends to analyze the dividend payout ratios; they are Aggregate Trends and Sectoral Trends

Aggregate Trends
The Aggregate dividend payout ratio consists of two broad phases: In the first phase, the dividend increases less than the earnings during the early high-investment stage of the resources. In the second phase dividends decreases but less than the earnings during the global financial crisis.

Sectoral Trends
The dividend payout ratios show an immense increase in the resources and banking sectors, while in the other sector they have generally displayed no trend. The companies paying the dividends, the payout ratios do not appear to be relatively high. The losses among the resources companies clarify why the payment ratio is currently above 100 percent while considering all the listed companies in the resources sector.

 
Findings
As per Li and Tran (2019), it is noted here in tax assignment that the total cash ETR suggests that the dividend-paying organizations or firms pay 25% of tax. The concerned firms could not handle manage the tax payment level in relation to the dividend payout ratio because the optimal tax rate indicates a lower value of 25%. Both cash ETR and optimal tax median values are lower than the average as it has marginally misrepresented the value for the variables. The average leverage is 13% (median 9.4%), the development expenditure and the research level are low it is caused due to the effect of imputation system in decreasing the tax incentives for the expenditure value. There is a fragile positive relation between both cash ETR and optimal tax and might cause the timing distinction between tax income and accounting methods.

Methods
According to the research on tax assignment, there are total numbers of four methods used to analyze the imputation credits

  1. Comparative pricing studies: The comparative pricing study is used for the interpretation of imputation credit value. The study measures the differences among the pricing security that offers proportionate stock exchanges and exposures but contradicts in imputation credits and dividends. The measurement of different pricing derivatives versus the underlying stock is compared during the ex-dividend periods. The various other underlying bonus claims and ADRs listed are relatives to a listed Australian stock.
  2. Price-level examination: Price level examination studies the imputation credits if it is related to the higher stock exchange value under different valuation models that include, residual income model, cash flow model and a regression model that clarifies the proposed earnings from the imputation credits under different yields of control range. The price-level also organize portfolios to investigate the relation between market valuations and imputation credit yields. 
  3. Dividend drop-off studies: The study recognizes the price drop-off when the stock is declared as ex-dividend. The price drop-off determines the market value related to imputation credits and dividends. The main objective of the study is to derive the value of imputation credits and determines the consequences of drop-off.
  4. Examination of returns: The study explored in the tax assignment analyzes and inspect the existence of imputation credits whether it is related to lower returns, market value and lower realized returns. The correlation among the imputation credits with lower returns might be associated with a different asset-pricing model. If the imputation is priced then the total stock paying the imputation credit generates a lower market return value.

As per Ainsworth, (2015) from the above study and methodology of imputation credits, it displays a mixed result between the finding of comparative pricing and dividend drop-off. The key findings suggest that imputation credit yields are partially priced. However, both the price-level and examination of returns represent a little proof that imputation credits are priced. The lower realized returns and imputation credits do not correlate with each other suggest the study. There is a decisive relation for both the imputation credits and realized returns, which are considered important under any circumstances. Therefore, it signifies a negative value on imputation credits and the total distribution of return value such as realized returns are lowered by imputation credits. The findings obtained in the tax assignment suggest that imputation credits could have been reflective in share prices under discounted cash flow models. As per Klement, (2014) However, the results in the model of earning yield and portfolio indicate that an imputation credit is not priced and it might be correlated with different higher-earning yield and stock exchanges. The lower prices might also be in association with the different valuation measures. The proper caution needs to be implemented and interpreted for the above findings as the earning yield results have highlighted the wrong gesture and signs.

Trends of franking credit
The present tax assignment examines the words of McClure, (2018) that it is important to understand whether investors in infrastructure assets have a precise idea about the franking credits or not. To get a clear view of the contribution to the value of franking credits, the analysis of investors with interests in infrastructure was conducted, which also includes Australian and foreign funds managers and superannuation funds and asset owners. The key points outlined in this tax assignment from the analysis include:

  • There were the least numbers of investors, who value franking credits. The main reason of this aspect is that the franking credits are essential to their underlying investors. 
  • A significant number of investors who have a formal policy stating about the inclusion of the value of franking credits while doing its valuations. 
  • The value of franking credits consists of the value in existence as well as future franking credits. 
  • The investors valuing the franking credits are valued by grossing up cash flows by evaluating the expected utilization rate. There are minimum numbers of investors who adjust the discount rate by the gamma factor which are used for crosschecking. 

As per Gray, (2016) it has been considered in the tax assignment that foreign investors do not value franking credits. In some cases, they strive to value the franking credits, which will help assess the potential bids from the Australian competitors, but there is so specific value that is placed on them by these investors. 

The following key trend has been considered from the research report of franking credits:

  • Over the past few years, the adoption of the utilization rate has been gradually increasing.
  • Investors are continuously attempting to discover the possibilities to release the ‘trapped franking credits’.
  • There are numerous foreign investors in the Australian infrastructure assets, and it is constantly increasing. The tax assignment also illustrates that Canadian pension funds and Asian investors are more concerned about Australian assets due to many different reasons. 
  • Some investors are worried about the potential risk of future restrictions on the repayment and use of franking credits.
  • The corporate investors investing in Australian infrastructure assets are unwilling to focus on franking credits due to the substantial tax loss position. There will be an immense focus on franking credits if the increasing numbers of the corporate shift to tax-paying status.

Conclusion
After proper analysis and research done in this context of tax assignment, we can understand that the Australian organization use the imputation tax system to avoid paying the double tax for the payment of the dividends to the shareholders of the organization. The dividends payout ratios provide important information for the dividends from which tax has been induced. Along with the dividend payout ratio, franking ration also provides important information through which the various dividends policies can be formed. The organizations that are stable with their cash flow pay their franking dividends without any fail on their dividend payout ratio. In the process of taxation explored in the present tax assignment, it is an advantage to handle the tax amount for providing the franked dividends but if the tax is paid excessively then it will be considered as the wastage. For properly managing the tax system of the organization, it is very important to keep the proper track of the optimal tax along with the proposed dividends. It will allow the company to set targets for payments of the tax. If the organization will have its effective target for paying the tax then it will result in the association of the cash effective tax rates and the optimal tax rate of the organization.

References
Abraham, M., Dempsey, M. and Marsden, A., 2015. Dividend reinvestment plans: a tax-based incentive under the Australian imputation tax system. Tax assignment Austl. Tax F., 30, p.435.

Ainsworth, A., Partington, G. and Warren, G.J., 2016. The impact of dividend imputation on share prices, the cost of capital and corporate behaviour. JASSA, (1), p.41.

Ainsworth, A.B., Partington, G. and Warren, G., 2015. Do franking credits matter? Exploring the financial implications of dividend imputation. Exploring the Financial Implications of Dividend Imputation (June 1, 2015). CIFR Paper, (058).

Cannavan, D. and Gray, S., 2017. Dividend drop-off estimates of the value of dividend imputation tax credits. Pacific-Basin Finance Journal, 46, pp.213-226. 

Gray, S., 2016. Dividend imputation and the corporate cost of capital. JASSA, (1), p.50. 

Klement, J., Greenrod, J. and O’Neil, J., 2014. Optimal Domestic Equity Allocations for AustralianInvestors and the Role of Franking Credits. The Journal of Wealth Management, 16(2), pp.88-98.

Li, E. and Tran, A., 2019, May. The Australian dividend imputation system and corporate tax avoidance. In Australian Tax Forum (Vol. 34, No. 2).

McClure, R., Lanis, R., Wells, P. and Govendir, B., 2018. The impact of dividend imputation on corporate tax avoidance: the case of shareholder value. Tax assignment Journal of Corporate Finance, 48, pp.492-514.

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