Imputation credit where credit is due

By MARY HOLM

Q. My annual earnings are $30,000 from dividends and $10,000 from my business, totalling $40,000.

Imputation tax of $10,000 is deducted from the dividends at source and paid directly to the IRD. The tax rate is 33 per cent.

As I have a low income and three dependent children, my tax liability is well below $10,000, but it seems the IRD will only credit me with overpaid tax if it is set off against other earnings.

This may never happen, and in the meantime my tax losses increase.

I do not know how to access the overpaid tax and feel the rules are unfair. I understand many older people have the same problem. Any ideas?

One option is to access investments where tax is not deducted at source, for example GPG 9 per cent capital notes.

I suppose there are a range of investment options that meet this criterion, and it would be helpful to know what they are.

A. You haven't got imputation quite right.

It's not a tax withholding system. Instead, it gives shareholders credit for tax that has already been paid by a company on its profits.

Let's assume that we're talking about fully imputed dividends, which is the usual case.

Say your share of a company's taxable income is $100. It pays 33 per cent tax, and pays the remaining $67 to you as a dividend.

Attached to the dividend is an imputation credit for the $33 it has paid in tax.

On your tax return, you add the $33 imputation credit to your $67, giving you a gross dividend of $100. The next step depends on your tax bracket:

* In the 39 per cent tax bracket (income more than $60,000), you would pay $39 of tax on that $100.

But you get credit for the $33 already paid by the company, and so have to pay only a further $6.

* In the 33 per cent bracket (income $38,000 to $60,000), you would pay $33 of tax. But you get credit for the $33 already paid, and so pay no more.

* In the 19.5 per cent bracket (income less than $38,000), you would pay $19.50 of tax.

But you get credit for the $33 already paid, which means you've paid $13.50 too much. You can use that to offset tax on other income earned that year.

This offsetting works well if dividends are a relatively small proportion of your total income.

You not only don't pay further tax on your dividends - because the company has already paid - but the tax ends up being paid at your marginal tax rate.

The trouble is that some people in the bottom tax bracket don't have enough other income on which to "use up" the excess tax that has been paid by the company.

They can, in effect, carry the excess over to future years.

But, in many cases, the situation won't be any different then. The excesses just keep building up.

You are among those people. The top $2000 of your income is taxed at 33 per cent, but the bulk of your income is taxed at a lower rate.

Legislation prevents the IRD from giving you back the excess as a refund, says Ernst & Young tax partner Mike Stanley.

Why? Well, before imputation was set up in 1988, dividends were taxed twice, in the company's hands and then in the recipient's hands.

The Government of the day felt the new imputation system was already giving shareholders a big break.

Allowing refunds as well would be just too costly, in terms of lost revenue, says Stanley.

"The philosophy was to give shareholders only the benefit to the extent they would otherwise have paid tax."

He points out that the current Government plans to lower the tax rate for Maori authorities to 19.5 per cent, in conjunction with an imputation system, so a similar problem doesn't arise when they make distributions to individuals.

"It reflects the stated fact that most of the recipients are on the lower tax rate," says Stanley.

But there's been no talk of similar changes that would help shareholders in companies.

So what can you do about it?

Perhaps go to election rallies and ask embarrassing questions about why lower income dividend recipients are discriminated against.

Or perhaps switch some of your money to fixed interest investments.

You could go for GPG capital notes.

You are right that they don't have tax deducted at source, because they are registered in the UK. New Zealand taxpayers must pay the tax themselves.

No doubt there are other similar investments.

But there's no particular point in favouring them over New Zealand-based investments, which withhold tax before paying interest to you.

That's because, unlike the dividend situation, if too much tax is withheld from interest payments you can get a refund.

In your situation, depending on your dividend/interest balance, you might get most or all of the tax withheld from interest payments refunded back to you.

Before you go selling shares and buying bonds, though, you should consider whether such a move is right for you.

If you prefer shares for non-tax reasons - perhaps because over the long term they tend to bring in higher returns - it might not be worth abandoning them for tax reasons.

Q. A letter in a recent column discussed a share's capital growth versus dividends.

It seems that at retirement many investors alter their portfolio to achieve dividend income.

However, in New Zealand, because we have no capital gains tax, it is to the investor's advantage to buy shares with high capital growth and small or no dividends.

Tax-free income can then be achieved by selling off parcels of shares as they rise in value.

The total worth of the portfolio would remain the same or could be slowly run down at will.

Inland Revenue would not deem such an investor to be a "trader", as few shares would be bought.

A. You're not quite right, either.

If we look first at non-tax issues, it doesn't much matter whether retired people or others own high-dividend shares or low-dividend shares.

The prices of the lower dividend ones will, on average, grow faster - because the companies have kept more of their profits for growth.

And, as you say, shareholders can always sell some of their shares to get income.

What about tax on dividends?

The typical New Zealand company pays tax on its income, regardless of whether it then distributes the money as dividends.

If it then pays fully imputed dividends, shareholders pay little or no further tax on that money, because of imputation, as explained above.

The situation is different for foreign shares.

Imputation doesn't apply, so New Zealand taxpayers are taxed in New Zealand on foreign dividend income.

Still, foreign companies, especially those beyond Australia, tend to pay much lower dividends than New Zealand companies.

The US average dividend yield is just 1.25 per cent. So paying tax on foreign dividends doesn't usually amount to a lot.

Turning to capital gains, I would be a bit careful about automatically assuming you wouldn't be taxed on them.

Strictly speaking, it's not only traders who are taxed on their gains, but anyone who has bought their shares with "a dominant intention" of making a profit by disposing of them in the future.

In reality, individuals who buy and hold shares for long periods, and receive dividends, are rarely taxed on their gains.

But, for the record, they could be.

Note, too, that if you're investing overseas, shareholdings in non-Grey List countries may be taxed in New Zealand under our complex "foreign investment fund" rules for taxing unrealised capital gains.

Countries on the Grey List - Australia, Canada, Germany, Japan, Norway, UK, and US - are exempt from that.

So where are we?

As far as tax is concerned, a New Zealand company that pays fully imputed dividends may be better than one that pays no dividends and therefore produces higher capital gains - if there's a likelihood you could be taxed on those gains.

When we look at foreign shares, your point makes a little more sense for shares in Grey List countries.

Over all, though, I don't think it is important enough to be a major factor in investment decisions.

Q. I would appreciate if you can elaborate or direct me and other readers to get more information on the golden rule, as per the letter from the expat Kiwi on July 7.

A. I can't take credit for the rule. Nor can I vouch for its validity.

But the man who sent it to me says it has served him well.

The rule, as he puts it, is that "rent needs to exceed 1.4 times the interest component of the mortgage, to ensure positive cash flow month on month".

When you're looking at a rental property, then, find out how much of your mortgage payments will be interest in the first year.

With a table mortgage, the common type of home loan, the answer will be most of the payments in the first few years. Your lender should be able to help with this information.

Under the rule, your rental income needs to be 1.4 times that figure. If it's less, the investment might not work well.

When calculating annual rental income, don't forget to allow for a few weeks without tenants.

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