Investment, the Corporate Tax Rate, and the Pricing of Franking Credits

Abstract

I apply a new single‐pass capital asset pricing model methodology for assessing systematic risk to all ASX stocks which indicates that securities which pay franking credits in Australia appear to face far less systematic risk than do stocks that never pay franking credits. But in this context, this apparent reduction in systematic risk can be interpreted as being due to franking credits that are close to being fully priced. An efficient equilibrium is reached in which the marginal investor in Australia pays little or no Australian corporate tax because, once she exhausts compulsory savings, she borrows offshore and converts debt to equity.

Company Income Tax and Business Investment

“…Franked dividends bear the 30 per cent company tax rate, and no additional withholding tax. About half of dividends paid to non‐residents are estimated to be fully franked, a smaller share than dividends paid to residents (Swan 2019). Swan (2019) argues that non‐residents who do not gain from imputation credits funded by company income tax in the first‐round, and are not subject to capital gains tax, play an arbitration game with resident shareholders who receive full value for imputation credits.…”

“…For most countries, unfranked dividends bare a withholding tax rate of 10 per cent or less, and for retained equity earnings an effective corporate tax rate less than the statutory rate. In response to the non‐neutral set of effective tax rates, the non‐resident mix of options is more heavily biased to debt rather than equity (drawing on Table 3 and discussion of Section 2) and to companies paying dividends with a lower share of franking credits (Swan 2019). The corporate tax rate is an important driver of effective tax rates for non‐resident shareholders.…”

“…About half of dividends paid to non-residents are estimated to be fully franked, a smaller share than dividends paid to residents (Swan 2019). Swan (2019) argues that non-residents who do not gain from imputation credits funded by company income tax in the first-round, and are not subject to capital gains tax, play an arbitration game with resident shareholders who receive full value for imputation credits. Non-residents sell shares with franking credits just before dividend payment and repurchase the shares ex-dividend, and effectively bear zero company tax.…”

The Capitalization Effect of Imputation Credits on Expected Stock Returns

“…Notable studies in this research strand include Lajbcygier and Wheatley (2012), Siau et al . (2015), and Swan (2019). Lajbcygier and Wheatley (2012) use various pricing models to examine whether the provision of imputation credits reduces realized stock returns.…”

“…Recently, Swan (2019) argues that the two‐stage approach adopted in previous studies is potentially flawed. In particular, the two‐stage approach involves estimating the CAPM betas in the first stage.…”