Retained earnings & imputation credits
A company is sometimes referred to as an interim taxing vehicle because the income of a company is first taxed when derived, but then taxed again when distributed to its shareholders. The benefit of the tax paid by a company is captured as imputation credits and able to be attached to dividends.
Ensuring that the amount of a company’s imputation credits is in-line with its retained earnings is akin to good housekeeping, and if the two are materially misaligned the reason should be known. This can happen for all sorts of reasons. For example, take a company with $100,000 of net income, but $50,000 of non-deductible legal expenses. Because the legal fees are non-deductible, additional income tax of $14,000 is paid. If a fully imputed dividend were declared, the company should be left with imputation credits of $14,000, i.e. the imputation credits are of no value. In the absence of knowing why the ‘spare’ imputation credits arose, there is a risk that an overstated dividend would have been declared to utilise them all.This scenario is better than the contrary – a company left retained earnings and no imputation credits to attach to a dividend, AKA “unimputed retained earnings”.
The reason why this is so important is that when a company is wound up and its assets are distributed, its assets progressively fall into one of three categories, each with its own tax treatment, as follows:
Available Subscribed Capital (ASC) – represents a company’s paid-up share capital and can be distributed tax-free to shareholders on liquidation.
Capital gain amounts – are generally able to be distributed tax-free to shareholders.
Remaining funds – to the extent that the distribution exceeds ASC and capital gain amounts, the balance comprises a taxable dividend. This is typically a company’s trading profits.
If insufficient imputation credits exist to attach to the remaining funds a comparatively higher tax liability will arise. This makes it very important to accurately record the income of a company, delineating between capital gains versus ordinary trading income. If non-taxable capital gains (e.g. gains on the sale of property, plant, equipment, shares etc) are accidentally recorded as retained earnings, the tax liability on wind up could be exaggerated. Step one is to ensure a separate capital gain account sits within the company’s trial balance, making it easy to distinguish between the two.
Earlier this year Inland Revenue released a discussion document regarding dividend integrity and personal services income attribution. It explores the fact that calculating ASC and capital gain amounts can be complex, and companies that don’t have sufficient records to substantiate the two do not satisfy their burden of proof.
The release of this document further emphasises the importance of:
undertaking annual imputation credit to retained earnings reconciliations to ensure any variance is explainable, and
maintaining separate equity accounts to separate non-taxable capital gains from normal business profits.
A small amount of work each year, could pay dividends in the long run.
