Textbook theory sets out two approaches to the taxation of a company and its shareholders, says Bill Dodwell, head of tax policy at Deloitte.
Under the classical system the company is charged tax on its profits and further tax is then levied on the shareholder when the company's profits are distributed. It's a double tax system, possibly ameliorated by charging the shareholder at a lower rate.
The imputation system attempts to reduce double taxation by giving the shareholder a credit for tax borne in the company. However, practicalities meant the credit needed to be given at a fixed rate, rather than by reference to actual tax. In 1973, the UK adopted the imputation system.
The issue of tax paid in the company was solved by requiring an advance payment of corporation tax (equal to the basic rate of income tax) when dividends were paid. The advance was then set against the actual tax levied on profits.
In 1979 the UK abolished exchange control and UK companies expanded overseas. Over time the imputation system started to present problems, as UK multinationals earned more profits and paid more tax overseas. The result was that dividends were increasingly sourced from overseas profits. There was thus less UK corporation tax against which to set the advance tax paid with dividends.
Chancellor Norman Lamont was persuaded in 1993 to break the link between UK corporate tax paid and the tax credit given to shareholders. The Foreign Income Dividend scheme gave individual shareholders a tax credit for dividends paid out of foreign profits without requiring that the company paid any advance tax.
What it didn't do was allow the shareholder to reclaim a credit, which was hugely important since most shares in UK companies are held by pension funds, accustomed to claiming refunds. Foreign dividends were worth the same as UK dividends to most individuals, but were worth much less to pension funds.
Chancellor Gordon Brown decided to solve that problem by abolishing the repayment of all tax credits in1997. He then accepted there was no logic in retaining the advance corporation tax system - and abolished that as well, in 1999.
Since 1993 the UK has given individuals a dividend tax credit without a link to UK tax paid by the company and in 1999 any connection disappeared completely. That's a sustainable system for quoted companies since such a low proportion of their shares are held by individuals.
However, it's triggered a major change for owner-managed companies. Suddenly the availability of a credit without a link to corporate tax means that owners save income tax by taking dividends instead of salary. Perhaps it's time for the UK to consider returning to the classical system, where all dividends are taxed on shareholders, perhaps at a lower rate.
Bill Dodwell is head of tax policy at Deloitte
