Dividend Taxation: The Comparative Analysis with Emphasis on Slovenia and Croatia UDK: 336.2 (497.12:497.13) Helena Blazic University of Rijeka, Faculty of Economics helena@fri.hr Dzeneta Basagic University of Rijeka, Faculty of Economics dzenetabas @yahoo.com ABSTRACT The paper presents and analyses different corporate tax systems (methods of integration of corporate and personal income tax). The comparative and dynamic analysis shows that schedular treatment gains in importance. Particular attention is given to Slovenia and Croatia, which has just modified its system of separate tax rate for dividends. Now both countries have the dividend exemption method -the former a partial and the later a full method. The measurement of the dividend relief shows that this benefit is distributed regressively in both of the countries. Keywords: economic double taxation, dividends, corporate tax, personal income tax, regressivity 1. Introduction The usual problem concerning combined corporate and personal income tax treatment of distributed profits (dividends) - their double taxation can be mitigated or eliminated through some of the forms (methods) of integration of corporate and personal income tax. The paper will analyze this combined treatment (also called "corporate tax system") in general and establish its development trends in the EU countries (taking into account the situation in the other developed countries too) and SEE countries, including Turkey, as EU candidate country. The degree of mitigation of double taxation (dividend relief) in the form of (partial) dividend exemption will be calculated for Croatia and Slovenia. Its effects, common to the all countries that use this method, will be analyzed in further and compared to the effects of other methods used. The paper will try to support the theses about the regressive impact of the analyzed method, its dynamic predominance, as well as the dilution of the standard classification of the integration methods. 2. Corporate tax systems The term "corporate tax systems" usually denotes different relationships and integration levels between corporate income tax and personal income tax on dividends, paid by shareholders. As known, corporate income is taxed first at the corporate level and then again at the shareholder level, due to the taxation of dividends (income tax) at the shareholder's marginal income tax rate. This phenomenon (economic double taxation of dividends) could be mitigated or even eliminated /avoided in a different ways. Figure 1 describes different forms of corporate tax systems. Figure 1: Forms of relationship between corporation tax and income tax of shareholders Divide rid - deduction Split - rate sjsteni Sutern tax credit separate (linear) dividend method tax rate exemption Source: authors addition to Cnossen, 1993, p.4 Classical system and full integration are two extreme positions. The former treats corporations as being completely separated from their shareholders. This means that corporate income tax and after that personal income tax (if profits are distributed to the shareholders in the form of dividends) are fully applied (economic double taxation). Proponents of such a system point out that the shareholders are completely divided from their (big) corporation (ownership and control functions are not integrated) and that they do not have any influence on profits, but only get dividends when they are declared by management. Such a system gives an incentive to retain profits, instead of distributing them to shareholders, since the later results in a full income tax burden of shareholders (in addition to corporate tax burden). The later (full integration) means complete integration of corporate and personal income tax. The corporate income tax is treated as withholding tax that is later completely credited from the personal income tax regardless whether profits are distributed or not. Since the effect is the same as with business entities paying personal (and not corporate) income tax, this form is also called partnership method. There is no economic double taxation here at all. Although this form is closest to the theoretical norms of S-H-S1 income concept, it has been never implemented in practice, maybe mostly due to its negative fiscal effects, relatively complicated procedure, but also the fact that the shareholders might have to pay income tax, although no dividends have in fact been received. So, only distributed profits are taken into account for integration. The relief can be given either at corporate or at shareholder level. At the corporate level, dividend relief can take the form of the dividend-deduction system or split rate. In the former case distributed profits - dividends are deducted from the taxable profits. If that is done in full, the elimination of double taxation is present. If it is done only for the part of distributed profits, the mitigation of double taxation is present. Under the split-rate system, distributed profits are taxed at a lower rate than retained profits. A drawback of this system is that relief is automatically distributed to foreign shareholders, but its final objection is that corporation tax cannot serve as a means to verify the correct return of dividend income for the income tax (Cnossen, 1993, p. 8). Next chapter shows that these systems are not in effect anymore. The reliefs at shareholder level can be divided into the imputation system and various schedular treatments. All the dividend reliefs at shareholder level, unlike these on the corporate level, promote profit distributions in order to stimulate stock markets. Imputation system is similar to the full integration, but regarding distributed profits only. Again, it enables for dividends to be taxed at marginal rate of personal income tax only, because the corporate tax paid on distributed profits is 1 Schanz, Haig and Simons treated as withholding tax. So, the relatively complicated technique of grossing up of dividends (allowing for the corporate tax) and later deducting tax credit of the same amount is applied. Schedular treatments do not take corporate income tax into account, but have a preferential treatment for dividends in comparison with other forms of personal income2. There are three methods that could be used here: tax credit, separate (lower, linear, flat) rate for dividends and dividend exemption. Tax credit is deducted from personal income tax on dividends, but without former grossing up of these dividends, as in the case of imputation system. This tax credit, as already outlined, is not directly connected with the amount of corporate tax previously paid. Separate tax rate of dividends is an easier and simpler method. It is usually done by applying final withholding tax on dividends, which rate is, of course, relatively low (for instance the lowest marginal tax rate of personal income tax)3. Alternatively and rarer two lower rates could be used, with the dividend income included in the tax return. The simplest solution is the 100% (full) dividend exemption (it is equal to zero tax rate on dividends). Here the elimination of economic double taxation is achieved, but with the final tax burden for shareholders being corporate income tax and not personal income tax (its relevant marginal) rate4. Dividend exemption could also be partial (only part of the dividends is exempt). 3. Development trends and current situation -comparative analysis The trends in the developed countries have been changing (Messere, 1999, Blaži} 2002, IBFD, 2005). In the fifties and early sixties when self-financing was considered a more reliable route to growth, most countries used the classical system. This view has been challenged in the sixties with the 2 Due to no direct connection of the dividend relief and corporate tax previously paid, the schedular treatment is also claimed to be a classical system (IBFD, 2005 and all previous years of the "European Tax Handbook") or at least modified classical system (Messere, 1993, p. 345). 3 This is mostly accompanied by the option of taxpayers to include dividend income in taxable income (income tax return) if it suits them (for incomes where marginal tax rate is lower than the rate on dividends or the incomes that are lower than the personal allowance (zero rated first bracket)). In that case they choose, in effect, the classical system. 4 In the case of rate of corporate income tax being the same as the (marginal) rate of personal income tax (for instance in the case of a flat tax, where both taxes have the same rate) this problem does not arise. recognition of the problem of double dividend taxation and the need for its mitigation/elimination. In the seventies and eighties the countries introduced integration systems mostly at the shareholder level. The most used form was the imputation system, which was also proposed in the 1975 for the entire EC (but this proposal was never accepted and finally abandoned in 1990). The reliefs at the corporate level were diminishing and were finally history at the end of the nineties5. Inside the reliefs at the personal level, at the end of the eighties the trend started towards schedular treatment6. The transition economies have never even tried to adopt complicated imputation systems and have at the beginning predominantly chosen separate (linear, flat, lower rate) tax, which has an advantage of simplicity, but also fits into latest trends of linear taxation of capital income in general. The same trend towards the separate tax rate was observed in the developed countries in the end of the nineties and at the beginning of the new century. Even the USA, one of the most stubborn classical system countries, moved in that direction. In the last couple of years, an obvious trend towards dividend exemption in both groups of the countries is observed7. In general, this exemption is more generous in the new EU members (EU 10) and SEE countries, than in old EU members (EU 15), as can be seen from the Tables 1 and 2.8 Now, more than ever, schedular systems, that were earlier mostly present in the transition countries, are now starting to be predominant in the EU, too (Table 1). Among them, separate tax rate and exemption are relatively of the same importance, with the tax credit not to be present anymore. The exemption is mostly partial. However, since trends in the preferential taxation of capital income (especially dual income tax and linear taxation of one or more of capital incomes) have been gaining in importance, it is difficult to classify some systems with flat (one or even two) dividend tax rate. Formally, it is a schedular system, but since other capital incomes could be taxed in the same way (with same rates), it is somehow closer to the classical system, the more capital incomes 5 Iceland abolished the dividend-deduction system in 1999, and Germany the split-rate system in 2000. 6 This trend is especially pronounced now, with Finland and France leaving full imputation system in 2005, Italy in 2004 and Portugal in 2003 7 Not only some transition countries, among them recently Croatia, but also Germany, France, Italy and Portugal recently moved to that system. 8 Tables cover, as usual for this presentation, only tax treatment of domestic-source dividends paid to resident shareholders. being taxed at same rates. So, the Netherlands and Sweden could have been said to have a classical system too9. Table 1: Corporate tax systems in EU 15, Switzerland, Norway, US and Canada in 2005 CLASSICAL SYSTEM IMPUTATION SYSTEM Ireland Canada (partial, modified) Switzerland (most cantons) Norway (full), but will be replaced with exemption in 2006 (an amount equal to a risk-free return on the invested capital will be exempt from tax) Spain (partial) United Kingdom (partial), see also under A SCHEDULAR SYSTEMS: A) Separate (reduced) rate B) Dividend exemption Country Rate Country Rate Austria 25% Finland - for quoted companies: 43% in 2005, later 30% - for non-quoted companies: 100% subject to limitation' Belgium 25% France 50% Denmark 28% for dividends not exceeding DKK 43,300), 43% on any excess Luxembourg 50% Italy 12,5% for smaller shareholders, see also under B Greece 100% Netherlands 30% - in effect classical system3 25% for substantial shares Germany 50% Sweden 30% - in effect classical system3, see also under B Italy 60% for substantial shareholders2, see also under A United Kingdom 10% 32% for higher incomes, see also under Imputation Portugal 50% US 15% (5% for taxpayers in 10% / 15% bracket) Sweden: for SMEs: 70% interest rate on government borrowing multiplied by acquisition value of shares, see also under A ' Finland: 30% (43% in 2005) of dividends from a quoted company is exempt, with the remaining 70% (57% in 2005) being taxed as the shareholder's income from capital (at 28%). For dividends from a non-quoted company, dividends representing an annual yield of up to 9% of the mathematical value of the shares (established for net wealth tax purposes) are fully exempt up to EUR 90,000 per shareholder per year. Thirty per cent (43% in 2005) of such dividends exceeding EUR 90,000 (subject to the 9% yield ceiling) is exempt, with the remaining 70% (57% in 2005) being taxed as the shareholder's income from 9 The final decision by the authors to classify them into the schedular system was also influenced by Jacobs, et al. (2003, p. 9). capital (at 28%). Finally, 30% of any dividend receipts in excess of the 9% yield ceiling is exempt, with the remaining 70% (57% in 2005) being taxed as the shareholder's earned income (at progressive rates). 2Italy from 2004: 60% exemption for individual shareholders, who hold the participation in a business capacity. Individual shareholders not holding the participation in a business capacity are also entitled to the 60% exemption if they own more than 2% of the voting power or 5% of the capital in listed companies, or more than 20% of the voting power or 25% of the capital in other companies (substantial participation). Otherwise, dividends derived by individuals are subject to a final withholding tax at a rate of 12.5%. 3Since the Netherlands and Sweden tax (almost) all capital income at the same rate (30%) as a result of dual tax system in Sweden and almost dual in the Netherlands, their systems are in effect classical systems (not taking into account another tax on dividends from substantial shares of 25% in the Netherlands and 70% exemption for SMEs in Sweden) and could be also classified in that way. The Netherlands has another specific feature - the taxation of savings and investment income is based on a deemed yield on assets. Source: Authors classification and synthesis from IBFD: European Tax Handbook, 2005 In effect, the trends of linearity in the capital income taxation have weakened the solid basis of this classification. It could be even argued that if some other capital incomes are taxed at flat rates, but harder than dividends, it is still separate rate system for dividends; if they are taxed at the same rate as dividends, then the real problem (described above) rises. It is relatively often for EU countries to tax dividends in a two separate way or even combine two methods. UK combines reduced rates and partial imputation system.10 Besides separate rate, Italy has an exemption for substantial shareholders too. Sweden has similar preferential tax treatment for the SMEs. Finland, Denmark and the Netherlands distinguish shareholders' investment/yield/participation also, but inside the same method. The UK, additionally, puts higher rate for higher incomes. As obvious from the Table 2, new EU members and SEE (Turkey is also included here since it is and EU Candidate country) apply either linear tax rate for dividends or their exemption. The only exception is Malta, due to its imputation system, inherited from the former UK system.11 The same problem of classification, pointed out in the Table 1 is present even here in the case of Lithuania, that has in effect dual income tax too, so it could be classified in a classical system. It could be also said, that a full dividend exemption is relatively more used for this group of the countries. 10 Germany had a combination of split rate system (corporate level relief) and imputation system (shareholder level relief) until 2000. 11 The Maltese tax system has its origins in the former British system (until 1965). There is no separate system of corporation tax, and a company is subject to income tax in much the same way as an individual. A full imputation system is used. Table 2: Corporate tax systems in EU 10, SEE and Turkey in 2005 Separate tax rate Exemption Country Rate Country Rate Albania 10% Croatia 100% from 2005 Bulgaria 7% Estonia 100%' Bosnia and Herzegovina min. 10-20%, possible additional 10-20%2 Latvia 100% Croatia 15% - only in 2005 for dividends out of distributed profits from 2004 Macedonia 50% Czech Republic 15% Serbia and Montenegro: Serbia 50% (but a rate on capital income is 20% in comparison with the flat rate on other income (10%)) - in effect classical system Hungary 20% on 30% of the dividends, 35% on the remaining 70% Slovak Republic 100% Lithuania 15% - in effect classical system Slovenia 35% Poland 19% Turkey 50% Romania 10% Serbia and Montenegro: 15% Imputation system: Malta (full) ' Dividends are fully exempt at a shareholder level, but there is a corporate income tax at corporate level. That means that retained profits are completely tax exempt and that only distributed profits are taxed at the corporate level. The «distribution tax» is levied at a rate of 26/74 (approximately 35.14%) of the net amount of the profit distribution (26% on the gross amount (distribution + distribution tax) of the distribution. 2The exact amount of dividend tax depends on the municipalities (only minimum rates stated); additional tax if all incomes exceed yearly ceiling. Source: Authors classification and synthesis from IBFD. (2005): European Tax Handbook, Dzafic, M.(2004): Oporezivanje dohotka fizickih lica u F BiH; http://www.nn.hr: Croatian Income Tax Act, 2004 4. Dividend taxation in Slovenia and Croatia Slovenia and Croatia both use the dividend exemption method. It seems that the Slovenian choice was influenced by the German model, where only half of the dividends received are taxable in the hand of the shareholders. Slovenia has slightly strengthened this relief, since the exempt amount was previously 40% and now 35%. The dividend taxation technique is a little bit more complicated than in Croatia. Dividends are first subject to a provisional 25% withholding tax levied on the gross amount. Annually dividends are aggregated with income from other categories; the taxable base is calculated by grossing up the amount of dividends received by the amount of withholding tax, less 35%. The tax withheld is creditable against the annual tax liability on aggregate income (IBFD, 2005). From 2006 dividends (together with capital gains and interests) will be taxed with separate tax rate 20% (as withholding and final tax). In Croatia the former system of separate (lower) tax rate (15% + local surcharge, if any), which was realized simple by the way of final withholding tax, is replaced by the full exemption in 2005. Still, dividends that are paid to resident shareholders out of last year's profits are still treated in the former way. Furthermore, the new full exemption system is in effect not "new" for Croatia at all. From 1994 until 2001 dividends were fully exempt under the consumption-based tax model - interest adjusted profit (corporate income) tax and interest adjusted (personal) income tax. Both countries have progressive personal income tax system (with highest marginal tax rates of 50% in Slovenia and 45% in Croatia). In Slovenia, only interests on bank current accounts are exempt (others up to 300.000 SIT) and capital gains are taxed at flat rate of 25%. In Croatia, more capital incomes are exempt (interest on bank deposits, on securities, long term capital gains from immovable property, capital gains from securities). Other capital incomes are taxed at the different (flat) withholding rates that are either final tax burden (rents) or could be final tax burden, depending on the taxpayers' decision to file and income tax return at the end of the year or not. 5. Degree of mitigation the economic double taxation of dividends (dividend relief) in Slovenia and Croatia In order to calculate dividend relief, the first ultimate burden when applying classical system (which is the benchmark to calculate the dividend relief) and the ultimate burden of the system in use (integration method) must be calculated. The former is calculated as12 Td = td + m (1 - td) (1) where Td = combined corporate and personal tax on a unit of distributed corporate profits, td = corporate tax rate, m = marginal personal income tax rate. For the schedular system with separate (linear, flat) tax rate on dividend income, which is achieved by the way of final withholding tax, the formula is Td = td + (1-td) w (2) where w = withholding (linear, flat, separate) tax rate. For the shareholders where w = m, the integration method (schedular system) has the same effect as the classical system (this is the case for low incomes). For Croatia this rate was 0,15, which is the lowest marginal tax rate13. For the schedular system, with partial or full dividend exemption, the formula is Td = td + (1-td-e(1-td))m (3) where e = part of the dividend that is exempt from personal income tax. It is 0,35 for Slovenia and 1 for Croatia, where than Td = td. That is, in fact, the same effect as with w = 0. The dividend relief could be expressed as Td- Tds Dividend relief= --(4) Tdc - m where cs denote classical system / schedular system (or any other integration method) in question. The alternative gradual calculation and concrete examples of all the above mentioned measures (tax burdens and dividend reliefs) is presented in Appendix. By applying the stated calculations to the cases of Slovenia and Croatia, we arrive to the results presented in figures 2 and 314. 12 The following formulas are based on the OECD, 1991, p. 245-247 and 254-259 with the author's modifications and additions. 13 It is the formula without local surcharge (surtax). If we include it also (for the municipalities that levy it), the formula is Td = td + (1-td)w + ((1-td)w)p, where p = rate of local surcharge. 14 The ultimate results using the above formulas and the examples could be slightly different due to the rounding of data at one decimal point. Figure 2: Dividend relief in Croatia > 5 m