Neutrality of a dividend imputation system under the Modigliani-Miller proposition

Abstract

In 'The Cost of Capital, Corporation Finance, and the Theory of Investment' (American Economic Review, June 1958, 48(3), pp. 261–97) and 'Corporate Income Taxes and the Cost of Capital: A Correction' (American Economic Review, June 1963, 58(3), pp. 433–43), Modigliani and Miller (M&M 1958, 1963) demonstrated that the value of a firm consists of the present value of uncertain future income and the present value of certain income, and that the tax shield will increase the value of a firm in the presence of tax deductibility of the interest payments on debt. However, often criticized is the double taxation of income received by the stockholders from the firm. In a classical taxation system, the double taxation happens because the income is taxed at a firm’s level first and then at a stockholder’s level when the income is delivered to them. Some countries, such as Australia, Canada, and the UK, have removed the double taxation and adopted a dividend imputation system where the amount of tax charged at the firm’s level will be credited back to the stockholders when they receive cash dividends. The most representative one is the system in which a firm is taxed at the corporate tax rate and such taxes are notionally pooled as franking credits. When cash dividends are paid, an amount equal to the cash dividends times the corporate tax rate will be given back to the stockholders as a tax credit.