Corporations distribute profits to shareholders in two main forms: dividends and share repurchases. In a world without taxes and with perfect information, share repurchases and dividends are equivalent.
However, the corporations in Albania appears to treat these two forms of payout very differently in practice. Reducing or terminating regular dividend payments carries a very negative signal and is heavily penalized by investors. In contrast, share repurchases (or one-time special dividend payments) are not seen as a commitment to continue paying in the future, and accordingly announcements of repurchases generate far lower excess returns than announcements of dividends.
Under Albanian tax law, realized capital gains have traditionally been taxed similarly as dividend income, making the way of distributing profits not preferred for the market of capital.
Recent changes to the taxation of company dividends provide an opportunity to analyse how dividend taxes affect firms’ dividend policies, cost of capital, and investment.
The taxation of corporate income can be split into two major categories: classical and imputation. These major categories lead to very different incentives for managers to engage in corporate tax avoidance.
A classical system imposes tax on income at the corporate level and then again at the shareholder level on the dividend distributed. This tax system results in economic double taxation: different taxpayers are taxed on the same income.
In a classical tax system, a money saved through corporate tax avoidance reduces the overall tax burden, increases the after-tax cash flows to shareholders and gives managers an incentive to avoid taxes on the shareholders’ behalf. Modified classical systems, which have preferential shareholder tax rates on dividends relative to interest, provide managers with the same incentive for corporate tax avoidance. While the shareholder-level tax burden is reduced by the preferential tax rate, the corporate-level tax burden is not, and money saved through corporate tax avoidance still reduces the overall tax burden and increases after-tax cash flow to shareholders.
Another tax system, an inclusion system, also lowers shareholder-level taxes but not corporate-level taxes. Rather than having preferential shareholder tax rates for dividends like the modified classical system, shareholders receive a preferential tax base in an inclusion system because only a portion of the dividend is included in their taxable income. As a result, inclusion systems, modified classical and classical tax systems, incentivize managers to engage in corporate tax avoidance in order to return more after-tax cash to their shareholders.
Other countries impose only a single layer of taxation on corporate income through an imputation system, also known as an integrated system.
An imputation system imposes a tax on corporate income, but the shareholder receives credits for the taxes paid by the corporation such that the shareholder pays only the difference between the corporate tax rate and the shareholder’s tax rate on dividends. As a result, the overall tax burden on dividends in an imputation system is equivalent to the shareholder’s tax burden and corporate tax avoidance simply shifts the tax payments from the corporation to the shareholder.
To demonstrate the incentives for corporate tax avoidance under classical and imputation systems of taxation, let’s develop the following example.
Assume that two identical “all equity” firms exist in two different countries. One operates under a classical system (Firm C) and one operates under an imputation system (Firm I). Both countries have a corporate tax rate of 30% and the shareholders of the firm in each country face a dividend tax rate of 50%. We also assume that each firm earns $100 in taxable income annually, pays all taxes in cash and distributes any remaining after-tax income as cash dividends.
Case 1. Without corporate tax avoidance
In our first case, we assume that firms cannot engage in tax avoidance. Both firms earn $100 of taxable income and pay $30 in corporate taxes. Thus each firm distributes a $70 cash dividend to their respective shareholders.
In the country with a classical system, Shareholder C pays $35 in individual taxes on that $70 dividend. In total, the government with the classical system receives $65 in taxes ($30 corporate, $35 individual) and Shareholder C receives $35 after all taxes are paid.
In the country with an imputation system, Shareholder I receives the same $70 cash dividend but pays a different amount of individual taxes.
First, Shareholder I’s taxes are determined based on Firm I’s taxable income (i.e. the entire $100 of taxable income). In other words, Shareholder I pays tax on the dividend, which is “grossed-up” to account for the corporate taxes. The tax owed on the grossed-up dividend is $50 ($100*50%) before any imputation credits.
Second, Shareholder I receives imputation credits equal to the corporate taxes paid ($30) which reduces Shareholder I’s tax burden from $50 to $20. In total, the government with the imputation system receives only $50 in taxes ($30 corporate, $20 individual), which is equivalent to the shareholder tax burden and Shareholder I receives $50 after-taxes. In the absence of corporate tax avoidance, Shareholder I receives more after-tax cash than Shareholder C because the imputation system avoids the double-taxation penalty of a classical system.
Case 2. With corporate tax avoidance
We assume that managers from Firm C and Firm I chose to engage in corporate tax avoidance that costs $10 and generate a non-cash deduction of $90 for tax purposes. At the corporate-level, Firm C and Firm I continue to be identical. Each firm still earns $100, but now spends $10 to engage in corporate tax avoidance. The $10 is deductible and yields an additional $90 deduction for tax purposes with no additional cash outflow.
Therefore, taxable income is zero for both firms ($100-$10-$90), but after-tax cash flow is $90 to each firm. Under the classical system, Shareholder C receives a cash dividend of $90 and pays taxes of $45. Under the imputation system, Shareholder I also receives a $90 cash dividend and pays the same $45 in taxes as Shareholder C. The dividend gross-up is not needed and the imputation credit is not available to Shareholder I because Firm I did not pay any corporate taxes.
In this tax avoidance case, both firms reduce the corporate tax rate from 30% to 0% and report higher after-tax cash flow but only Shareholder C is better off relative to Scenario 1 ( $45- 35 = $10); Shareholder I is worse off ($45-50 = -$5). If the managers of Firm I are strongly aligned with Shareholder I’s interests, they will not engage in the corporate tax avoidance. Conversely, the managers of Firm C have incentives to engage in corporate tax avoidance to benefit Shareholder C. Thus, firms in imputation countries have lower incentives for corporate tax avoidance than firms in classical countries.
Based on the difference between country-level shareholder dividend tax policies, we predict that firms from countries with imputation systems have less corporate tax avoidance than firms from classical systems. To test this prediction, while controlling for confounding variables, we employ two difference-in-differences analyses as our primary research designs.
Imputation systems remove the shareholders’ incentive for corporate tax avoidance without affecting managers’ private benefits. Firms, which reside in countries with an imputation system, where the shareholders do not have the incentive to avoid corporate tax, have less corporate tax avoidance.
This differential in corporate tax avoidance between imputation and classical tax systems is accentuated in closely-held companies where the manager-shareholder alignment is stronger. Furthermore, firms in countries that switch from an imputation to classical system experience an increase in corporate tax avoidance.
Tax avoidance could decrease as a result of the implementation of an imputation system. Our study is the first to provide evidence that shareholder dividend tax policy, which has been the focus of extensive research for its effects on firm value and investment, significantly relates to corporate-level tax planning.
 Which is implemented in Albania