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Distributing Company Profits - Shareholders Salaries & Dividends 

 
Grange Associates Ltd - 26 April 2012 (updated 24 May 2012)

Distributing Company Profits

Essentially there are two ways that closely held companies can distribute trading profits to shareholders. Their profits can either be allocated to shareholders as shareholders salaries or they can be distributed as dividends.

Shareholders Salaries

Shareholders salaries, which are sometimes also designated as being directors fees, must be paid to individuals and are deducted before calculating the company’s taxable income. For income tax purposes they are treated in a manner similar to other wages and salaries expenditure, except PAYE is not normally deducted. Instead shareholders include the salary on their personal income tax return for the same year as the company takes the deduction and pay income tax thereon at their marginal tax rate. Because shareholders salaries are not taxed at source through the PAYE system the shareholders usually become provisional taxpayers. The company pays ACC levies on shareholders salaries in the normal manner, albeit on a different account.

Dividends

Whereas shareholders salaries are paid “above the line”, dividends distribute the company’s after tax profit. The tax paid surplus is accumulated in the company’s retained earnings account and dividends are distributed through the appropriation account. Unlike shareholders salaries which are allocated on the basis of effort, dividends must be paid in proportion to shareholdings. Unless a shareholder has an exemption certificate generally dividends must carry tax credits equivalent to 33% of the gross value. Generally the tax credits come in two forms, imputation credits and resident withholding tax.

Imputation Credits

Imputation credits allocate the income tax paid by the company to its dividends so as to avoid double taxation on the company’s profits. To understand how this works please consider the following example in which a company tax rate of 33 cents in the dollar is assumed.

Profit before tax 

 10,000

Less income tax at 33% 

 3,300

Profit after tax 

 6,700


The company has $6,700 in tax paid profits available to pay out as a dividend.

Net dividend paid

 6,700

Add imputation credits attached 

 3,300

Gross dividend 

 10,000


 

From the shareholder’s perspective and assuming a marginal tax rate of 33 cents in the dollar, the above dividend will appear on their income tax return as follows.

 

Dividends received 

 10,000

Income tax payable at 33%

 3,300

Less imputation credits received 

 3,300

Residual income tax payable 

 Nil

 

Resident Withholding Tax (RWT)

RWT is payable on company dividends at a rate of 33 cents in every dollar of the gross dividend, less any imputation credits attached to that dividend. The above simple example accurately presented the situation as it was when the company tax rate was 33 cents in the dollar and no additional RWT was required.

However, since the reduction in company tax rate to 30 cents in the dollar and now to 28 cents in the dollar, imputation credits could only be attached at a rate of 30% up to 31 March 2013 and, for current and future year tax payments, 28%. This creates a shortfall in the tax paid on the dividend and RWT must be paid on the difference.

To demonstrate this, please consider the following example based on the current company tax rate of 28 cents in the dollar.

 

Profit before tax 

 10,000

Less income tax at 28%

 2,800

Profit after tax 

 7,200

 

The company has $7,200 in tax paid profits available to distribute but must ensure that it pays sufficient RWT so the total credits attached represent 33% of the gross dividend. In this case the required RWT is $500 ($7,200 x 5%/72%) leaving a net dividend payable of $6,700 ($7,200 - $500).

 

Net dividend paid 

 6,700

Add RWT paid 

     500

 

 7,200

Add imputation credits attached 

 2,800

Gross dividend 

 10,000

 

From the shareholder’s perspective and assuming their marginal tax rate is 33% the above dividend will appear on the shareholder’s income tax return as follows.

 

Dividends received 

10,000

Income tax payable at 33% 

 3,300

Less imputation credits received 

 2,800

Less RWT 

 500

Residual income tax payable 

 Nil

 

The RWT is due for payment to Inland Revenue on the 20th of the month following the dividend payment date and should accompany an IR4K.
 

ICA Account

As stated above imputation credits allocate the income tax paid by the company to its dividends. This process is managed through the ICA Account which is a “memorandum account” maintained parallel to but not as part of the company’s general ledger.

The ICA balance represents the cumulative total of all the company’s income tax transactions (payments, withholding tax on interest received, ICA credits received, use of money interest, penalties, refunds) less all ICA credits attached to past dividends paid. Credits increase the balance while debits reduce it.

The key stipulation imposed on ICA accounts is that as at 31 March each year the account must have a credit balance (ie cumulative credits exceed cumulative debits). The following example has a closing credit balance of $1,208. Had the ICA credits attached to the dividend paid been $9,200 the account would have had a closing debit balance of $792 which would have incurred a $79.20 penalty.

 

Balance 1 April 

 1,000

Credit

Add income tax paid 

 8,500

Credit

Add withholding tax on interest received 

 
1,200


Credit

Add use of money interest received 

 554

Credit

Less refund 

 2,846

Debit

Less ICA credits attached to dividend paid 

 
7,200


Debit

Balance 31 March 

 1,208

Credit

 

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All information is correct at the date of article publication. Please note we provide the information as a service only. Accordingly, the contents are not intended as a substitute for specific professional advice and should not be relied upon for that purpose.   


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