ENTRETELONES DEL PACTO PARTIDOCRÁTICO.

Franking credits (also called imputation credits) are of value to resident shareholders who can claim the credits as tax offset against their personal tax liabilities. However, franking credits have no value unless passed to shareholders via dividend distributions. Thus, as proposed by Howard and Brown (1992), the introduction of the dividend imputation system creates a bias towards dividend payments. Monkhouse (1993) demonstrates that, with dividend imputation, the optimal dividend policy is to pass franking credits to shareholders on a timely basis to avoid the loss of value as time passes. Nigol (1992, p. 42) argues that ‘companies should pay dividends to the limit of their franking account balances’.

Indeed, significant increases in dividend distributions are observed in the post-imputation periods in Australia. A study published by the Reserve Bank of Australia documents an approximate 38% increase in real dividends per share between 1985/1986 and 1990/1991, and estimates that about 20% was attributable to tax changes, including the introduction of the dividend imputation system in 1987 (Callen, Morling & Pleban 1992).30 Recent data from the Australian Taxation Office show that, since the introduction of the imputation system, at the aggregated level, the number (value) of franked dividend

30 _{The other changes include the introduction of the capital gains tax and the taxation of the earnings of}

payments in 2012/2013 was around 4.4365 (6.6786) times as large as that in 1989/1990, despite the almost doubled number of companies included in the sample over the period (Australian Taxation Office 2015b).

In the academic literature, Bellamy (1994) find that increases in dividends are greater for companies distributing franked dividends than for companies distributing unfranked dividends. Pattenden and Twite (2008) report that companies raise their dividend initiations, dividend payouts and DRPs in the post-imputation periods. Brown, Handley and O’Day (2015) and Henry (2011) show that Australian companies use off-market share repurchases to distribute franking credits in excess of the needs of ordinary dividends.

The prevalence of franked dividends in Australia can be largely explained by the tax benefits of franking credits, as well as the signalling effect of taxed corporate profits from which franked dividends are distributed. Specifically, distributing fully franked dividends allows companies to pass the corporate income tax to shareholders as franking credits, which can be used to offset shareholders’ tax liabilities. This means that distributed corporate profits are only taxed in the hands of shareholders at their personal tax rates. Thus, corporate income tax becomes only a pre-payment of shareholders’ tax and does not reduce shareholders’ after-tax returns.

This tax offset benefit is more profound for superannuation funds that comply with superannuation regulations and are taxed at a rate of 15%—that is, only half the STR of 30%.31 Thus, upon claiming the 30% franking credits from fully franked dividends received, superannuation funds can not only reduce the dividend income tax to zero, but can also reduce the tax liabilities on their other income or obtain a tax refund. This generous tax benefit is so evident that investing in companies that pay franked dividends is recognised and used as an active practice to manage taxes of funds (Mackenzie & McKerchar 2014). Apelfeld, Fowler and Gordon (1996) show that tax-aware investment funds outperform tax-unaware funds on an after-tax basis. Jun, Gallagher and Partington (2011) report that pension funds are overweight in shares with fully franked dividends, and underweight in shares with partially franked or unfranked dividends. It is clear that superannuation funds exhibit an investment preference for companies distributing fully franked dividends. Given that superannuation funds are the major shareholders of listed

Australian companies, their investment preference encourages a high level of franked dividend distributions.32

Apart from the tax benefits associated with franking credits, the pervasiveness of franked dividends in Australia can also be explained by the signalling effect of taxed corporate profits. To be more specific, taxed corporate profits from which franked dividends are distributed are perceived as more persistent than untaxed corporate profits because they contain less management discretions. Coulton, Ruddock and Taylor (2014, p. 1310) propose that ‘dividend and their tax status are expected to serve a signal of earnings persistence’. They find that companies distributing fully franked dividends have significantly more persistent earnings than do companies distributing unfranked dividends. Similarly, a number of studies—such as those by Blaylock, Shevlin and Wilson (2012); Hanlon (2005); Jackson (2009); and Weber (2009)—show that larger BTD is associated with less persistent earnings.

Earnings persistence is an important consideration when making investment decisions. Thus, for companies distributing unfranked dividends (possibly because of insufficient franking credit balance as a result of insufficient payment of domestic corporate income tax) or companies with large BTD (indicating possible earnings management), shares may be undervalued. Prior studies show that investors reduce their expectations on earnings persistence for firm-year observations with large BTD (Hanlon 2005) and rely on current earnings to a lower extent (Joos, Pratt & Young 2000). Moreover, Hanlon (2005) finds that analysts view large BTD as a red flag for future earnings problems and produce less optimistic (less negative) forecast errors (the difference between realised earnings and forecast earnings).

In short, the tax benefits of franking credits and the positive signalling effect of taxed corporate profits explain shareholders’ preference for franked dividends, hence the increased prevalence of franked distributions by Australian listed companies. To avoid adverse reactions from shareholders, companies typically adopt stable dividend policies (e.g. Brav et al. 2005; Denis & Osobov 2008; Lintner 1956). This means that companies distributing franked dividends for a particular year are likely to have been and continue distributing franked dividends. To keep a stable dividend policy of making franked

32 _{Australian institutional investors, largely consisting of superannuation funds and managed funds, were}

the largest single class of investor of listed Australian equities before 2007. From 2007 to 2010, their ownership remained at around 45% (Black & Kirkwood 2010).

distributions, companies need to constantly pay sufficient Australian corporate income tax to maintain a sound franking credit balance. Thus, the current study hypothesises that companies distributing more franked dividends engage in less corporate tax avoidance than do companies distributing less franked dividends, as engaging in tax avoidance arrangements not only reduces franking credit availability, but also requires substantial tax planning costs. This leads to the first hypothesis in this chapter:

Hypothesis 4.1: Ceteris paribus, companies with higher franked dividend distributions engage in less corporate tax avoidance (and thus have higher CETR) than do companies with lower franked dividend distributions.

This hypothesis is similar to the one tested in Ikin and Tran (2013); however, Ikin and Tran (2013) do not incorporate a foreign ownership measure in their regression model because of data paucity. As will be discussed in the following subsections, this study simultaneously considers franked dividend distributions, foreign ownership and foreign operations.