Tricky Tax Question

Can someone please explain the following question Felix has annual pretax earnings of £300. The corp tax rate on ret earnings is 40% and corp tax rate that applies to earnings paid out as divs is 25%. felix paysout 50% of it’s earnings as divs and indivuda tax rate that apllies to divs is 40%. What’s the effective tax rate on corp earnings paid out as divs? Found it very confusing and don’t really understand the answer which is 55% BTW.

Earnings * ( 1- 0.4) = Post tax earnings. This is taxed at 25% so (1-0.4) ( 1-.25) = .45 goes out as Dividends So Tax rate on dividends = 1- 0.45 = 0.55

Nice simple explanation. Thanks

cpk ur da bomb! according to the schweser quicksheet formula - 0.25 + ((1-.25) * .4)) - .55 would this be the wrong way to do it? the .4 i am using is the individual’s tax rate.

Niraj you are right. I would follow the same formula.

Out of interest what is the formula on the quicksheet? Could you type it out?

its Efffective rate= Corp.rate + (1-corp rate)*(individual rate)

This is another one of those places where remembering a formula is brain clutter that won’t help. Go with cpk’s method above or even more simply: Company earns $1 -> pays 40% taxes which reduces it to $0.6 -> pays it out as dividends which lops another 25% off -> after-tax dividend = 0.75*0.6 = 0.45. So for every $1 they earn, the shareholders get 0.45 and the govt gets 0.55. And the govt takes on no risk. Sigh.

You can trace the life of a dollar between the time it is earned and the time it is in a shareholder’s pocket. First 25 cents is taken away due to the corporate rate on dividends, leaving 75 cents. Then another 30 cents is taken away in personal taxes. That leaves 45 cents in the shareholders’ pocket from the original dollar. Since 55 cents was taken away from the dollar in total, the combined rate is 55%.