Chartered Financial Analyst Level 2

Explanation

In a split-rate tax system, the effective tax rate on distributed earnings can be calculated using the formula:

Effective Tax Rate = Corporate Tax Rate on Dividends + (1 - Corporate Tax Rate on Dividends) × Shareholder Tax Rate on Dividends

Given:

• Corporate tax rate on earnings allocated to dividends = 15%
• Marginal shareholder tax rate on dividends = 40%

Calculation:

• First, the corporate tax is applied: 15% of pretax income
• The remaining amount after corporate tax: 100% - 15% = 85%
• Then the shareholder tax is applied to the dividend: 40% × 85% = 34%
• Total tax burden: 15% + 34% = 49%

Alternative calculation: Effective Tax Rate = 15% + (1 - 15%) × 40% = 15% + 85% × 40% = 15% + 34% = 49%

Therefore, the effective tax rate on pretax income distributed as dividends is 49%.

Why not the other options:

• 40%: This is only the shareholder tax rate, ignoring the corporate tax component
• 58%: This would be too high and doesn't match the calculation

The corporate tax rate on retained earnings (30%) is not relevant here since we're assuming a 100% payout ratio, meaning all earnings are distributed as dividends.