How Taxes Affect Dividend Policy

Personal taxes on dividends can profoundly affect a firm's choice between paying dividends and repurchasing shares. Because the pretax proceeds from both strategies are equal, the only difference between the two methods of cash distribution is the amount of the tax liability generated by each.

The Tax Disadvantage of Dividends. Exhibit 15.4 details the immediate tax consequences to an individual investor, if a firm chooses to distribute $100 million in the form of a dividend versus distributing $100 million as a share repurchase. It assumes that the investor currently owns 10 percent of the outstanding shares and plans on maintaining the 10 percent ownership. It also assumes that the shares, if repurchased, will be repurchased at a price of $50 a share and that they were originally purchased at a price of $38 a share. It uses 35 percent as the tax rate on dividends and 20 percent as the tax rate on capital gains.

Although the immediate tax liability is considerably higher with the dividend alternative, the future tax liability incurred by shareholders when their shares are eventually sold is higher when shares are repurchased. This is because the share prices drop by the amount

6Until 1982, the tax on dividend income in the United States could be as high as 70 percent while capital gains were taxed at 50 percent of the ordinary rate. With the passage of the Tax Equity and Fiscal Responsibility Act of 1982, the maximum tax on dividends fell to 50 percent and that on capital gains was reduced to 20 percent. Since 1987, the maximum tax rate on dividends has fluctuated between 33 percent and 39.6 percent, while the rate on capital gains has fluctuated between 20 percent and 28 percent. Under the 2001 tax bill, the highest rate on ordinary income is scheduled to decline in increments to 35 percent by 2006.

Exhibit 15.4 Tax Consequences: Dividend versus Share Repurchase (in $ millions)

Dividend Alternative

Dividend

$100.0

Tax rate

X 35%

Immediate tax liability

$ 35.0

Share Repurchase Alternative

Proceeds from sale of 2 million shares

$100.0

Less original cost (at $38/share)

- 76.0

Taxable capital gain

$ 24.0

Tax rate

X 20%

Immediate tax liability

$ 4.8

of the dividend when a dividend is paid, making the future capital gains lower for shareholders who purchased stock prior to the dividend. However, the total amount paid in taxes (and its present value) is still considerably lower with the repurchase alternative.

Result 15.3 In the United States, taxes favor share repurchases over dividends. The gain associated with a share repurchase over a cash dividend depends on:

• The difference between the capital gains rate and the tax rate on ordinary income.

• The tax basis of the shares—that is, the price at which the shares were purchased.

• The timing of the sale of the shares (if soon, the gain is less, but if too soon, the gain may not qualify for the long-term capital gains rate).

Can Individual Investors Avoid the Dividend Tax? Miller and Scholes (1978) claimed that individual investors should be indifferent between repurchases and dividends because they can avoid the tax on dividends. Their dividend tax avoidance scheme is quite simple: An individual borrows money and invests in tax-deferred insurance annuities. The interest on the loan is tax deductible and can offset the taxable dividend income but not the individual's labor income. However, the tax on the insurance annuity can be deferred indefinitely. These transactions are illustrated in Example 15.3:

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