How Taxes Affect Dividends and Share Repurchases

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REVIEW OF ‘HOW TAXES AFFECT THE DIVIDEND POLICY AND SHARE REPURCHASES’

Review of ‘How Taxes affect the Dividend Policy and Share Repurchases’

• Dividends and share repurchases are both used by firms as part of their payout policy • According to the Miller-Modigliani dividend irrelevance theory, in the absence of taxes and transaction costs, a share repurchase will result in the same return for shareholders via capital gains as the return that a cash dividend would yield. Hence shareholders would be indifferent between a dividends or share repurchases and dividend policy would be irrelevant. However, taxes and the different stages of the product life cycle into which the firm falls, do affect dividend policy. • Investors will choose their stocks based on their tax bracket and the stocks’ dividend yields. Investors facing high dividend taxes in comparison to capital gains will choose dividends with a low dividend yield and vice versa (Ogden et al, 2003). This means that dividend policies are directly affected by the tax system in which they operate as shareholders will have a preference for higher or lower dividends depending on their particular tax bracket (Bender & Ward, 2002). Firms have to be aware of this and create their dividend policy with their investors and their tax concerns in mind. • The tax system used affects the choice between paying dividends and reinvesting in the firm. The classical tax system imposes a double taxation on dividends as it taxes a company’s profit at the corporate tax rate and taxes dividends declared from profits at the personal tax rate. In some cases, from a shareholders perspective this could mean an effective tax on dividends of above 50% (Hillier et al, 2008). The imputation tax system allows shareholders to have a tax credit and thus, they do not pay a personal tax on some or all of the dividends when the corporate tax has already been paid (Hillier et al, 2008). • Personal taxes on dividends affect a company’s...
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