Dividends: Taxation, Integration, and Mental Accounting
How faith often trumps logic in dividend investing – and why it shouldn’t
By: Jason Pereira Editor & Contributor: Alexandra Macqueen
One of the first theories university finance students learn is Modigliani-Miller irrelevance theory: the idea that a company’s dividend policy is largely irrelevant to investors because they can always generate cash flow from their shares by selling them.
In the real world, however, one of the first things you learn as a financial advisor is that despite this theory, investors love dividends. To be fair, the allure is easy to understand. I know I feel good when I get money handed to me with no effort on my part.
Does this mean that dividend irrelevance theory doesn’t hold up outside the ivory tower? Nope: Modigliani and Miller are right – and investors’ love of dividends is really just mental accounting at work.
A Dollar is A Dollar is A Dollar
In theory, a corporation should only seek to distribute after-tax cash to shareholders when it has exhausted all capital expenditures that meet its required rate of return.
If a company opts to distribute cash, however, it has two options: dividends or share repurchases – and the choice doesn’t matter, which is clearly borne out by the math.
Consider three companies who each have a $100 million dollar valuation and $20 million in cash:
Company A chooses to hold onto the $20 million to fund future operations. The total value held by shareholders is $100 million.
Company B pays a dividend of $10 million. Its shareholders now hold $10 million, and the company is now worth $90 million. As with Company A, the total value held by shareholders is $100 million.
Company C decides to buy back $10 million in shares. Post repurchase, the company is worth $90 million, and the shareowners who participated in the buyback have $10 million in cash. Once again: total shareholder value equals $100 million.
As you can see, while the decision about how (or whether) to distribute cash may be relevant to operations, to shareholders it is irrelevant.
It Always Comes Back to Factors
If that simple example doesn’t convince you, there’s plenty of academic backing to support it. Take a look at this episode of Ben Felix’s Common Sense Investing, in which he takes the same stance as I do – but gets further into research by Dimensional Fund Advisors and the legendary academics Eugene Fama and Kenneth French. (Podcast spoiler alert: Dividend stock outperformance is largely the value factor “in disguise,” and dividend growth outperformance is really the value, profitability, and investment factors combined.)
Furthermore, the dividend yield factor has been handily beaten by other factors. Consider this graph from Research Affiliates that plots various factors, versus their volatility, for developed markets since 1989. As you can see, Dividend Growth (1) and High Dividend Factor (2) stocks had a lower return than Value stocks (3), and were also lower than Quality, Size and Low Volatility stocks.
Source: Research Affiliates Smart Beta Interactive
The Tax-Man Cometh
Now we can get to the real point of this article, which is (you guessed it) tax.
While I've read many articles over the years on dividend irrelevance, none of them have viewed it through the lens of the Canadian tax system and one of its foundational biases when it comes to corporations: integration.
To review, integration is the principle that no Canadian should be better off, from a tax point of view, if they draw money from a company as dividends or earn it as interest. That is, the tax bill on $1 should be identical no matter where the dollar is coming from – dividends, interest income, or earned income.
Given that corporations pay tax, and dividends are paid from after-tax profits, this means that tax on dividends must be lower than on income – so that the tax paid by the corp is “integrated” into the tax paid by the individual. (This goal is accomplished by a system of “grossing up” the amount of dividends reported on the individual tax return, and then applying a dividend tax credit to offset the tax bill that would otherwise arise.) This system of integration works pretty well, but as there are 13 provincial and territorial jurisdictions each with their own tax systems, in addition to overall federal rates, integration is more often “close” than perfect.
Accountants and financial planners spend a lot of time talking about tax integration with their business-owner clients – but when it comes to publicly traded companies, however, more often than not everyone just reverts to thinking about dividends as “tax-efficient income.”
But reaching this conclusion is actually a form of logical fallacy, specifically mental accounting – a form of bias that has no place in logic or reason (or your portfolio).
When 39.34% Doesn’t Equal 39.34%
Let’s imagine a Canadian publicly-traded company generates a $100 million pre-tax profit. For simplicity’s sake, we’ll assume it’s all earned in Canada, and subject to Ontario tax rates.
In this case, the corporation would pay the combined federal and provincial general rate of 26.5%, leaving it with $73.5 million after the tax bill is paid.
Again for simplicity, let’s say that the entire $73.5 million is paid out as eligible dividends, and thus taxed in the recipient’s hands at the top marginal rate on eligible dividends of 39.34%.
After taxes, this leaves the recipient with $44,585,100. The total combined tax rate on that income: 55.41%. The top marginal rate for income in Ontario? 53.53% – nearly two percentage-points lower (it’s 1.88% lower, to be precise).
To make matters worse, Canada’s Old Age Security program bases its clawback calculation on gross income, i.e., including grossed-up dividends. If you’re an OAS recipient – which 90%+ of Canadians over 65 are – that when dividends are grossed up for tax purposes, the clawback is applied without consideration for the dividend tax credit.
The end result: marginal tax rates and clawback to result in effective tax rates that can actually be in excess of 56%.
Are Share Buybacks the Answer?
What if, instead, the after-tax profit was used to buy back shares, instead of issuing dividends?
In that case, the tax calculation is not as simple, because the individual’s tax situation would depend entirely on the cost base of their shares.
But, in general terms, an amount that triggers a taxable gain would be taxable at 26.77%. The resulting combined tax rate would be 46.18% – or fully 7.35% lower than the top marginal tax rate. That’s a 9.23% tax-rate advantage over dividends!
Keep in mind this is the worst-case scenario. In actuality, the tax situation would depend on both the client’s cost base and if they even choose to participate in the buyback at all.
Factoring in Foreign Dividends
Finally, when it comes to foreign dividends the situation can be even more punishing still. Foreign dividends are fully taxable at full marginal tax rates of up to 53.53% (Ontario rates here) and here integration does not apply.
If Canada has a cross-border tax treaty with the country where the company is domiciled, at best an investor can get the foreign income tax credit on taxes paid in other countries, but there is no consideration for corporate taxes paid.
In our example, if the company was based in the US, the dividends would be subject to a 21% corporate tax rate, and our investor would end up with a combined tax rate of 63.39% on dividends received – while buybacks would have a combined tax rate of up to 42.14%
No (Tax) Shelter
Thus far, all of our examples have used taxable accounts – but the situation is even worse when dividends are held in tax-sheltered accounts (RRSP/RRIF/DC Pension/LIRA etc.). That’s because the tax on the dividends paid to the account is not eliminated, but simply deferred – and then taxed as full income when withdrawals are made from that account.
Only within a TFSA is there any tax advantage to receiving Canadian dividends, but to be fair, all forms of income are tax-advantaged in a TFSA. As for foreign dividends, you are actually worse off given you wont qualify for the foreign dividend tax credit on holdings within a TFSA.
More Mental Accounting
Let me stop here with a quick aside, when I point all of this out to “dividend junkies” (I mean “dividend lovers”) they often fire back with “yes, but it's the corporation paying that tax, not me, so why should I care?”
The rebuttal is simple: The company is paying dividends because it has cashflow that exceeds its capital expenditure needs. If corporate-tax rates were dropped to zero, they would have more money to pay in dividends. Even if they didn’t change their payout ratio, the net payout would be higher given that the after-tax profit would be higher. Conversely, if tax rates doubled, you can pretty much bet that dividends would go down.
Here’s the bottom line: The investor thinks they are receiving a dollar when in actuality they are actually getting the 74 cents left over after corporate taxes. The real test is how much of a pre-tax dollar ends up in an investor’s hands after Ottawa (and your provincial capital) has chipped away at it from all sides.
Faith Is A Powerful Thing
I have presented this argument to more than one dividend junkie, and I usually encounter nothing but resistance as the belief in dividends seems to be one that encourages near-religious zeal.
In the end, dividends are just one factor or element in your overall portfolio, and not the be-all and end-all unicorn-like source of tax-efficient income that most people believe. In fact, dividends are, in actuality, both irrelevant and inefficient.