Questionable Yield

The White House wants dividends to be tax-free. But will companies pay out?
Craig Schneider and Tim ReasonApril 1, 2003

Eliminating the double tax on corporate dividends — the centerpiece of George W. Bush’s latest tax plan — is by no means a new idea in Washington, having been kicked around in one form or another at least since Jimmy Carter’s Administration. This time, though, the idea has a fighting chance of becoming reality. Despite President Bush’s initially clumsy promotion of the dividend tax cut as a short-term economic stimulus, the basic issue of not taxing profits twice plays well with some centrist Democrats as well as Republicans. The question is whether a deficit-wary Congress is willing to gamble on another huge ($364 billion) tax cut when an expensive war with Iraq looms.

For CFOs of companies that don’t issue dividends, the main question is whether a dividend tax cut will change their minds. Certainly, given the current pessimism on Wall Street, a regular payout can make a stock more attractive. There’s also the cachet of financial integrity that a dividend confers on a stock (though both WorldCom and Enron paid dividends). During the bull market, no self-respecting technology firm would have dreamed of issuing a dividend, but today, some tech outfits are having second thoughts.

In January, Microsoft announced an 8 cent dividend, a yield of 0.34 percent. That’s tiny compared with the S&P 500’s 1.75 percent, and a token gesture for a company with $43.4 billion in cash. Still, the announcement represents a remarkable change in attitude. In February, wireless-communications provider Qualcomm Inc. became the latest tech payer of dividends. A dividend tax cut would no doubt persuade other tech firms to follow suit.

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Nonetheless, there are several reasons why a sudden wholesale shift to dividends is unlikely. First among them is the long-held view that dividend-paying stocks attract a distinct class of investors who seek stable returns — the sort of returns provided by mature, slow-growth businesses. The dividends issued by companies in younger, more-volatile sectors will have greater yield volatility, and some companies may even pay one-time dividends. Would such variation in payout attract the usual dividend-seekers?

Slow and Steady Wins

Jim Judge, CFO of Boston-based utility Nstar, doesn’t think so, although he’s strongly in favor of Bush’s plan. “Dividend-sensitive investors like predictability,” he says. He should know. Nstar is the holding company for electric utility Boston Edison; together, they have paid dividends for 455 consecutive quarters — almost 114 years. Even the rate of dividend growth (roughly 3 percent a year) is deliberately held steady. When Nstar sold six fossil-fueled power plants and its nuclear power plant in the late 1990s, the company did not increase the dividend, but instead returned a portion of the one-time gain to shareholders through share buybacks.

By contrast, CFOs of companies that don’t pay dividends say their investors would view a payout with suspicion. “Part of the subtext to [issuing a] dividend is the acknowledgement that growth opportunities aren’t as robust as they were before,” explains Harlan Plumley, CFO of Lightbridge Inc., a microcap telecommunications software and services firm in Burlington, Massachusetts, that doesn’t pay dividends. Plumley says the Bush proposal might diminish the dividend stigma enough to provide an alternative, if secondary, source of capital for high-growth companies. “But it is still not going to be an easy decision for small- to midcap companies,” he adds.

In fact, another reason there won’t be a rush to issue dividends is that the Bush plan offers an alternative for companies that prefer to reinvest their earnings. Companies retaining profits that would otherwise qualify to be paid out as tax-exempt dividends will be allowed to declare a phantom payment. This “deemed dividend” will increase the cost basis of a shareholder’s stock, thereby reducing capital-gains taxes when the shares are sold.

That’s a deliberate attempt to maintain a balance between dividend payments and reinvestment, but it also inadvertently discourages yield volatility and the payment of one-time dividends. Although tracking changes in cost basis is a relatively simple bookkeeping matter for a corporate finance department, Bear, Stearns & Co. analyst Pat McConnell calls the proposal “a tax-planning nightmare” for investors. Companies will be able to calculate the amount of the previous year’s income that is eligible for tax-free distribution at the beginning of the current year. But, she notes, unless they also announce how much of it they plan to distribute and how much they plan to retain — and stick to that plan throughout the year — investors will be unable to calculate the taxability of their dividend or their potential capital gain with any certainty. That is likely to reinforce the conviction among CFOs that investors prefer stable, predictable dividends.

Simplification It’s Not

Indeed, to CFOs, what makes the Bush plan so complex is not its administration, but the various effects it may have on investors. David Wyss, chief economist at Standard & Poor’s, echoes McConnell’s assessment, calling the Bush tax plan “a full-employment act for tax accountants and tax lawyers.” Making dividends tax-free would be far easier if companies could simply deduct them, as they now do with interest payments on debt. But of the $409 billion paid out last year in dividends, more than half went to tax-exempt institutional investors or tax-deferred retirement plans. That means that shifting the tax break to dividend payers could almost double the cost of the plan.

The Bush proposal makes dividends tax free only to the extent that the corporation has already paid the full 35 percent corporate tax rate on them — the so-called excludable dividend amount, or EDA. But the average corporate rate for most companies is actually only 23 percent. Indeed, a study by McConnell of 2001 dividend payments by the companies in the Dow Jones Industrial Average suggests that only 11 of those 30 companies would be able to issue fully tax-free dividends if they continued to pay the same amounts under the Bush plan.

Much has been made of the fact that the proposal might actually dissuade companies from pursuing tax-avoidance strategies. But CFOs are likely to find themselves caught between individual investors lobbying for an end to such strategies and institutional investors that will no doubt continue to prefer any measure that increases earnings. “I still think it is going to be in the best interest of any corporation to take advantage of opportunities to minimize its tax,” says Bill Hibbitt, vice chair of tax operations at KPMG LLP.

Tell-All Tax Cut?

Regardless of a company’s strategy, the proposed dividend tax cut has implications for financial disclosure. To fulfill their purpose of providing investors with the information needed to make an investment decision, future financial statements presumably would have to include EDA. Investors might also demand prior-year information about actual tax paid, foreign tax credits, tax deductions taken for exercised employee stock options, and other tax-related information that often goes undisclosed today. “It wouldn’t be at all surprising if there was an expansion of the tax footnote, at least to disclose EDA,” notes Hibbitt. Wyss goes even further, suggesting companies might have to disclose Internal Revenue Service Schedule M-1, which reconciles their reported income with taxable income, or even their entire tax return.

That may be overstating the case. Still, at the very least, says Hibbitt, “one of the interesting side effects of this [plan] is that readers of the financial statements are going to have a better understanding than ever before of what tax was paid to the IRS.”

Tim Reason is a senior writer at CFO. Craig Schneider is an assistant editor at