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Trying to comprehend the dichotomy of dividends

Denver Business JournalOn the Money
From the May 16, 2003 print edition

For years there has been a dichotomy surrounding dividends. Fundamentally, it’s because while dividends represent an attractive characteristic for investors seeking income (rather than growth) from their portfolios, dividend payments are not a tax-deductible expense for the company issuing them. At the same time, dividend income is taxable to the person receiving them at the time of delivery. This creates the infamous “double dividend tax.”
Another way to look at it is Company A earns $100, pays out $25 of tax-deductible expense, pays tax on $75 at 34 percent of $25.50 leaving a return of $49.50.
Company B earns $100, pays tax on $100 at 34 percent of $34, and then pays a dividend of $25 making its return $41; $8.50 lower than

Company A with the same earnings. In addition, the receiver of the dividend from Company B pays tax on $25 as income.

To maintain “tax efficiency” corporate tax avoidance (not to be confused with evasion), has increased. Firms are engaging in strategies that are more aggressive to shield income from taxation through tax shelters and other means.
A recent analysis published by the National Bureau of Economic Research found that the gap between what corporations report as profits to their shareholders and the profits reported to the IRS for tax purposes has grown sharply over the past decade.
The study finds that $154 billion cannot be explained by traditional accounting differences, indicating higher levels of sheltering activity.
Most firms try to follow a consistent dividend policy. This attracts investors who seek a stable, dependable income. However, dividend payments are not guaranteed. More than one company has found itself in trouble by continuing to pay dividends when earnings were too low.

There is currently a great deal of attention focused on dividend tax relief. Many believe it will provide a substantial economic revival; both in this country and around the world.
Thirty nations around the world belong to the Organization for Economic Cooperation and Development (“OECD”). Nearly all major nations allow full or partial relief of dividend double taxation, and thus have lower maximum dividend tax rates than the United States. Indeed, the latest data show that the United States has the second highest dividend tax rate in the Organization. The top U.S. rate of 70.1 percent surpasses every country except Japan. Mexico, imposes an upper rate on dividends of just 35 percent – half the top U.S. rate

Overall, 27 of 30 OECD countries have adopted one or more ways of reducing or eliminating dividend double taxation. Only Ireland, Switzerland, and the United States do not provide relieve from this double taxation.
On the other hand, Ireland and Switzerland have corporate tax rates of merely 12.5 percent and 24.5 percent, respectively, much lower than the U.S. federal corporate rate of 35 percent.
One common method of dividend tax relief is to set the tax rate on dividends lower than the ordinary rate on wages. Austria, Belgium, Italy, Korea, the Netherlands, Poland, Portugal, Sweden, use this approach.
Another methodology is to provide an individual dividend exclusion. Germany and Luxembourg provide a 50 percent exclusion. Greece provides a 100 percent individual exclusion, which is currently being proposed by President Bush.
Numerous countries provide individuals a dividend tax credit to offset the corporate tax paid on the earnings. Canada, France, and the U.K. offer partial credits. Nations providing credits that fully offset double taxation include Australia, Finland, Italy, Mexico, New Zealand, and Norway.
Many say that the most straightforward way to address the inequity would simply be to provide corporations with a full deduction for dividends paid. Currently, the Czech Republic and Iceland allow a partial dividend deduction to corporations

Historically in the United States, between 1954 and 1986, the income tax code included various exclusions for dividend income. In some years, the code also provided a further credit for a percentage of dividend income in excess of the excluded amount. Starting in 1954, the first $50 of dividend income ($100 for married couples) was excluded along with a credit incentive. Beginning in 1965, only a fixed-dollar exclusion was retained. Before it was repealed in 1986, the dividend exclusion was set at $200 per couple.
The Bush proposal cuts taxes on dividends. The administration’s plan is to exclude dividends from tax at the individual level. They estimate it would save taxpayers a projected $364 billion over the next 10 years. The administration also believes that dividend tax cuts would boost the stock market and reduce incentives for firms to take on too much debt.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.