Changes to Income Trust Taxation in Canada: Investor Reaction and Dividend Clientele Theory

Abstract:  This paper explores the relationship between tax-induced dividend clientele theory and the recent changes to the taxation of income trusts in Canada. On October 31, 2006, the Canadian government announced the Tax Fairness Plan ( TFP ) calling for the elimination of the considerable tax advantage enjoyed by income trusts. Generally, distributions from income trusts are now taxed at rates comparable to those imposed on corporate dividends. We examine market reaction to the  TFP  to address three issues: first, whether the valuation effect of a dividend tax increase is consistent with the traditional or the new view of dividend taxation; secondly, whether the market reaction to tax increases has a differential impact on firm value that is related to the tax preferences of taxable, tax-exempt, and foreign investor tax clienteles; and thirdly, whether firms change their dividend policies in response to the preference of institutional investors (tax-based dividend policy effect) or whether institutional investors are sorting themselves across firms based on their dividend policies (investor sorting effect). Our results provide strong evidence as follows. First, the valuation effect in reaction to the  TFP  announcement is consistent with the traditional view of dividend taxation – i.e. that taxes on dividends reduce the net return to investors, increase the firm's cost of capital and lower the firm's ability to access capital markets, thereby discouraging investment and savings. Secondly, we saw that trusts with a larger percentage of their units held by tax-exempt, low-tax, and foreign investors had a higher decline in value when compared with trusts held mostly by ordinary taxable investors. These results support dividend tax clientele theory. Finally, we observed changes in institutional investor clienteles consistent with the investor sorting effect.     

Direct evidence on the marginal rate of taxation on dividend income

Miller and Scholes (1978) hypothesize that the marginal tax rate on dividend income may be less than the marginal rate of tax on capital gains. Their hypothesis is dependent upon individuals utilizing existing provisions of the Code which serve to reduce the taxation of dividends. In this study, estimates of the marginal and effective rates of tax on dividend income for the year 1979 are presented using the Statistics of Income sample of returns. The average marginal rate of tax on dividend income is estimated to be 40%, while the average effective rate of tax is estimated to be 30%.     

Effects of Capital Gains Taxation on Life-Cycle Investment and Portfolio Management

We examine the impact of capital income taxation, both accrual forms of taxation and taxation of realized capital gains, on total savings and the demand for corporate financial instruments. We find that investors may hold both debt and equity in the face of effective collection of capital gains taxation even in a flat tax system. We also find that the two taxes will have substantially different effects on saving and consumption behavior, making it unlikely that the tax structure can be summarized by any single equivalent accrual tax rate.     

Dividend Taxes and Implied Cost of Equity Capital

We estimate firm‐level implied cost of equity capital based on recent advances in accounting and finance research and examine the effect of dividend taxes on the cost of equity capital. We investigate whether dividend taxes affect firms' cost of capital by testing the relation between the implied cost of equity capital and a measure of the tax‐penalized portion of dividend yield, which we define as the product of dividend yield and the dividend tax penalty. The results generally support the dividend tax capitalization hypothesis. We find a positive relation between the implied cost of equity capital and the tax‐penalized portion of dividend yield that is decreasing in aggregate institutional ownership, our proxy for tax‐advantaged investors. The evidence in this study adds to the understanding of the effect of investor‐level taxes on equity value.     

Relationship between franking credits and the market risk premium

In a dividend imputation tax system, equity investors have three potential sources of return: dividends, capital gains and franking (tax) credits. However, the standard procedures for estimating the market risk premium (MRP) for use in the capital asset pricing model, ignore the value of franking credits. Officer (1994) notes that if franking credits do affect the corporate cost of capital, their value must be added to the standard estimates of MRP. In the present paper, we explicitly derive the relationship between the value of franking credits (gamma) and the MRP. We show that the standard parameter estimates that have been adopted in practice (especially by Australian regulators) violate this deterministic mathematical relationship. We also show how information on dividend yields and effective tax rates bounds the values that can be reasonably used for gamma and the MRP. We make recommendations for how estimates of the MRP should be adjusted to reflect the value of franking credits in an internally consistent manner.     

Shareholder taxation and aggregate dividend payout: Evidence from the tax reform act of 1986

The effect of shareholder taxation on corporate dividend policy is a major controversy in financial economics. The Tax Reform Act of 1986 eliminated the statutory tax disadvantage of dividends versus long-term capital gains for individual shareholders. Using aggregate time series data I find evidence that corporate dividend payout has become more generous in the period after tax reform.     

The impact of tax rate changes on intercorporate investment

We examine how tax rates impact investment by corporations in the stock market. We regress changes in intercorporate investment on changes in the various individual and corporate top statutory marginal tax rates (MTRs). We find a significant negative association between changes in individual capital gains MTRs and changes in intercorporate investment, while no such association is evident for changes in either individual ordinary or dividend MTRs. These results support the notion that corporations respond to the after-tax rate of return and/or market efficiency consequences brought about by a change in individual capital gains MTRs. We find a significant positive relation between changes in intercorporate investment and changes in corporate MTRs on ordinary income. These results are consistent with corporations scaling back expansion plans and instead investing free cash flows in equity securities as MTRs increase.     

Foreign portfolio equity holdings and capital gains taxation

Using panel data from 23 developed countries over the 2001–2011 period and employing the Arellano-Bover/Blundell-Bond dynamic panel estimation technique, this paper shows that the source country capital gains tax has a negative and statistically significant impact on foreign portfolio equity holdings. On average, a 1 percentage point increase in capital gains tax rate leads to 0.018% decrease in foreign equity holdings. The negative relationship between the capital gains tax and foreign equity holdings is found to be robust to alternative measures of the source country capital gains tax, inclusion of the dividend imputation tax rate, foreign dividend tax withheld rate, dividend tax credit and other control variables (the source and host country financial wealth, trade, exchange rate volatility, foreign listing and institutional quality). We find that a 1% increase in financial wealth of the source (host) country leads to, on average, a 0.428% (0.427%) increase in foreign equity holdings. An improvement in institutional quality has a positive effect on foreign equity holdings but an increase in the exchange rate volatility has the opposite effect.     

DIVIDEND POLICY AND CAPITAL STRUCTURE UNDER THE IMPUTATION TAX SYSTEM: SOME CLARIFYING COMMENTS

This paper analyses the effects of the imputation and capital gains taxes on the dividend and financing decisions of Australian companies. We develop a framework, consistent with Miller's [1977] approach, in which interactions between dividend and financing decisions can be explored. The significance of these interactions depends on both corporate dividend policy and on the relationship between personal and corporate income tax rates. We conclude that under imputation, dividend decisions are more important relative to capital structure decisions, than under the classical tax system.     

The Cost of Equity Capital at the Corporate and Investor Levels Allowing a Rational Expectations Model with Personal Taxations

This paper argues that the conventional definition of the cost of equity at the corporate level is likely to be fundamentally flawed under conditions of personal taxation. A 'dimensionally consistent' definition is developed utilising the pioneering contributions of Auerbach and Elton and Gruber. Consequent benefits are straight-forward expressions for the cost of equity capital at the corporate level (for both retained earnings and new equity) as well as at the investor level (post personal tax) in terms of both the dividend discount and CAPM-type models, which are applicable to classical and imputation tax systems. A fundamental framework is thereby provided which succeeds in illuminating investor pesonal tax liabilities as they might be expected to impact on a firm's investment and related dividend policies.     

Does the investment interest limitation explain the existence of dividends?

Miller and Scholes have shown that under certain conditions the Federal Income Tax taxes dividend income at a rate no higher than the rate on capital gains. Tabulations of actual 1977 tax returns show that the special circumstances under which this can occur apply to recipients of two and one half percent of dividend income and that no dominant role may therefore be ascribed to their hypothesis in the determination of corporate dividend policy.     

THE RELATIONSHIP BETWEEN BEFORE- AND AFTER-TAX YIELDS ON FINANCIAL ASSETS

In this research, the traditional approximation that after-tax yields equal before-tax yields times one minus the tax rate is shown in general to be incorrect. The traditional relationship holds only for one-year assets and perpetuities when a single tax rate applies to both ordinary income and capital gains. For all other multiperiod assets, the correct relationship is much more complex and is a function of the statutory tax rates on ordinary income and capital gains, the holding period, the dividend growth rate for common stocks, and any premium or discount on bonds. The direction of bond price changes is related inversely to the direction of the tax rate changes, but the direction of common stock price changes is related ambiguously to the direction of tax rate changes.     

Fundamental Tax Reform in The Netherlands

The Netherlands has abolished the tax on actual personal capital income and has replaced it by a presumptive capital income tax, which is in fact a net wealth tax. This paper contrasts this wealth tax with a conventional realization-based capital gains tax, a retrospective capital gains tax with interest on the deferred tax, and a mark-to-market tax which taxes capital gains as they accrue. We conclude that the effective and neutral taxation of capital income can best be ensured through a combination of (a) a mark-to-market tax to capture the returns on easy-to-value financial products, and (b) a capital gains tax with interest to tax the returns on hard-to-value real estate and small businesses.     

Valuation of companies and projects under differential personal taxation

This paper develops formulae for the valuation of companies and projects where there is both differential personal taxation of dividends and interest arising from dividend imputation, and differential taxation of interest and capital gains. The former has been addressed in the literature. This paper represents an extension to recognize both phenomena. It is also shown that valuation errors from ignoring these phenomena are all significant, with the errors from ignoring the interest/capital gains tax differential being at least as great as those from ignoring imputation. Thus, a valuation formula that allows for both phenomena is indicated.     

Corporate Investment and Dividend Tax Imputation

The capital investment/dividend decision of the firm is analyzed under alternative assumptions about the system of dividend taxation. Relative to the classical system, imputation can yield (1) more disagreement amongst shareholders as regards the optimal investment plan, (2) less capital investment on aggregate and (3) fewer gains from mergers. Moreover, in contrast to the classical system, shareholders with high marginal tax rates can be more disadvantaged by dividend deferral than shareholders with low marginal tax rates.     

Neutral Taxation of Shareholder Income

A Norwegian tax reform committee recently proposed a personal tax on the realized income from shares after deduction for an imputed risk-free rate of return. This paper describes the design of the proposed shareholder income tax and shows that it will be neutral with respect to investment and financing decisions and decisions to realize capital gains, provided that full loss offsets are granted. Thus the tax allows some non-distortionary double taxation of corporate equity income. With an appropriate choice of tax rates, it also solves the problem of income shifting under a dual income tax. JEL Code: H24, H25     

“两税合一”对台湾上市公司股利税资本化的影响

本文以1994～2001年两税合一税制实施前后的台湾上市公司为样本，运用Harris-Kemsley股利税后收益模型，探讨所得税制改革对权益投资者收益的影响，以及两税合一税制的实施对股利税资本化的影响。实证结果表明：两税合一税制实施前，台湾上市公司的末分配盈余与其股利税资本化程度负相关，即股利税资本化效果存在；两税合一税制实施后，台湾上市公司的股利税资本化程度低于两税合一前的程度。     

Dividend yields and stock returns: Implications of abnormal January returns

This study examines the empirical relation between stock returns and (long-run) dividend yields. The findings show that much of the phenomenon is due to a nonlinear relation between dividend yields and returns in January. Regression coefficients on dividend yields, which some models predict should be non-zero due to differential taxation of dividends and capital gains, exhibit a significant January seasonal, even when controlling for size. This finding is significant since there are no provisions in the after-tax asset pricing models that predict the tax differential is more important in January than in other months.     

Machines,buildings, and optimal dynamic taxes

The effective taxes on capital returns differ depending on capital type in the U.S. tax code. This paper uncovers a novel reason for the optimality of differential capital taxation. We set up a model with two types of capital – equipments and structures – and equipment-skill complementarity. Under a plausible assumption, we show that it is optimal to tax equipments at a higher rate than structures. In a calibrated model, the optimal tax differential rises from 27 to 40 percentage points over the transition to the new steady state. The welfare gains of optimal differential capital taxation can be as high as 0.4% of lifetime consumption.     

Ex-Day Behavior: Tax or Short-Term Trading Effects

This study examines the behavior of share prices around the ex-dividend dates before and after the introduction of the 1988 Income and Corporation Taxes Act that reduced substantially the tax differential between dividends and capital gains in the United Kingdom. We find that, in the pre-1988 period when the differential taxation of dividends and capital gains is high, ex-day returns are positive and significant. In contrast, in the post-1988 period, ex-day returns are, in most cases, negative and insignificant. Further analysis reveals that, while ex-day returns are significantly related to dividend yield and to the length of the settlement period, they are not affected by the commonly used measures of transaction costs, such as the bid-ask spread and trading volume, or by the day of week, month of the year, type of dividend distribution, or number of days to the actual receipt of the cash dividend. We conclude that taxation affects significantly ex-day share prices in the United Kingdom.