Check out the securities going ex-dividend this week.
David Dierking Jan 26, 2017
Dividends are the cornerstones of many investors’ portfolios. They offer a predictable source of income while helping provide overall portfolio risk protection. Plus, dividend-paying stocks, along with mutual funds and ETFs that focus on dividend-paying companies, have historically outperformed their non-dividend counterparts.
Dividend seekers in the U.S., however, have been experiencing lean times. CDs and short-term Treasuries might net you only 1% while the S&P 500 currently offers just a 2% dividend yield. It’s not like that in other areas around the world, though. Of the G20 economies worldwide, the U.S. ranks just 15th in equity dividend yields. Australia tops the list with a yield of more than 5%. What’s Australia doing that the U.S. isn’t and is it something that can be replicated here?
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The answer in large part is dividend taxation policy. In the U.S., corporate dividends are double-taxed. They are taxed first at the corporate level as earnings, from which dividends are paid. They are taxed again at the individual level when shareholders report these dividends on their tax returns. This treatment significantly reduces the dividend that ultimately ends up in the shareholder’s pockets.
In Australia, dividends are only taxed once via franking credits. A franking credit is a tax credit that is given to shareholders who receive dividends on equities. Investors who receive corporate dividends get a corresponding franking credit that can be claimed on their tax returns.
Another factor that causes higher yields in Australia is that its economy tends to behave more like an emerging market, whereas the U.S. is a developed market. Emerging markets carry greater risks which translate into higher interest rates.
Get a complete list of foreign companies that have ADRs listed in the U.S. on our dedicated page tracking foreign dividend stocks.
How franking credits work exactly is usually best clarified through an example.
Let’s assume that a company in Australia wishes to distribute a dividend to shareholders. We’ll also assume that the company pays the standard Australian corporate tax rate of 30% and distributes all after-tax earnings as dividends.
If XYZ company earns $1.00 per share on a pre-tax basis, it will pay $0.30 in corporate taxes and distribute $0.70 in dividends. The shareholder will receive the $0.70 dividend and a $0.30 franking credit to offset the corporate tax already paid, essentially giving the shareholder the full $1.00 per share dividend. If the shareholder’s marginal tax rate is 25%, the total dividend they’d end up receiving would be $0.75. Using the franking credit, the shareholder ends up paying only their marginal tax rate on the full dividend.
Using the same example in the U.S., a $1.00 pre-tax profit would be taxed at the 35% corporate rate resulting in a $0.65 dividend available to shareholders. If the shareholder pays a 20% rate on dividend income, the final dividend received would be just $0.52.
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There has been some interest in reforming the domestic tax code to eliminate the double taxation of dividends. In early 2016, Senator Orrin Hatch announced that he was working on a plan to eliminate the double taxation issue. Details around the plan are largely unknown, and it’s unclear if such a plan would be more beneficial to corporations or individuals. A plan that helps individuals could ultimately look like the franking credit system in Australia, but a corporate-friendly plan could result in tax deductions for the corporation on any dividends distributed to shareholders.
There are obstacles, however, to passing a plan like this domestically, the most notable one being that it reduces tax revenue. S&P 500 companies in the third quarter of 2016 alone distributed $104.5 billion to shareholders in the form of dividends. Assuming the 35% federal corporate tax rate, this would result in a loss of roughly $36 billion quarterly and that doesn’t even consider dividends paid by non-S&P 500 companies. This amount would represent roughly 1% of the estimated annual federal budget of $4 trillion. This would be a significant loss of revenue for the government that would likely try to make up for in the form of higher tax rates in some other form.
A plan to eliminate the double taxation of dividends would be popular among corporations and individuals, but would likely face a number of difficulties in successfully getting passed.
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President Trump has discussed the possibility of instituting a repatriation holiday, an event that would allow corporations the ability to avoid large tax penalties for bringing cash held overseas back to the U.S.tes. While a repatriation holiday would be great news for dividend investors, it wouldn’t work quite the same as dividend tax reform.
Repatriation would be politically unpopular for the same reasons tax reform would be. It would reduce government revenue. With an estimated $2.5 trillion being held in cash overseas by corporations, this is no small consideration. While tax reform would increase the after-tax dividend shareholders would receive, a repatriation holiday would largely just increase the potential for higher dividend payouts overall.
Both solutions offer benefits for corporations and individuals while reducing the government’s potential tax revenue. For these reasons, it seems likely that repatriation would face similar obstacles to passing tax reform.
There appears to be recognition that the dividend double taxation policy is unfair to some degree, but it seems that any change to fix it is some ways off into the future. While there are good reasons for both corporations and individuals to push for such changes, getting a reform pushed through Congress looks like it would be a significant hurdle.
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Check out the securities going ex-dividend this week.
In the end, the market continued its ebb and flow as traders viewed...