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Definition: Tax Differential View of Dividend Policy
Tax Differential View of Dividend policy expounds the view or belief that shareholders or investors would prefer capital gains over dividends, because capital gains have effective lower taxation rates as compared to dividends. The understanding from this is that investors would prefer low payout ratios.
Alternatively, in simple words, the tax differential view of dividend policy states that investors would rather receive equity appreciation over dividend distribution due to the favourable taxation. In a nutshell the view holds that capital gains are preferred over dividends by investors – because of the comparatively higher tax liability on dividends.
Both corporations (i.e share issuing companies) and investors can ascribe to this view. Corporations adopting the tax differential view of dividend policy generally have lower targeted payout ratio or lower long term dividend earnings ratio. The implication here is that dividend payments are set rather than variable. The company would focus on increasing its share price.
Due to the investors’ view or due to companies assuming the tax differential viewpoint the stock growth is focussed on share appreciation, hence the firm will have more available funds for growth and expansion. Contrast this with a company that merely focuses on increasing its dividends, which has relatively lower growth prospects.
Significance of the Tax Differential View of Dividend Policy:
• The company’s responsibility to act in the best interests of its shareholders involve putting any excess cash to best possible use which implies a growth strategy rather than a value strategy. Thus shareholder tax needs are served as leftover cash is spent on capital expenditures and growth measures(boosts stock value), rather than dividend distribution.
• The key here is the assumed difference in capital gains tax rates and dividend tax rates. The larger the positive difference, the more is the aversion of investors (have the tax differential viewpoint of dividends) toward dividend paying stocks.
Consider the following example:
If the capital gains tax is 15% and the dividend tax rate is 28%. Suppose X owns a share of Company ABC originally bought for Rs 100, his tax liability under 2 different scenarios would look like:
Scenario 1: Company ABC stock rises by 10 Rs to 100 Rs per share. When X sells, his capital gain is 10 Rs and he must therefore pay 1.5 Rs in taxes for the extra 10 rupees of value he receives. Scenario 2: Company ABC decides to pay shareholders a 10 Rs dividend. X must pay ordinary income tax of 28% on the 10 Rs, which is 2.8 Rs.
In both cases, X receives an extra 10 Rs of value, but when the value is in the form of a dividend, due to higher tax rates, X retains a smaller portion of his profit. As a result, X is inclined to avoid heavy dividend-paying stocks and focus on growth stocks instead (growth stocks are known for their capital gains, rather than their dividends )
Capital gain – an increase in the value of capital assets such as common stock, which is realized upon sale of the asset. It can be long term/short term capital gain.
Dividends – refer to periodic distributions of earnings to the owners of stock in a firm paid only at the discretion of the board of directors.