Bull Vs. Bear - Special Dividends Are A Good Thing

By Stephen D. Simpson, CFA | December 07, 2012 AAA

Question: Is early payment of dividends an effective way of avoiding the tax due to the fiscal cliff?

Bull's Response
There's really only one fundamental reason for publicly-traded companies to exist - to pool capital from shareholders, invest it in projects that generate positive net economic returns on that capital and return the capital to shareholders. Whatever legal moves a company can take to maximize the value of the capital they return to shareholders is, on balance, a good thing.

So too with the recent spate of special dividends and accelerate dividend payment schedules in light of the potential tax ramifications of the fiscal cliff.

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And Here Come the Pretzels ...
In recent weeks, over 120 companies (according to Markit) have announced special dividends - well ahead of the usual seasonal trend in such announcements. At the same time, many companies that are not paying special dividends are at least goosing up their payment schedules such that the dividends are paid in the 2012 tax year, due to real world factors affecting dividend taxes.

Perhaps the biggest example of this calendar gerrymandering is Oracle (Nasdaq:ORCL) - the tech giant is pushing its next three quarterly dividend payments into December, saving Oracle co-founder Larry Ellison (and owner of roughly one-quarter of the shares) potentially tens of millions in higher taxes on those dividends. But it's not just Oracle - companies as diverse as Disney (NYSE:DIS), Walmart (NYSE:WMT) and HCA Holdings (NYSE:HCA) are likewise running ahead of the taxman.

Taxes Are Real
It's not hard for investors to find advice online telling them not to make decisions on the basis of taxes. While I can appreciate this advice in principle (I'd never recommend selling a winner just to get a slight edge on capital gains taxes, for instance), it doesn't hold up so well in practice.

The upcoming change in dividend taxation is not trivial - taxes on qualified dividends are going to move from 15% (for most investors) to an investor's ordinary income tax rate (over 39% at the high end), and a special additional 3.8% tax is going to be levied on some "high earners." Moreover, while it's true that a large percentage of U.S. equity is held by wealthier people, more than half of American families own stock and have more than one-third of their total financial assets in stocks.

As a result, I would argue that this significant change in the tax policy is adequate motivation for public companies to respond. In the case of Oracle, these dividends were almost certain to be paid anyway, so why not save investors a potentially meaningful amount of money and maximize the value of that returned capital? Sure, if you own 100 shares of Oracle and fit into the 28% bracket you are only talking about $2.34 of tax savings and that sounds trivial, but I suspect that if I put out the offer that anybody who doesn't want the $2 can just mail it on to me, I don't think I'll get many takers.

Special Dividends May Just Be Accelerating the Inevitable
It seems relatively easy to defend accelerated dividend payments. If the raison d'etre of public companies is to maximize the return of capital to shareholders (which it is) and those dividends were going to be paid anyway, shifting the schedule a few weeks to avoid the taxes is logical.

The case for the special dividends is a bit harder to make, but not impossible. The idea behind the special dividend payments is basically the same - companies have identified these amounts as surplus capital and see a means of returning it to shareholders at a lower tax rate. Companies do this sort of thing all the time; whenever there are tax breaks on repatriating capital, it comes flooding in from abroad, and likewise accelerated depreciation or tax credits reliably coax companies into adjusting their capital spending and allocation priorities.

Is this a good thing? On balance, probably not - companies should be in the business of their business, and not playing tag with the taxman. At the same time, the government created this mess all on their own and taxes are an economic signal like any other - if you make something more expensive (capital, in this case), independent economic agents are going to move to minimize the damage.

The Bottom Line
A cynical evaluation of history suggests at least a couple of companies are going to get themselves in trouble by paying too much out in these special dividends and will later have to turn to more expensive supplementary capital. That's really not a dividend timing or tax policy problem, though; rather, it's a case of poor planning and capital allocation, and odds are that the company(ies) in question would have made some other mistake with the capital independent of the fiscal cliff.

As it stands, these decisions to pay special dividends and/or accelerate dividend payments are a logical reaction to a significant oncoming change in U.S. tax rates. While it may be true that Congress will figure something out and work out a compromise that neutralizes or reverses the anticipated tax increases, it really doesn't change the math of these moves. At a bottom line net present value level, money received today is always more valuable than the same sum received tomorrow, so while these companies may or may not be saving their shareholders substantial sums in dividend taxes, they are at a minimum enhancing the net present value of that dividend stream by paying early.

At the time of writing, Stephen D. Simpson did not own any shares in any company mentioned in this article.

Don't forget to read the Bear side of this debate and weigh in with your opinion below.

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