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ML: INVESTMENT STRATEGY: Dividend Renaissance -Cinderella's Tax Cut. 01:41pm EDT 2-Jun-03 Merrill Lynch (A.Redlich) No Symbols ML++ML++ML Merrill Lynch Global Securities Research ML++ML++ML INVESTMENT STRATEGY Dividend Renaissance -Cinderella's Tax Cut. Adrian Redlich ******************************************************************************* Highlights We believe the reduction in dividend and capital gains tax rates will have the same effect on equity valuations as a 50-basis-point cut in interest rates, by reducing the cost of equity. The new tax rates are due to revert to previous levels in 2008. Even so, we believe it is highly likely that Congress will extend them. We believe the biggest beneficiaries of the new tax rates will include the Utilities, Telecom, Financial and Food & Staples Retailing sectors. The Utilities sector, in particular, has performed well, but we do not believe the 38.2% increase in after tax returns for some investors is fully reflected in the market.
Our examination is broken into four sections. 1. The immediate impact on the financial market participants - who are the beneficiaries? 2. The longer-term impact to corporate asset allocation and the multiplier effect in decreasing the cost of capital and risk. 3. Increased efficiency in the US economy as tax bias is removed and investors are now more likely to invest where they get the best pre-tax returns. 4. The details of the new laws. Some of the long-term pluses of the tax law changes are likely to be more significant than the immediate impact of increased after tax return of current dividend payouts.
They include: o A potential increase in S&P500 dividend yield from 1.7% to 3.5% as share repurchase plans are replaced by more consistent dividend programs. o Cheaper equity should encourage debt to be swapped for equity via the issue of certain hybrid equity products (as opposed to the boom in debt products over the last two years). Additional equity will allow for more rapid balance sheet repair. o Lower corporate interest rates and equity risk premiums as a result of less debt on corporate balance sheets. o Better returns for the broader economy as investments are based on the highest expected pre-tax returns as opposed to the previous bias toward capital investments due to the 23.6-percentage-point spread over income tax rates. Two obvious examples include o Improved returns on capital as share repurchase or growth opportunities do not become a matter of course. In hind sight it seems strange that the largest 20 US companies spent more on repurchases than dividends during 1999-2001 when they traded at high multiples. o The release of retained income from small closely held businesses to owners (consumers). o The size of tax efficient mutual funds should grow. The very mandate of these funds will result in the arbitrage of opportunities created via the new tax rates.
In this report we assess the impact of the new tax law, which effectively reduces top marginal tax rates on dividends from 38.6% to 15% and taxes on long-term capital gains from 20% to 15%.
Our examination is broken into four sections. 1. The immediate impact on the financial market participants - who are the beneficiaries 2. The longer-term impact to corporate asset allocation and the multiplier effect in decreasing the cost of capital and risk. 3. Increased efficiency in the US economy as tax bias is removed and investors are now more likely to invest where they get the best pre-tax returns. 4. The details of the new laws.
1.Who are the biggest beneficiaries? Individuals The reduced tax rates only apply to individuals (not corporations) who pay domestic taxes. Of all the dividends received from listed companies only 56% have traditionally been paid to domestically taxable investors. We suspect this percentage will increase, as taxable investors will no longer have a bias towards capital gains.
Asset Classes Taxable owners of equities (directly or via mutual funds) are clearly the big beneficiaries because they will be the only ones to enjoy the 23.6-percentage- point step shift in dividend tax rates. For investors in the top marginal tax bracket, after tax dividend returns have risen by 38% without taking on any additional risk. Investors in property and fixed income products will also benefit from the 5-percentage-point reduction in long term capital gains tax; however, unlike dividends, the income distribution will still be treated as ordinary income. Sectors & Countries Apart from owners of REITs, almost all US-listed investments held by domestic investors will qualify for the reduced tax rates. In addition, most major international companies not listed in the US will also pay "qualified" dividends to US investors. The high yielding sectors such as Utilities and Telecom Services responded well to announcements of a potential removal of double taxation in early January and to the actual law itself. However, given the strong performance of the market and the potential 38% increase (23.6-percentage-point reduction in dividend tax) in after tax return for some investors, we are not convinced the benefits from the new law is fully reflected in these sectors. In addition, we would highlight several other sectors, such as Food & Staple Retailing and Financials, as potential opportunities. The F&S Retailing group currently pays a low yield but generally has consistent cash flow and a low payout ratio. If a low-growth environment persists and investors demand dividend income, this sector has the potential to transition rapidly to higher payouts.
Table 1: Dividend Yield by sector Dividend Yield % Payout Ratio % 2001 2002 2001 2002
CONSUMER DISCR 1.0 0.8 57 nm Source:Factset, Merrill Lynch. Payout ratio represents net income divided by dividends
Financials also have relatively low pay out ratios but the major reason we highlight this sector is that they are naturally arbitrageurs of the cost of capital. The reduction in dividend and capital gains tax effectively reduces the cost of equity and, potentially, debt. We believe the Banks are the most likely to take advantage of this change. The removal of double taxation in Australia in 1980s has proved to be boon for the domestic banks because it permitted them to obtain capital at lower rates. In the following section we detail how the tax reductions reduce the cost of capital.
Countries The US has a relatively poor dividend yield compared to the dividend yield of several mature markets from which US investors will gain the tax relief. The increased after-tax value of dividends combined with further weakness in the value of the dollar should increase the focus on international investments. However, the low payout ratio in the US does highlight the potential to increase dividends more significantly than other countries now that the bias in favor of capital gains has been removed and most investors would not be adverse to high dividend payments. Table 3 shows $159bn of share repurchases and $131bn of dividend payments for the largest 20 companies in the US during 1999-2001. This was the first time on record that repurchases consistently outstripped dividends. If funds previously used for repurchases were now reallocated to dividends, the yield on the S&P500 could well double.
Table 2: International Comparison
Index Region Dividend Yield (%) Payout Ratio (%) Source: Bloomberg, Merrill Lynch. Ratios are based on the prospective years earnings forecasts..
2. Lowering the Cost of Capital The cost of equity represents the expected return an investor needs to receive to take the specific risk of making an equity investment. The cost of equity can change if either the expected return or the risk outlook is altered. The recent tax changes have increased the returns significantly for some investors.
How tax impacts the expected rate of return It is important to keep in mind that investors determine the risk/return trade- off at a post-tax level. After looking at IRS statistics, we believe the average individual tax rate for dividends and capital gains is approximately 25%. Thus for an investor who requires a expected post-tax return of 7.5% for taking the risk involved with a particular investment, the pre-tax yield on the stock would need to be 10%. Taxable yield = Net yield / (1 - tax rate) 10% = 7.5% / (1 - 0.25) Under the new code, taxable individual investors now automatically get a higher return for the same level of risk. Shareholders may receive up to an additional 23.6 cents per dollar of dividend paid or five cents per dollar through lower capital gains. On average, that would reduce the average tax rate from 25% to 15%. Seen from another perspective, the pre-tax required rate of return decreases by 10 percentage points.
How does a company tap the lower cost of equity? Assuming that the risk and the risk tolerance of investors remain constant, there is no reason that they would demand a higher expected return. Consequently, companies affected positively by the tax reduction may see higher demand for their stock leading to higher stock prices. In the example above, share prices would presumably increase up to the 7.5% after-tax return rate, i.e., to a 9% return taxed at 15%. This would represent share price appreciation of 11% (10% / 9%). Companies could effectively then issue new equity at a premium to previous levels, reducing the dilution (cost) of new shares. We expect to see a significant issuance of hybrid equity product such as perpetual preferred securities which amplify the benefits of the reduced tax rates. Although still considered equity, these securities offer more secure, and usually, higher dividends. Their equity nature will also qualify the dividends for the lower tax rate under the new law. Currently the preferred perpetual market amounts to only $24 billion. However, we believe it may increase under the new legislation. The financial sector may find these securities of particular interest, as they qualify as "Tier-1" capital.
First round effect = cheaper equity We believe the reduction in dividend and capital gains tax rates will have the same effect on equity valuations as a 50-basis-point cut in interest rates, by reducing the cost of equity. While numerous factors influence the cost of equity, the largest single factor in determining the new expected rate of return will be the degree to which investors realize the tax relief. We expect there will be arbitrage between taxed and non-taxed investors as the market moves to reflect the adjusted returns created by the effective tax reduction. (That is, investors who do not pay tax may have less demand for certain securities which are bid up by taxed investors.) To quantify this arbitrage, we are going to be conservative and assume the breakdown of equity holders is the same as that of investors who own only dividend paying stocks. Currently, almost 45% of shareholders who receive dividends do not pay tax on the income stream; thus we will assumed that only 55% of investors will receive any benefit from the latest tax change. However the risk an investor is willing to take on a post-tax basis should not change, meaning that investors with a required rate of return of 10% (or higher) will sell, and those with a required rate of return 9% (or lower) will buy. This will cause a shift in price as the market normalizes to reflect the new required rate of return at 9.45%. Mathematically, the new cost of equity could be determined as: Required rate of return (subnew) =
RRR (subold)x % tax exempt + RRR (subold)x % taxed x
Second round effect = more rapid balance sheet repair. If the average cost of equity across the market decreases, we believe that there will be: o A relative rotation away from debt financing towards equity financing, without an overall increase in the cost of capital o Lower risk as companies have less debt and more equity o Narrower credit spreads due to lower risk o Lower equity risk premium, which will further lower the cost of equity The catalyst to lowering the risk of the corporate capital structure is well-timed, as record debt levels have become burdensome in the face of a weak economic environment. While companies have already begun the process of restoring their balance sheets, this new tax policy may speed up the recovery.
3. More efficient capital allocation Debate will rage around whether the new tax law will help to stimulate the economy in the short term. However, there is little doubt that the policy change will affect individual, corporate and national "economics". By this we mean economics in its purist sense - "the allocation of scarce resources". The old tax structure effectively created a bias against dividends and towards reinvestment and risk taking. Higher taxes on dividends relative to capital gains lead investors to prefer "growth stories", effectively encouraging companies (almost regardless of their prospects) to retain and reinvest capital rather than return excess funds to shareholders via dividends. Put another way: basic economic theory suggests that capital should flow to investments that provide the highest returns. This "natural arbitrage" effect should lead to the greatest return for investors and the most productive use of capital for the nation. However, the old tax structure encouraged companies to take risk and reinvest, regardless of whether or not the capital could be used more productively in another part of the economy. The choice between reinvesting or returning capital to shareholders should now simply become a business decision based on an assessment of the risk and relative return on an investment as opposed to an almost insurmountable 18.6-percentage-point higher tax spread between dividends and capital gains. We believe that the changes to the tax code will result in lower risk, cheaper equity, and a reallocation of capital. We should point out, however, that the environment is ripe for this structural change to investing. Other factors such as low growth and over-capacity are clearly playing a role. Nonetheless, the equal taxation of dividends and capital gains will be an important and perhaps critical new catalyst in the movement away from "the growth obsession."
There are two areas in particular where we believe capital will be allocated more efficiently. 1. Under the old tax code, return of value to investors via reinvestment or repurchases, rather than through dividends, had become widely accepted as more tax effective. However, we believe repurchase programs have not been a completely effective way to distribute capital. This is because, oftentimes, share repurchase plans are used to offset the acceleration of stock option compensation with little regard for value. The old tax bias - coupled with the increase in the use of stock options - has led to massive undercurrents of capital in the form of repurchases. Share buybacks are more sporadic than dividends as a method of returning value and also have limited transparency. This trend has also created, on occasion, a conflict between shareholders and company managements; this is because managements have incentive to increase returns with less regard for risk. We believe that repurchase programs and stock options are worthwhile if used correctly - but they were sometimes misused during the "growth obsession" of the bubble period. Specifically, these instruments may have led to sub-optimal risk-taking and over-investment. In many cases, we believe that alternative allocations, such as dividends, could have better maximized ROE if the massive tax bias toward capital gains had not existed. 2. Small closely held businesses are likely to have retained significant amounts of capital over the years. Release of this capital via dividends effectively incurred double taxation at high marginal rates. The reduction of dividend tax rates may encourage a significant release of capital to consumers/small business owners.
4. The devil is always in the detail. President Bush signed the tax bill into law on May 28. The bill accelerates the timing of previously enacted reductions in income tax rates and increases in various credits and benefits, offers depreciation and expensing benefits to small businesses, and reduces taxes for individuals on dividends and capital gains. Our focus will be on the cuts in tax on dividends and capital gains. Although much of the President's original proposal did not make it into the final bill, he did get Congress to tax dividends and long-term capital gains at the same rate. This should make companies indifferent, from a tax perspective, to paying cash dividends or buying back stock (assuming that stock buybacks increase the value of the outstanding shares).
Lower Rates for Now The law provides for a preferential tax rate of 15% (5% for those in the 10% or 15% regular tax brackets) on both "qualifying dividends" and net long-term capital gains. These rates apply for six years, 2003 to 2008 inclusive. (In 2008, only the 5% lower bracket rate changes to 0% for that one year.) The dividend tax provisions are retroactive to January 1, 2003. At the end of 2008, all of this disappears: dividends go back to being taxed as ordinary income, and long-term capital gains revert to a 20% rate. Table 4: Dividend Tax Rates
Tax Bracket 25%-35% 10%, 15% Source: Conference Report on H.R. 2
Which Dividends Qualify? We will call dividends that are subject to lower rates for the next six years "qualifying dividends". These include dividends paid out of earnings and profits by domestic corporations, by foreign corporations whose shares or ADRs are readily tradeable on a U.S. stock market, and dividends paid by other foreign corporations located in countries (except Barbados) that have a comprehensive tax treaty with the United States that provides for information-sharing. Countries that do not have tax treaties with the U.S. include Singapore, Hong Kong (the PRC treaty does not include Hong Kong), Argentina, Brazil, and Chile. Excluded from the benefit of the lower rate are dividends paid by REITs and other entities that do not pay income tax. (Dividends paid out of REIT income that has been taxed would qualify.) Special rules apply to mutual funds, which are treated as pass-through entities. Mutual fund dividends qualify to the extent that the fund received qualifying dividends as income. Accordingly, dividends paid on bond funds or money-market funds would be taxable as ordinary income, while dividends paid out of dividends received by stock funds would qualify for the lower rate. As we understand it, funds will be able to offset expenses against other income first, then against qualifying dividends, thereby maximizing the amount of qualifying dividends paid out to fund shareholders. Payers will need to indicate on investors' 1099-DIV form which dividends qualify for the lower rate and which ones do not. Shareholders will also have to meet a holding period requirement to enjoy the lower tax rate. Shares must be held for 60 days during the 120-day period beginning 60 days before the ex-dividend date, otherwise the dividend will be taxed at regular rates. Payments received in lieu of dividends (frequently in connection with short sales and similar transactions) will not be qualified dividends. Extraordinary dividends that qualify will cause a subsequent loss on the sale of the stock to be treated as a long-term capital loss regardless of the actual holding period. This prevents investors from "gaming the system" by buying a stock ahead of an extraordinary dividend and then selling the stock for a short- term loss that could otherwise offset short-term gains taxable at regular rates.
Borrowing
money to buy dividend-paying stocks may not be a good strategy. Dividends paid by foreign investment companies, passive foreign investment companies and foreign personal holding companies, as defined in the tax code, do not qualify for the lower tax rate. Special rules are designed to keep the foreign tax credit on low-tax dividends from offsetting taxes on domestic income. Moreover, foreign tax credits cannot be used to reduce the overall tax (U.S. and foreign) on dividend income to less than 15%. The construct outlined in the Administration's original dividend tax proposal that considered the amount of a company's income tax liability for each year is not part of the tax law.
Capital Gains Tax Reductions Taxes on capital gains also have been reduced temporarily. The rates of 20% in the higher brackets and 10% in the lower brackets are now 15% and 5%, respectively, for sales made after May 5, 2003. Long-term capital gains earned this year before May 6(**th) are taxed at 20% (10% in the lower brackets). These lower rates also expire at the end of 2008, at which time the capital gains rate will revert to 20% or 10%. In addition, the preferential 18% rate (8% for lower brackets) on property held for five years after the end of 2000 has been repealed, at least until 2009; there is no further reduction for five-year property. The benefit of the lower capital gains tax rate applies for alternative minimum tax (AMT) purposes. Although dividends and long-term capital gains are taxed at the same rate, this does not mean that a taxpayer can offset dividend income with a capital loss or loss carry forward. The $3,000 limit of capital loss that can be used annually to offset ordinary income remains unchanged. It's small consolation for some investors that capital losses in excess of the limit can be carried forward indefinitely.
Tax Deferred Savings Plans Investments in tax-deferred vehicles, such as IRAs, 401(k)s and the like gain no direct benefit from the reduction in tax rates on dividends and capital gains - all income distributed from these accounts that were funded with tax- deductible contributions remains subject to tax at ordinary rates regardless of the character of the income. Of course, distributions from these accounts will benefit from the lower ordinary tax rates.
Corporations Unlike the President's initial tax proposal in January, there are no provisions for changes in corporate taxation of dividends or capital gains. The 70% dividends-received deduction still applies to those dividends that previously qualified, and corporate capital gains are taxed at the same rate as ordinary income, 35%.
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