7. Tax Considerations

Finally, as we have already seen in the introductory chapter, dividends and buybacks often have different tax implications for the participating or receiving shareholders: While dividends are generally subject to (qualified dividend) income taxes, buybacks often trigger capital gains taxes.

Depending on the specific tax status of the firm and its shareholders, the after-tax value of a specific gross amount of payout will therefore typically not be the same. We have seen that, in many instances, buybacks are less heavily taxed than dividends.

  

Reinvestment Return, Payout Decision, and Taxes: Summary

Together with our considerations about the reinvestment return and the associated payout vs. reinvestment decision, we can now summarize the relevant alternatives management faces:

  • A1: Reinvest profits in a project and later pay a dividend
  • A2: Reinvest profits in a project and later repurchase shares
  • A3: Pay dividend today and shareholders invest in a project
  • A4: Repurchase shares today and shareholders invest in a project.

 

To formalize the relevant trade-offs between these alternatives, let us use the following notation:

  • Reinvestment return of the firm: ROICC
  • Reinvestment return of the shareholder: ROICP
  • Corporate income tax rate: τC
  • Personal income tax rate: τP
  • Qualified dividend tax rate: τD
  • Capital gains tax rate: τG

  

Example

Let us consider a firm that has 100'000 of excess cash. The firm can reinvest that cash at a rate of return (ROICC) of 11% for one year. Alternatively, it can return the cash to shareholders, who have a reinvestment return of 10% (ROICP). The relevant taxes are as follows:

  • Corporate income tax rate (τC): 38%
  • Personal income tax rate (τP): 30%
  • Qualified dividend tax rate (τD): 15%
  • Capital gains tax rate (τG): 15%

 

What should the firm do? The following sub-sections look at the four alternatives listed above and discuss the key management implications.