U.S. shareholders face higher taxes

NEW YORK Aug 23 (Reuters) - The prospect of a higher tax on dividends next year could mean corporations turn increasingly to stock buybacks and special payouts as way to return cash to shareholders.

Tax breaks on investments adopted under President George Bush in 2003 are set to expire at the end of the year. Unless Congress imposes new rules before then, the capital gains tax will revert to 20 percent and the dividend tax would jump to 39.6 percent. Both are currently 15 percent.

From 2003 to the end of this year, Bush's dividend tax breaks will have saved individual owners of U.S. domestic stocks $274.47 billion, according to an analysis by Howard Silverblatt, a senior index analyst at Standard & Poor's.

Democrats have proposed capping the dividend tax at 20 percent for high earners next year, while Republicans want to keep it at current levels. The final outcome will depend on the ability of Congress to act after the mid-term elections in November -- elections that could well increase political divisions and make any decision difficult.

"I think of it as a crucial point in investors' decision-making that will come around the elections," said David Bianco, Merrill Lynch Bank of America's chief U.S. equity strategist, in a recent interview. It's "probably the most heated topic, especially for the retail clients that we have."

With the electorate potentially more receptive to suggestions of tax unfairness due to the weak economy and the sheer size of the gaping budget deficit, tax policy is more highly charged and less predictable than usual.

"It is so hard to tell because it so depends on what the political mood of the country is," said Anne Mathias, an analyst at Concept Capital in Washington.

Democrats face pressure that their proposal to raise the dividend tax rate from 15 to 20 percent for high-earners could hurt the economic recovery, while Republicans risk being labeled as seeking to protect wealthy investors.

The top income tax bracket will rise to 43.4 percent when a 3.8 percent Medicare levy on high earners takes effect in 2013, further increasing the burden on dividends.

Stock buybacks, in which a company buys its own shares and cancels them to increase the earnings per share accruing to shareholders, are one option open to companies looking to help shareholders get around the dividend tax. Special dividend payments are another.

"Special dividends, especially tax-differed stock distributions or those classified as a return of investment, have been openly discussed but little has occurred as of yet," said Silverblatt.

A higher dividend tax could also push more investors away from traditional dividend-paying stocks at a time when their spread over less-risky bonds has been narrowing. But the tough investing environment may reduce this effect. For more, see: [ID:nN17127685].

Silverblatt believes a higher capital gains tax could result in a selling spree as investors take advantage of this year's lower tax rate, although it may take more than a 5 percent increase to make that happen.

Bianco takes a more optimistic view of tax policy. He expects Congress to cap the dividends tax at 20 percent next year, which he believes could lead to a rush into dividend-paying stocks by investors who have been expecting worse.

"Investors seeking income can take advantage of this tax advantage through bond-substitute investments such as consumer staples and utilities stocks," he wrote in a recent note to clients. (Reporting by Edward Krudy; additional reporting by Kim Dixon in Washington; Editing by Dan Grebler)