November 18, 2010 / 8:55 PM / 9 years ago

Analysis: Tax changes won't kill dividend trend

NEW YORK (Reuters) - A looming tax increase on dividends is not putting investors off equity income funds, which history suggests could outperform other asset classes.

Companies and investors have been left in limbo as Congress and the White House wrangle over whether to extend the Bush-era tax cuts on dividends and capital gains as well as income, or strike a compromise before year’s end.

U.S. companies sitting on a record $842.5 billion in cash have a few weeks left to decide, let alone implement, a dividend increase or additional payment that lets investors claim income at the current 15 percent tax rate.

Investors pouring cash into equity income funds in the pursuit of returns — against a paltry backdrop of benchmark 10-year U.S. Treasury yields under 3 percent — could see dividend and capital gains taxes rise only slightly or potentially more than double.

Research from Allianz Global Investors shows it may not matter if dividend taxes return to a pre-Bush era marginal rate of up to 39.6 percent, rise to 20 percent as outlined in President Barack Obama’s 2011 budget or somewhere in between.

“So, worst case scenario they expire... historically where you have had tax regimes where the highest rate was 50 percent or 70 percent, in those periods, dividend-paying stocks (still) outperformed,” said Kristina Hooper, head of portfolio strategies at Allianz in New York.

Allianz reviewed tax rates from 1972 to the present, identified nine distinct time ‘regimes’ and found dividend-paying stocks outperformed nondividend-paying stocks in all but one period.

Prior to present tax levels, in the 1997-2002 period, when dividend taxes topped out at 39.6 percent, dividend-paying shares gained 3.03 percent on an annualized basis versus a drop of 8.73 percent for nondividend-paying stocks.

The current dividend yield for companies in the Standard & Poor's 500 stock index .SPX is 1.97 percent. When considering just the 368 stocks in the index that actually pay a dividend, the yield rises to 2.45 percent.

On a relative value basis “the current dividend yields are still competitive even at a nominal tax rate of 39.6 percent, which is an amazing statement,” said Howard Silverblatt, senior index analyst at S&P in New York. He noted the average dividend yield on the S&P 500 since 1926 is 3.78 percent.

S&P’s Dividend Aristocrats index .SPDAUDP, which tracks S&P 500 companies that have boosted dividends for 25 straight years, is up 9.5 percent year-to-date, versus 5.7 percent for the broader index. Family Dollar Stores FDO.N is the Aristocrats’ best performer, up nearly 74 percent this year.

Benchmark 10-year U.S. Treasuries currently yield 2.88 percent.

After a modest first half, cash flows into equity income funds accelerated to $3.8 billion by the end of the third quarter, data from Lipper, a Thomson Reuters company, showed.

The group, widely held in tax-deferred accounts, averaged total returns of 17.07 percent while returns from dividends and interest, otherwise known as income returns, was 2.23 percent.

Allianz’s NFJ Dividend Value Fund (NFJEX.O), a top 10 equity income fund, had income returns of 4.17 percent in the year ended October 31, according to Lipper.

The top two over the same period are the Eaton Vance Enhanced Equity Option Income Fund EEEAX.O and the Prudential Jennison Equity Income Fund AGOAX.O, with 8.81 percent and 4.87 percent income returns, respectively.

According to Thomson Reuters, S&P 500 companies paid out $195 billion in total common share dividends last year, down from the $226 billion in 2008.

PERFECT STORM

Companies may be facing the uncertainty of politics but the conditions for paying out special dividends couldn’t be better, says tax and accounting consultant Robert Willens.

“Borrowing rates are low, tax rates are increasing, companies are flush with cash. It is a tired old phrase, but it is a perfect storm for special dividends,” he said.

Companies with executives who are also large shareholders have been the main proponents of special dividends.

“Since we have had lower (tax) rates, there has been an increase in these episodic dividends... But that will come to an end, no doubt in my mind, if rates go up,” he said.

Recent dividend payouts highlighted by Willens include the $8 per share by casino operator Wynn Resorts (WYNN.O) and the $1 per share by insurer Progressive Corp (PGR.N)..

“Everybody has been expecting Cablevision (Systems Corp.) CVC.N to do something... (they) meet that profile. There is large insider ownership. They have the borrowing capacity to fund a special dividend,” he said, referring to the media and entertainment company.

SLIGHT IMPACT

“If what we are discussing is a one-year extension or a two-year extension (on dividend taxes), which is where the debate seems to be in Washington at the moment, then the effects on people’s investment decisions is going to be pretty slight,” said Donald Marron, director of the Urban-Brooking’s Tax Policy Center, a nonpartisan research institute in Washington.

According to the TPC, if no compromise is reached by December 31, households with income in the $200,000 to $500,000 range would pay an additional $421 in taxes on ordinary dividends and $826 in extra taxes on capital gains, starting next year.

When averaged across all income groups, the extra tax would be $112 and $205, respectively.

Reporting by Daniel Bases; Editing by Kenneth Barry

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