Capital Gains

Capital Gains

Tax Effect:

1. Investors prefer tax-exempt distributions to taxable ones

After the Bush plan was proposed to eliminate taxes on dividends(investor level) that were paid out of earnings that had already been taxed(corporate level), investors reacted more favourably towards dividends.

2. Capital gain(share repurchase) is taxed more favourably than dividend income

Before Jobs and Growth Act of 2003 in US, cash dividends were charged at a much higher rate (treated as normal income) as compared to the lower capital gain tax of 15%. After the implementation of the Act, the tax rate on the cash dividend has been reduced to the same as on long term capital gain. Nevertheless, capital gain will still have a tax advantage over dividend. As a result of time value effects, capital gain which can be deferred will have a lower effective tax rate as compared to dividend. Also, no capital gain tax will be imposed should the stock be held by someone until his/her death. Beneficiaries who inherit the stock needn’t pay capital gain tax too.

Clientele Effect:

Clienteles who prefer cash dividend

This group of investors generally prefers stable, regular cash income. They are normally in the low or zero tax bracket, so taxes are of no concern for them. (Prior to 2008, low income investors are taxed 5% for both capital gain and dividend. In 2008, the 5% tax rate dropped to zero.) Falling into this category would be the retired individuals, pension funds and university endowment funds. These investors who seek current investment income would want to own shares in high dividend payout firms.

Clients who prefer share re-purchase

This group of investors generally prefers long term capital gain, and looks for firms with high growth potential. These investors mostly fall in their peak earning years and they do not want the higher effective tax rate on dividends, and do not want the trouble and expense of reinvesting their after-tax dividends Since...

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