Shareholder-level Taxes Research Articles

Whose Taxes Matter?: The Effects of Institutional Ownership on Dividend Payout Policy Around Tax Rate Changes

Prior research finds that firms accelerate dividends into the period before tax rate increases, especially when insider ownership is high, thus reducing insiders’ taxes (Hanlon and Hoopes 2014). However, this research does not consider the preferences of other investors, many of which are tax-insensitive. First, ignoring insider ownership, we find that the likelihood and magnitude of dividend acceleration is lower for firms with high tax-insensitive institutional ownership, providing new evidence on the broad relation between shareholder taxes and dividend payout. Second, accounting for insider ownership, we find that dividend acceleration increases with insider ownership even when tax-insensitive institutional ownership is high, indicating managers’ preferences outweigh institutions’ preferences. Third, accounting for both insider ownership and institutions’ monitoring ability, we find that tax-insensitive dedicated institutions constrain insiders’ ability to accelerate dividends, particularly when acceleration costs are high. This suggests dedicated institutions play a part in monitoring potentially excessive and costly tax-motivated dividend payments made in managers’, not shareholders’, best interest. Overall, our results differ from several recent studies and provide important new insight into the relation between shareholder-level taxes and dividends.

Leveraged Share Repurchase: A Tax-Based Explanation

This paper investigates a corporate tax-based and shareholder tax-based explanation for a firm’s decision to finance a stock repurchase by utilizing debt, commonly referred to as a leveraged share repurchase. I find that during tax regimes in which corporate tax rates are more favorable for the use of debt, and during tax regimes in which shareholder tax rates are more favorable for firm distributions of funds to shareholders through stock repurchases, firms are more likely to aggressively utilize debt to undertake a leveraged share repurchase. Further supporting this claim, I find that firms aggressively utilize debt to fund leveraged share repurchases when they are likely to have low share turnover, suggesting that a greater percentage of shareholders qualify for preferential long-term capital gains. In contrast, I find that a firm is less likely to undertake a leveraged share repurchase if the firm has high stock turnover, low stock appreciation, or has greater ownership by short-term institutional shareholders. Overall, my results support the notion that corporate and shareholder-level taxes influence corporate leveraged share repurchases.

The Effect of Shareholder-Level Taxes on Organizational Form and Stock Ownership: Evidence from Equity Carve-Outs of Master Limited Partnerships

ABSTRACT I examine the role of heterogeneous shareholder-level taxes in organizational form decisions and in subsequent changes in investor stock ownership. Specifically, I investigate the decision to form a master limited partnership (MLP), which is a tax-advantaged entity for tax-sensitive shareholders, but a tax-disadvantaged entity for tax-exempt shareholders. Consistent with shareholder-level taxes influencing organizational form decisions, I find that firms owned by more tax-exempt shareholders are less likely to carve-out MLPs. Consistent with shareholder-level taxes influencing stock ownership, I find that tax-sensitive investors, on average, decrease their ownership in the parent and hold a relatively larger ownership share in the MLP than in the parent after the carve-out. In contrast, tax-exempt investors own less of the MLP than of the parent. These results provide evidence that firms cater to investors' shareholder-level taxes in making organizational form decisions and that investors sort on tax characteristics inherent to organizational form. JEL Classifications: G32; H24; H25. Data Availability: Data used in this study are available from public sources identified in the paper.

The Effect of Shareholder-Level Taxes on Organizational Form and Stock Ownership: Evidence from Equity Carve-Outs of Master Limited Partnerships

I examine the role of heterogeneous shareholder-level taxes in organizational form decisions and in subsequent changes in investor stock ownership. Specifically, I investigate the decision to form a master limited partnership (MLP), which is a tax-advantaged entity for some shareholders (tax-sensitive investors) and tax-disadvantaged for others (tax-exempt investors). Consistent with shareholder-level taxes influencing organizational form decisions, I find that firms owned by more tax-exempt shareholders are less likely to carve-out MLPs. Consistent with shareholder-level taxes influencing stock ownership, I find that tax-sensitive investors, on average, decrease their ownership in the parent and hold a relatively larger ownership share in the MLP than in the parent after the carve-out. In contrast, tax-exempt investors own less of the MLP than of the parent. These results provide the first evidence that firms cater to investors’ shareholder-level taxes in making organizational form decisions and that investors sort on tax characteristics inherent to organizational form.

Summaries of Papers in this Issue

Summaries of Papers in this Issue

Did the 2003 Tax Act Increase Capital Investments by Corporations?

This study investigates the role of shareholder-level taxes on corporate investment. We use the passage of the Jobs and Growth Tax Relief Reconciliation Act of 2003 (hereafter, 2003 Tax Act) as a quasi-natural experiment to answer our research questions. The 2003 Tax Act reduced shareholder-level taxes on dividends and capital gains. Relative to legislative changes in 1993 and 1997 that also impacted shareholder-level taxes, the 2003 Tax Act changed tax rates on both capital gains and dividends and led to a dramatic decrease in the average marginal shareholder-level tax rate. Furthermore, prior research suggests that the 2003 Tax Act increased firms' share prices (Auerbach and Hassett 2006) and reduced firms' cost of equity capital (Dhaliwal et al. 2007). We predict that firms increased investment in response to the Act.Our study focuses on corporate investment for two reasons. First, a stated goal of the 2003 Tax Act was to encourage capital investment by corporations. Second, capital investment is a fundamental component of firm value (Hanlon and Heitzman 2010). Thus, our study is of interest to policymakers and academics. Whether changes in shareholder-level taxes will impact corporate investment is an open empirical question. Prior research suggests that firms could increase dividends in response to reductions in shareholder-level taxes instead of increasing investment (Chetty and Saez 2005). In addition, some firms may fund investment with internal funds and not equity, in which case, any reduction in the cost of equity capital derived from the 2003 Tax Act is unlikely to impact investment.We regress capital expenditures on an indicator variable equal to one for time periods after the Act, and controls for cross-sectional differences in capital expenditures. We first document that capital expenditures increase after the 2003 Tax Act. Because the economy was coming out of a recession around the 2003 Tax Act, it is possible that macroeconomic conditions unrelated to taxes caused investment to increase. To better link our findings to the 2003 Tax Act, we use a difference-in-differences research design to show that this increase in capital expenditures varies predictably with two shareholder-level tax-motivated hypotheses. First, we find that the increase in investment is smaller for firms largely held by investors that are less sensitive to shareholder-level taxes. Second, we find that the increase in investment is larger for firms most likely to fund investment from new equity issuances, rather than internal funds.In additional analysis, we examine how firms' dividend payout policy impacts our results. We find that while the majority of firms increase investment after the tax cut, a small subset of larger, older, and cash-rich firms increased dividend payout instead. Overall, our results suggest that, consistent with the intent of policymakers, the shareholder-level tax rate reductions set forth in the 2003 Tax Act increased corporate investment. Our findings add further evidence to the question of whether taxes impact firms' value and investment.

Did the 2003 Tax Act Increase Capital Investments by Corporations?

ABSTRACT On May 28, 2003, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act) reduced shareholder-level taxes on dividends and capital gains. One of the goals of the 2003 Tax Act was to encourage capital investment by corporations. We investigate whether firms increased investment in response to the Act. We first document that capital expenditures increase after the 2003 Tax Act. We then use a difference-in-differences research design to show that this increase in capital expenditures varies predictably with two shareholder-level tax-motivated hypotheses. First, we find that the increase in investment is smaller for firms largely held by investors that are less sensitive to shareholder-level taxes. Second, we find that the increase in investment is larger for firms most likely to fund investment from new equity issuances rather than internal funds. Additional analysis suggests that while the majority of firms increase investment after the tax cut, a small subset of larger, older, and cash-rich firms increased dividend payout instead. Overall, our results suggest that, consistent with the intent of policymakers, the shareholder-level tax rate reductions set forth in the 2003 Tax Act increased corporate investment. JEL Classifications: G12, G31, G32, G24

Valuation of Pass-Through Entities: Looking at the Bigger Picture

A critical and ongoing controversy in the valuation of closely held companies relates to the relative value of pass-through entities vis-a-vis traditional corporations which are subject to double taxation. This issue gained significant recognition in 1999 with the Tax Court's decision in Gross v. Commissioner. In that case, the Tax Court first examined and then rejected the concept of affecting the earnings of a Subchapter S corporation when using the income approach to estimate the fair market value of a firm. Absent tax affecting, the appraised fair market value of a typical closely-held corporation increases by more than 50 percent when it elects to be taxed under Subchapter S, since that is how much its after-tax income increases. This is a conclusion that has been rejected outright by the majority of private equity analysts, creating significant controversy and uncertainty for valuation analysts and the IRS. This paper documents a wealth of empirical research that demonstrates that the Tax Court, the IRS and indeed the valuation profession are missing the larger issue. Cost of capital estimates based on publicly traded markets impound shareholder-level taxes, but at varying rates across firms and over time. Fortunately, research may also provide a means of removing the effects of shareholder-level taxes, yielding an untainted and defensible cost of equity capital appropriate for the valuation of closely held companies.

Did the 2003 Tax Act Increase Capital Investments by Corporations?

On May 28, 2003, the Jobs and Growth Tax Relief Reconciliation Act of 2003 (2003 Tax Act) reduced shareholder-level taxes on dividends and capital gains. One of the goals of the 2003 Tax Act was to encourage capital investment by corporations. We investigate whether firms increased investment in response to the Act. We first document that capital expenditures increase after the 2003 Tax Act. We then use a difference-in-differences research design to show that this increase in capital expenditures varies predictably with two shareholder-level tax-motivated hypotheses. First, we find that the increase in investment is smaller for firms largely held by investors that are less sensitive to shareholder-level taxes. Second, we find that the increase in investment is larger for firms most likely to fund investment from new equity issuances rather than internal funds. Additional analysis suggests that while the majority of firms increase investment after the tax cut, a small subset of larger, older, and cash-rich firms increased dividend payout instead. Overall, our results suggest that, consistent with the intent of policymakers, the shareholder-level tax rate reductions set forth in the 2003 Tax Act increased corporate investment.

Capital Gains Taxes, Pricing Spreads and Arbitrage: Evidence from Cross-Listed Firms in the U.S.

We examine how shareholder-level taxes affect the contemporaneous pricing of foreign firms' U.S. cross-listed and underlying home-country securities surrounding the 1997 reduction in U.S. capital gains tax rates. Consistent with tax capitalization, we find that the performance of cross-listed shares is negatively related to dividend yield, suggesting an abnormal price increase for shares with greater anticipated taxable capital gains. Due to barriers to cross-border arbitrage, underlying home-country securities, on average, do not react during the event, creating a temporary tax-induced pricing spread. When costs of arbitrage are low, the pricing disparity quickly dissipates and home-country shares closely mirror the pricing of their cross-listed counterparts. In further tests, we are unable to document lock-in behavior, which predicates a decrease in prices attributable to a surge in volume for shares with greater accrued taxable capital gains. Overall, our findings suggest that an exogenous shock to the U.S. tax regime reverberates in international asset prices, thereby affecting foreign firms' costs of capital.

Did the 2003 Tax Act reduce the cost of equity capital?

The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced shareholder-level taxes on equity income. If shareholder-level taxation is a component of cost of equity capital, then the cost of equity capital should decrease after the Tax Act. We find that the cost of equity capital decreases by 1.02% and that the decline is smaller for firms largely held by institutional investors to whom the tax rate reduction does not apply. These results suggest that the Tax Act lowered the cost of equity capital and add further evidence to the question of whether taxes impact valuation.

Fundamentals of shareholder tax capitalization

We investigate how shareholder-level taxes are capitalized into stock prices using a model that incorporates the investment and payout decisions of a firm and the investment alternatives available to investors. Shareholder taxes affect stock prices both indirectly, via the effect of taxes on corporate investment decisions, and directly, by reducing both the mean and variance of after-tax returns. In our model, tax capitalization is not eliminated by the presence of tax-exempt investors, does not depend on whether equity is composed of contributed capital or retained earnings, and does not depend on the tax rate faced by a hypothetical marginal investor.

Dividends and Tax Policy in the Long Run

There is a long-standing debate as to whether changes in shareholder-level taxes have an effect on firm dividend policy. The traditional view is that tax changes influence dividends, while the new view is that there generally is no such effect. In support of the traditional view, recent observers point to the rise in dividends following the reduction in the tax rate on dividends in 2003. In fact, the resurgence in dividends has been so strong that President Bush has made it one of his top legislative priorities to permanently extend the tax cut, which is currently set to expire at the end of 2010. The popular assumption is that the rise in dividends - and any associated economic and corporate governance benefits - will only continue if the lower rate is made permanent. This Article challenges that assumption. Using finance theory and empirical evidence from the U.S. and other countries, this Article shows that the relationship between dividends and taxes over the long run is more complex than dividend tax cut proponents suggest. Because the 2003 tax cut was only a temporary cut, making it permanent may actually have an effect that is opposite of what is intended. The implication is not that a temporary tax cut is preferable to a permanent one, but rather that the attempt to influence corporate behavior through the tax laws should be resisted as either futile or potentially counterproductive.

Momentum, Book-to-Market Equity, and the 2003 Dividend Tax Cut

We investigate market reactions and portfolio performance around the announcement of the January 2003 proposal to eliminate shareholder-level taxes on dividends. Although stock reactions during the period depend on dividend yield, we find momentum and book-to-market are also important in explaining cross-sectional stock returns. It appears that the dividend tax cut proposal triggered a market-wide re-valuation of stocks, which magnified the momentum and book-to-market effects, even for those stocks that were not paying dividends. Therefore, the period surrounding this announcement provides a unique opportunity to present new evidence on the causes for the momentum and book-to-market effects. We examine portfolios formed on dividend yield, momentum, and B/M during a 26-day window that includes a 9-day sub-window. Our most striking finding is that the momentum effect is extremely sensitive to the holding period. There is strong return continuation during the long window but reversal during the short window. The momentum and reversal effects are not driven by dividend yield, because these effects are among the strongest across zero-yield stocks. The coexistence of strong momentum and reversal in the same sample over a short period with reinforcing news announcements suggests that time-varying risk premia cannot explain the momentum and reversal effects, because the probability of the risk premium flipping signs in 26 days is remote, and it is equally improbable to expect this strong pattern of returns to be caused by chance, especially in view of the fact that we observe the effect in portfolios of stocks, not individual equities. We find that the B/M effect is not driven by dividend yield since, even for zero-yield stocks, high B/M portfolios outperform low B/M stocks in the 9-day window. After controlling for yield and momentum, we detect significant and positive B/M coefficients. While, in principle, the B/M effect could be driven by risk, the evidence does not appear to support such an explanation because (1) the B/M effect over the 26-day window is significant only when conditional on momentum, (2) the B/M effect is concentrated in the highest and lowest momentum stocks, (3) the reversal effect is strongest in high B/M stocks, and (4) we continue to find significantly positive B/M effects even after controlling for distress risk. Taken as a whole, our results are consistent with the notion that momentum and reversal are related to investor sentiment and the B/M effect a result of market's correcting its own misvaluation.

Capital Gains Taxes, Pricing Spreads, and Arbitrage: Evidence from Cross-Listed Firms in the U.S.

ABSTRACT: We examine how shareholder-level taxes affect the contemporaneous pricing of foreign firms' U.S. cross-listed and underlying home-country securities surrounding the 1997 reduction in U.S. capital gains tax rates. Consistent with tax capitalization, we find that the performance of cross-listed shares is negatively related to dividend yield, suggesting an abnormal price increase for shares with greater anticipated taxable capital gains. Due to barriers to cross-border arbitrage, underlying home-country securities, on average, do not react during the event, creating a temporary tax-induced pricing spread. When costs of arbitrage are low, the pricing disparity quickly dissipates and home-country shares closely mirror the pricing of their cross-listed counterparts. In further tests, we are unable to document lock-in behavior, which predicates a decrease in prices attributable to a surge in volume for shares with greater accrued taxable capital gains. Overall, our findings suggest that an exogenous shock to the U.S. tax regime reverberates in international asset prices, thereby affecting foreign firms' costs of capital.

Treasury Bill Yield Reactions to the 1997 Capital Gains Tax Rate Reduction

I provide evidence that changes in shareholder-level taxes influence investment returns even when income from the investment is not subject by statute to the rate that is changed. Using an equilibrium model of after-tax investment returns I predict the yields of Treasury bills, which are subject only to ordinary tax rates, will have an inverse reaction to changes in the capital gains tax rate as the income on them becomes increasingly tax-disadvantaged when compared to other investments. In a sample comprised of short-term Treasury bills, yields appear to increase in response to the May 7, 1997 surprise reduction in capital gains tax rates. The increase is statistically significant and is robust to other macroeconomic and institutional determinants of Treasury bills.

The Effect of Shareholder-Level Capital Gains Taxes on Acquisition Structure

This study investigates the effect of shareholder capital gains taxes on the structure of corporate acquisitions. We analyze a sample of large publicly traded firms acquired in taxable cash-for-stock and tax-free stock-for-stock acquisitions from 1975 to 2000. We model acquisition structure (i.e., taxable cash-for-stock acquisitions versus tax-free stock-for-stock acquisitions) as a function of target shareholder capital gains taxes and other economic factors believed to influence acquisition structure. Consistent with expectations, we find a positive association between the capital gains tax rate for individual investors and the use of tax-free stock-for-stock acquisitions. In addition, we find that the effect of the capital gains tax rate for individuals decreases with target institutional ownership (a proxy that represents the likelihood the price-setting shareholder is not subject to the individual capital gains tax rate). We reconcile our analyses with previous studies and identify a plausible explanation for the lack of results in prior research. In supplemental analysis, we also report evidence that corporations “time” the completion of taxable acquisitions around major tax rate changes to minimize shareholder capital gains taxes. In sum, results suggest that shareholder-level taxes have a significant effect on the choice of taxable cash-for-stock versus tax-free stock-for-stock acquisitions, and this effect varies with the tax status of target shareholders.

Capitalization of Shareholder Taxes in Stock Prices: Evidence from the Revenue Reconciliation Act of 1993

We investigate the capitalization of shareholder-level taxes into stock values and provide evidence that capitalization of dividend taxes is influenced both by dividend policy and institutional ownership. We regress weekly abnormal stock returns surrounding the passage of the Revenue Reconciliation Act of 1993 on firm dividend yield, institutional ownership, and control variables. We document a negative stock price reaction conditioned on dividend yield during the two weeks in August, 1993, that Congress passed and President Clinton signed legislation that increased individual income tax rates. In addition, we find that the level of institutional holdings, which proxies for whether the marginal investor in a particular stock is an individual taxpayer, moderates this negative stock price reaction. These findings demonstrate that dividend tax capitalization depends upon both the expected dividend policy of the firm and the tax status of the marginal investor.

The Share Price Effects of Dividend Taxes and Tax Imputation Credits

The relation between shareholder-level taxes and firm value has fundamental implications for understanding why firms pay dividends and how taxes influence capital structure choices. Despite its importance, however, several underlying problems have hampered existing research on the specific question of dividend tax capitalization. We take a new approach, directly testing the relationship between dividend taxes and the valuation of common equity and earnings. Retained earnings are subject to dividend taxes upon distribution, but paid-in equity can be returned to shareholders as a tax-free return of capital. Therefore we test the prediction that dividend taxes result in a lower value for retained earnings than for paid-in equity, after controlling for the predictable influence of dividend taxes on the valuation of earnings. We strengthen this research design by repeating the basic test in several different tax regimes. In the United States, we perform tests for five tax regimes in the 1975-1994 period corresponding to five different levels of dividend taxation. We also conduct tests for the 1984 1994 period for Australia, France, Germany, Japan, and the United Kingdom. The non-U.S. settings allow for comparisons of empirical results across different levels of dividend tax relief provided by tax imputation credits. Our investigation results in three principal findings. First, firm-level results for the United States indicate that accumulated retained earnings are valued less per unit than contributed capital. This finding is consistent with the capitalization of future dividend taxes in retained earnings, and it is robust to inclusion of a variety of control variables and tests for possible alternative explanations. Second, we find that differences in dividend tax rates across U.S. tax regimes are associated with predictable differences in the implied tax discount for retained earnings. Third, cross-country variation in dividend tax rates is associated with predictable variation in the implied tax discount. Furthermore, the difference in dividend tax rates across two different tax regimes in the United Kingdom is associated with predictable differences in the value discount.

Taxation and Mutual Funds: An Investor Perspective

Shareholder level taxes are taken into account in determining the performance of growth and growth and income mutual funds over the 1963-1992 period. We rank a sample of funds on a before- and after-tax basis for investors in different income classes facing various investment horizons. The differences between the relative rankings of funds on a before- and after-tax basis are dramatic, especially for middle- and high-income investors. For instance, one fund that ranks in the 19th percentile on a pretax basis ranks in the 63rd percentile for an upper-income, taxable investor. We also present an analysis of the extra taxes that shareholders bear because of the failure of mutual funds to manage their realized capital gains in such a way as to permit a substantial deferral of taxes. While it is not possible to determine precisely this magnitude, the extra taxes almost certainly amounted to more than $1 billion in 1993.