Abstract
Abstract
The article examines the impact of regulatory changes in the tax on dividends on the payout policy of Indian companies. The tax law was recently amended to levy tax on dividends received by large shareholders. As the promoters group is the largest shareholder, this is expected to have a negative impact on the payout policy of companies. Furthermore, companies with larger promoter holdings have a higher motivation to reduce their payout. The study covers 370 companies present in the BSE 500 Index and compares the dividend payout of the companies before and after the introduction of tax levy. The study finds that the newly introduced tax indeed caused a shift in the dividend policy of companies, particularly those companies which have high levels of inside ownership. The findings have significant implications for companies, investors and the government.
Introduction
The main goal of all corporate financial decisions is to maximize shareholder value. One of these decisions relates to the payout policy of the company. Companies have to decide on the part of their earnings that can be paid to shareholders as dividends and the part that is to be retained in the business. Miller and Modigliani (1961) argued that the dividend policy of a company has no effect on its value. The value of the company depends on its income and not on how this income is divided between dividends and retained earnings. A key assumption made by Miller and Modigliani in developing their theory was the absence of taxes. However, taxes do exist in the real world. The division of corporate earnings between dividends and retained earnings has different tax implications for shareholders. Dividends received by shareholders are taxed in the year of receipt at higher tax rates. Retention and reinvestment of earnings are expected to lead to an increase in the stock price and lower taxed capital gains. In general, cash dividends are taxed at a higher rate as compared to tax on capital gains. Further, tax on capital gains is paid only when the stock is sold, resulting in lower effective tax costs. Tax status of a company’s shareholder is, therefore, an important factor that has an influence on its payout policy. Wealthy investors who hold majority of stock and receive most of the dividends may prefer that companies retain profits rather than pay dividends or substitute dividends by share repurchases. Share repurchases have tax consequences for shareholders similar to that of retention and reinvestment.
The rest of the article is organized as follows. The second section deals with the review of literature. The third and fourth sections lay down the objectives and rationale of the study, respectively. The fifth section covers data and research methodology. The sixth section analyses the empirical results. The seventh section concludes the article. The managerial implications of the results are discussed in the eighth section.
Review of Literature
Many studies in the USA have analysed the changes in corporate dividend policy in response to changes in investor-level taxes on dividend income. Two major changes were effected in the USA by the Tax Reform Act of 1986 and the Jobs and Growth Tax Relief Reconciliation Act (JGTRAA) of 2003. Under both these Acts, the tax rate on the dividend income of shareholders was lowered.
Gordon and Mackie-Mason (1990) found that after the Tax Reform Act of 1986, corporate dividend payments increased. Bolster and Janjigian (1991) also found a significant effect of change in dividend taxation on the prices of stocks. Stocks with high dividend yields increased in value relative to low-yielding stocks and stocks not paying dividends.
Poterba (2004) analyses the potential impact of JGTRRA on corporate payout behaviour by examining the historical relationship between the relative tax burden on dividends and capital gains and the share of corporate earnings distributed as cash dividends. He also considers actual changes in payout behaviour since JGTRRA was enacted and discusses the interaction between payout decisions and investment decisions. Poterba finds that the enactment of JGTRRA raises the after-tax value of dividends relative to capital gains by more than five percentage points. Based on the historical patterns of corporate behaviour, he predicts that JGTRRA ultimately will increase dividends by almost 20 percent.
Blouin, Raedy, and Shackelford (2011) found that firms adjusted their distribution policy, specifically, dividends versus share repurchases, in a manner consistent with the altered tax incentives for individual investors in response to the 2003 rate reductions.
The ownership structure of a company also has an influence on its payout policy. Kumar (2006) examines the possible association among ownership structure, corporate governance and firms’ dividend payout policy and found consistent support for the potential association between ownership structure and dividend payout policy.
DeAngelo, DeAngelo, and Skinner (2008) assert that idiosyncratic preferences of controlling stockholders have a first-order impact on the corporate payout policy. Investors with large shareholding are most affected by the change in tax rates on dividend income. Companies with high levels of large taxable institutional owners or promoters are expected to be more sensitive to changes in the tax structure of dividends.
Chetty and Saez (2005) document a 20 per cent increase in dividend payments by non-financial, non-utility publicly traded corporations following the tax cut in individual dividend income under the JGTRAA. An unusually large number of firms initiated or increased regular dividend payments in the year after the reform. The response to tax cuts varied with the ownership structure of the firm.
Firms with high levels of non-taxable institutional ownership did not change payout policies, supporting the causality of the tax cut in increasing aggregate dividend payments. The response to tax cuts was the strongest in firms with strong principals whose tax incentives changed (those with large taxable institutional owners or independent directors with large shareholdings) and in firms where agents had stronger incentives to respond (a high share ownership and low-options ownership among top executives). Hence, principal-agent issues appear to play an important role in corporate responses to taxation.
Chetty and Saez (2006) observed that tax reform played a significant role in the recent increase in dividend payouts. Controlling for observables such as profits, forecasted earnings and industry composition does not affect the results. There is no change in dividend initiations for a ‘control group’ of firms for which primary shareholders are large non-taxable institutions unaffected by the tax cut.
Taxability of Dividends in India
Dividends paid by Indian companies are tax free in the hands of the shareholders. However, a company distributing dividends is required to pay a dividend distribution tax (DDT) on the amount of dividend distributed. The DDT was introduced to simplify the complexities of tax collection as tax is paid by the company distributing the dividend rather than shareholders receiving the dividend. The effective rate of DDT currently stands at 20.36 per cent of the amount of dividend paid. The tax law was further amended with effect from 2015 to 2016 and accordingly, in addition to the DDT paid by companies, tax at the rate of 10 per cent of gross amount of dividend will be payable by recipients, receiving dividend in excess of INR1 million per annum. Justifying the additional tax, the finance minister in the budget speech said, ‘Dividend Distribution Tax (DDT) uniformly applies to all investors irrespective of their income slabs. This is perceived to distort the fairness and progressive nature of taxes. Persons with relatively higher income can bear a higher tax cost’ (The Economic Times, ‘Budget 2016...’).
Clearly, amendment in tax law would impact large shareholders receiving dividends in excess of INR1 million in 1 year. As promoters are the largest recipients of dividends, the move would result in higher tax outgo by the promoters’ group. The tax liability may prompt Indian companies to reduce their dividend payout and look for alternate ways of rewarding the shareholders who are more tax efficient.
Analysts are expecting realignment in the corporate dividend policy as a consequence of the newly introduced tax on dividends in the hands of large shareholders.
Wipro is considering a share buyback, the first such by any of the top five Indian IT companies, and appears at least partly to be a response to the Budget proposal imposing a 10 per cent tax on dividends of more than INR one million per year. If the buyback is in lieu of a dividend payout, large shareholders can save on the new tax. (The Times of India, 2016, April 13). When Wipro announced its buyback, analysts immediately pinned it on the new dividend tax. Announced in the Budget, companies now have to pay 10% additional tax on dividends above INR one million besides the 20% distribution tax. For a company like Wipro, where promoters hold 73.4% stake, this tax has compounded matters. Considering last year’s dividend of INR 29,455 million, the company might have to pay INR 1,727 million on top of the INR 5,924 million paid last year. A buyback though can save it close to INR 7,650 million besides enhancing shareholder value. (Outlook Business, 2016, May 5)
Graham (2003) reviews tax research related to many corporate finance decisions. He found that tax research generally supports the hypothesis that high tax-rate firms pursue policies that provide tax benefits. According to him, the issue of whether corporate actions are affected by investor-level taxes remains unresolved and needs further research.
The research on this issue mainly relates to the US market. The recent change in the taxability of dividends under Indian tax laws provides a natural setting to examine the effect of investor-level tax changes on the corporate payout policy in India.
Objectives
The article aims at examining the impact of the newly introduced tax on the dividend distribution policy of the Indian companies controlling the effect of other variables impacting dividend payout, namely size, liquidity, free cash flow, tangible assets, growth, cash flow volatility and leverage.
Rationale
Research on dividends in India has mainly focused on the determinants of corporate dividend (Labhane & Mahkud, 2016) and on the effect of dividend announcements on stock prices (Chatterjee & Dutta, 2017; Sarvanakumar, 2011). To the best of our knowledge, this is the first article in India that attempts to examine the impact of tax changes on corporate dividend policy in India. We predict that the increase in taxes on large dividend income will lower the dividend payout in companies with large inside ownership.
Data and Methodology
Variables Impacting Dividend Policy
Following the extant literature, we have used dividend payout ratio (DPR) as the measure of dividend policy. DPR has been defined as the ratio of dividends per share (DPS) to earnings per share (EPS). We use DPR as the dependent variable and the following variables as explanatory variables.
Free cash flow (FCF): The ability of the firm to pay dividend is affected by the free cash flow generated during the year. A firm with higher FCF has a higher ability to pay dividend, signifying a positive relationship between the DPR and FCF. Free cash flow is the cash flow available with the company after meeting the requirements of capital expenditure and additional working capital. Liquidity (LIQ): The dividend decision of a firm is also affected by the liquidity position of the firm. A firm with higher liquidity is more likely to pay higher dividend and vice versa. We have used the current ratio as the measure of liquidity. The current ratio is measured as the ratio of current assets to current liabilities. A positive relationship is expected between DPR and liquidity position of the firm. Cash flow volatility (CV): In general, the more predictable are future cash flows, higher the dividend payout ratio. Cash flow volatility can be taken as a proxy for business risk. Firms with stable and predictable cash flows are considered to be less risky. We expect an inverse relationship between DPR and cash flow volatility. The standard deviation of the operating cash flows in the past 10 years has been taken as the indicator of cash flow volatility. Growth (GR): It may be argued that growing firms would need higher internal equity and therefore they tend to pay lower dividends. On the other hand, it may also be argued that growth leads to the improved ability of the firm to pay higher dividends. As growing companies enjoy better valuation in the stock market, the ratio of market value of equity to book value of equity has been taken as the proxy for growth. Size (SZ): Larger firms have a higher number of non-promoter shareholders and also have better ability to access the capital market. With easy access to the capital market, larger firms can afford to pay higher dividends. In addition, they also need to pay higher dividends to keep external shareholders happy. We measure the size as the natural log of the total assets of the firm. A positive relationship between DPR and SZ is hypothesized. Tangibility of assets (TANG): A higher proportion of tangible assets in total assets enables a company to easily raise external finance as these tangible assets can be offered as collateral to prospective lenders. The higher proportion of tangible assets also ensures a higher level of protection for the bondholders, thereby reducing the agency problem arising due to the conflicts between the bondholders and shareholders. Such a company can, therefore, pay a higher amount as dividend. The tangibility of the asset has been measured as the net fixed assets divided by total assets, and a positive relationship has been hypothesized between tangibility and DPR. Leverage ratio (LEV): Companies having a larger amount of debt are likely to retain greater proportions of their profits for debt servicing. Profits are first used to pay interest and repayment of principal. Lenders also impose restrictive covenants, limiting the rate or amount of dividend that can be paid by the borrower. Therefore, an inverse relationship between leverage and dividend ratio is expected. The ratio of long-term debt to shareholders’ funds was used to estimate leverage. Promoter holding (PH): Companies with larger levels of promoter shareholding are expected to reward their shareholders by way of capital gains instead of by dividends. We hypothesize a negative relation between PH and DPR.
Determinants of Dividend Policy
Data
The study examines the difference in the payout of companies comprised in the BSE 500 Index for 2015 and 2016. Data for only two years 2015 and 2016 have been taken as the amendment in the tax law pertaining to dividends became applicable in 2015–2016. If the change in tax law has any effect on the payout policy of companies, it should reflect in the payout for 2016 relative to 2015. The sample for the study excludes companies in the financial service sector, utility sector and public sector as their payout policies are governed by different norms and regulations. The effective sample consists of 358 companies for 2015 and 370 companies for 2016. The difference in the sample size for 2 years is that new companies enter, while some others exit the BSE 500 Index from year to year.
Methodology
We first test whether the dividend policy of the sample companies changed in 2016 relative to 2015. For this purpose, we run the regression model given by Equation (1), one for 2015, second for 2016 and the third for the pooled sample for the 2 years. The difference between the two regression results is tested using the Chow test.
Next, we attempt to relate the change in dividend payout to the level of promoter holding as we expect that companies with higher promoter shareholding would be more inclined to reduce the dividend payout consequent to increase in the tax on high dividend income. For this purpose, we divide the sample into several subgroups based on promoters’ shareholding and test whether the reduction in dividend payout in 2016 is higher for companies with larger promoter shareholding. These subgroups are companies with promoter shareholding of 0–25 per cent and thereafter for every 5 per cent interval (e.g., 25–30 per cent, 30–35 per cent, etc.).
We run the regression given by Equation (2) for different levels of promoter holdings with a dummy variable for the year and a dummy variable that interacts with the year dummy (YR) and the dummy for promoter holding.
The coefficient of interest in Equation (2) is α9 as it will reveal the percentage change in the payout ratio of companies in the sub-group in 2016 that could be attributed to the effect of change in the level of personal taxes on dividends.
Analysis
Correlation Matrix
Regression Results for Change in Dividend Payout Ratio
The correlation coefficients are very low (the highest value being 0.296), indicating the absence of multicollinearity.
The results from the regression model in Equation (1) are presented in Table 3.
The Effect of Promoter Holdings on Change in Dividend Payout Ratio in 2016 in Response to Tax Rate Change in 2015
We then examine the types of companies where the impact of change in tax law is higher. This is done by running the regression in Equation (2). Table 4 presents the change in the dividend payout ratio in 2016 for companies with different levels of promoter holdings.
The change in the dividend payout is mixed, positive in some cases and negative in others. The changes are not statistically significant except in the subgroup of 60–65 percent promoter shareholding where dividend payout ratio in 2016 is lower by 21.3 per cent compared to that in 2015. Companies in the next higher subgroup with 70–75 per cent promoter shareholding have also reduced their dividend payout ratio by 14 per cent in 2016 though the change is not statistically significant. These results support our expectation that with an increase in tax on large dividend incomes, companies with higher inside ownership should reduce dividend payout and adopt more tax-efficient methods of rewarding their shareholders.
The evidence of the effect of change in personal dividend income on the company dividend payout is not very strong. It has been only 1 year since the change in the tax rate. With the passage of time, we expect more companies to align their dividend payout policy with the new tax law.
Conclusion
We started with the expectation that imposition of tax by the government of India from 2015 to 2016 on dividend income in excess of INR 1 million per annum received by investors should cause a shift in the dividend policy of companies, particularly those companies which have high levels of inside ownership. Such companies are in a better position to fine tune their dividend policies according to the changes in investor-level tax on dividend income. We find that the sample of companies other than financial, utility and public companies comprised in the BSE 500 Index has changed their dividend payout ratio in 2016 compared to that in 2015. A statistically significant change in the dividend payout ratio is observed in companies with a high proportion of inside ownership. The evidence, thus, supports our initial expectation. We expect more companies to tweak their dividend policy in the times to come.
Implications
Many investors prefer investing in those stocks that pay high dividends. For this purpose, they analyse the historical dividend payout ratios of different companies. The implication of new tax on high dividend income is that those companies that have been paying high dividends in the past may change their dividend payout policy in the future to save their internal shareholders from additional personal tax liability. This will be particularly applicable to companies with high insider shareholding. External investors, therefore, will need to take this factor into account in deciding on the company in which to invest. Companies, especially with higher promoters’ holding, may be tempted to reduce their dividend payout. Those investors, including institutional investors, who invest for getting large and regular dividend payouts would need to reassess their investment portfolio.
The results indicate that companies would reduce their payout ratio in view of the newly introduced tax on dividend in the hands of shareholders. This would adversely impact tax collection by the government. Instead of being able to collect extra amounts by taxing dividends in the hands of large shareholders, the government would actually lose DDT.
Footnotes
Acknowledgement
The authors are grateful to the anonymous referees of the journal for their extremely useful suggestions to improve the quality of the article. Usual disclaimers apply.
Declaration of Conflicting Interests
The authors declared no potential conflicts of interest with respect to the research, authorship and/or publication of this article.
Funding
The authors received no financial support for the research, authorship and/or publication of this article.