Dividend stripping
Encyclopedia
Dividend stripping is the purchase of shares just before a dividend
is paid, and the sale of those shares after that payment, i.e. when they go ex-dividend.
This may be done either by an ordinary investor as an investment
strategy, or by a company's owners or associates as a tax avoidance
strategy.
, and a capital loss
when the shares fall in value (in normal circumstances) on going ex-dividend. This may be profitable if the income is greater than the loss, or if the tax
treatment of the two gives an advantage.
Different tax circumstances of different investors is a factor. A tax advantage available to everyone would be expected to show up in the ex-dividend price fall. But an advantage available only to a limited set of investors might not.
In any case the amount of profit on such a transaction is usually small, meaning that it may not be worthwhile after brokerage fees, the risk of holding shares overnight, the market spread, or possible slippage if the market lacks liquidity
.
scheme works to distribute a company's profits to its owners as a capital sum, instead of a dividend
. The purpose is generally that capital gains may be subject to less tax.
As a basic example, consider a company called ProfCo wishing to distribute $X, with the help of a stripper called StripperCo.
The net effect for the owners is an $X capital gain. The net effect for StripperCo is nothing, the dividend it receives is income, and its loss on the share trading is a deduction. StripperCo might need to be in the business of share trading to get such a deduction (i.e. treating shares as merchandise instead of capital assets).
Many variations are possible:
The tax treatment for each party in an exercise like this will vary from country to country. The operation may well be caught at some point by tax laws, and/or provide no benefit.
, ordinary external investors are free to buy shares cum-dividend and sell them ex-dividend, and treat the dividend income and capital loss
the same as for any other investment. But schemes involving a deliberate arrangement by a company's owners to avoid tax are addressed by anti-avoidance provisions of Part IVA the Income Tax Assessment Act 1936
.
there are franking credits attached to dividend
s under the dividend imputation
system. Those credits can only be used by eligible investors (see the dividend imputation
article), so there's a tension between different investors for the amount shares should fall when going ex-dividend. A rationally priced
drop for one group is a bonus or trading opportunity for the other.
But the difference is not large. In a franked dividend, each $0.70 cash has $0.30 of franking attached (at the 30% company tax rate for 2005). To eligible investors it's worth $1.00, to others it's worth only $0.70 (of before-tax income in both cases). A typical half-yearly dividend (in 2005) of 2% of the share price would mean an extra 0.85% in franking credits, an amount which might easily be swamped by brokerage and the general risks noted above.
schemes described above presently fall under anti-avoidance provisions of the Income Tax Assessment Act part IVA amendments introduced in 1981.
Part IVA is a set of general anti-avoidance measures addressing schemes with a dominant purpose of creating a tax benefit. Section 177E specifically covers dividend stripping. That section exists to avoid any difficulty that might arise from identifying exactly where a tax benefit arises in dividend stripping. Dividend stripping will generally result in money to owners being taxed as dividends, irrespective of interposed steps.
Section 177E also applies to related schemes which draw off profits from a company, benefitting its owners, not just to the formal payment of a dividend. For example,
Losses in the company for such related schemes may be recognised immediately in its accounts, or only booked progressively over future years, the latter being various "forward stripping" schemes. Both are caught by section 177E.
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
is paid, and the sale of those shares after that payment, i.e. when they go ex-dividend.
This may be done either by an ordinary investor as an investment
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
strategy, or by a company's owners or associates as a tax avoidance
Tax avoidance
Tax avoidance is the legal utilization of the tax regime to one's own advantage, to reduce the amount of tax that is payable by means that are within the law. The term tax mitigation is a synonym for tax avoidance. Its original use was by tax advisors as an alternative to the pejorative term tax...
strategy.
Investors
For an investor dividend stripping provides dividend incomeIncome
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. However, for households and individuals, "income is the sum of all the wages, salaries, profits, interests payments, rents and other forms of earnings...
, and a capital loss
Capital loss
Capital loss is the difference between a lower selling price and a higher purchase price, resulting in a financial loss for the seller. The IRS states that "If your capital losses exceed your capital gains, the excess can be deducted on your tax return"....
when the shares fall in value (in normal circumstances) on going ex-dividend. This may be profitable if the income is greater than the loss, or if the tax
Tax
To tax is to impose a financial charge or other levy upon a taxpayer by a state or the functional equivalent of a state such that failure to pay is punishable by law. Taxes are also imposed by many subnational entities...
treatment of the two gives an advantage.
Different tax circumstances of different investors is a factor. A tax advantage available to everyone would be expected to show up in the ex-dividend price fall. But an advantage available only to a limited set of investors might not.
In any case the amount of profit on such a transaction is usually small, meaning that it may not be worthwhile after brokerage fees, the risk of holding shares overnight, the market spread, or possible slippage if the market lacks liquidity
Market liquidity
In business, economics or investment, market liquidity is an asset's ability to be sold without causing a significant movement in the price and with minimum loss of value...
.
Tax avoidance
Dividend stripping as a tax avoidanceTax avoidance
Tax avoidance is the legal utilization of the tax regime to one's own advantage, to reduce the amount of tax that is payable by means that are within the law. The term tax mitigation is a synonym for tax avoidance. Its original use was by tax advisors as an alternative to the pejorative term tax...
scheme works to distribute a company's profits to its owners as a capital sum, instead of a dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
. The purpose is generally that capital gains may be subject to less tax.
As a basic example, consider a company called ProfCo wishing to distribute $X, with the help of a stripper called StripperCo.
- 1. StripperCo buys ProfCo shares from their present owners for $X+Y.
- 2. ProfCo pays a dividend of $X to StripperCo.
- 3. StripperCo sells its shares back to the owners for $Y.
The net effect for the owners is an $X capital gain. The net effect for StripperCo is nothing, the dividend it receives is income, and its loss on the share trading is a deduction. StripperCo might need to be in the business of share trading to get such a deduction (i.e. treating shares as merchandise instead of capital assets).
Many variations are possible:
- StripperCo might buy different "class B" shares in ProfCo for just the $X amount, not the whole of ProfCo.
- Such class B shares could have their rights changed by ProfCo, rendering them worthless, instead of StripperCo selling them back.
- ProfCo might lend money to StripperCo for the transaction, instead of the latter needing bridging finance.
The tax treatment for each party in an exercise like this will vary from country to country. The operation may well be caught at some point by tax laws, and/or provide no benefit.
Australia
In AustraliaAustralia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
, ordinary external investors are free to buy shares cum-dividend and sell them ex-dividend, and treat the dividend income and capital loss
Capital loss
Capital loss is the difference between a lower selling price and a higher purchase price, resulting in a financial loss for the seller. The IRS states that "If your capital losses exceed your capital gains, the excess can be deducted on your tax return"....
the same as for any other investment. But schemes involving a deliberate arrangement by a company's owners to avoid tax are addressed by anti-avoidance provisions of Part IVA the Income Tax Assessment Act 1936
Income Tax Assessment Act 1936
Income Tax Assessment Act 1936 is an act of the Parliament of Australia. It's one of the main statutes under which income tax is calculated. The act is gradually being rewritten into the Income Tax Assessment Act 1997, and new matters are generally now added to the 1997 act.The reason for...
.
Investors
Dividend stripping by investors has the general advantages or disadvantages described above, but in addition in AustraliaAustralia
Australia , officially the Commonwealth of Australia, is a country in the Southern Hemisphere comprising the mainland of the Australian continent, the island of Tasmania, and numerous smaller islands in the Indian and Pacific Oceans. It is the world's sixth-largest country by total area...
there are franking credits attached to dividend
Dividend
Dividends are payments made by a corporation to its shareholder members. It is the portion of corporate profits paid out to stockholders. When a corporation earns a profit or surplus, that money can be put to two uses: it can either be re-invested in the business , or it can be distributed to...
s under the dividend imputation
Dividend imputation
Dividend imputation is a corporate tax system in which some or all of the tax paid by a company may be attributed, or imputed, to the shareholders by way of a tax credit to reduce the income tax payable on a distribution...
system. Those credits can only be used by eligible investors (see the dividend imputation
Dividend imputation
Dividend imputation is a corporate tax system in which some or all of the tax paid by a company may be attributed, or imputed, to the shareholders by way of a tax credit to reduce the income tax payable on a distribution...
article), so there's a tension between different investors for the amount shares should fall when going ex-dividend. A rationally priced
Rational pricing
Rational pricing is the assumption in financial economics that asset prices will reflect the arbitrage-free price of the asset as any deviation from this price will be "arbitraged away"...
drop for one group is a bonus or trading opportunity for the other.
But the difference is not large. In a franked dividend, each $0.70 cash has $0.30 of franking attached (at the 30% company tax rate for 2005). To eligible investors it's worth $1.00, to others it's worth only $0.70 (of before-tax income in both cases). A typical half-yearly dividend (in 2005) of 2% of the share price would mean an extra 0.85% in franking credits, an amount which might easily be swamped by brokerage and the general risks noted above.
Tax avoidance
The kind of dividend stripping tax avoidanceTax avoidance
Tax avoidance is the legal utilization of the tax regime to one's own advantage, to reduce the amount of tax that is payable by means that are within the law. The term tax mitigation is a synonym for tax avoidance. Its original use was by tax advisors as an alternative to the pejorative term tax...
schemes described above presently fall under anti-avoidance provisions of the Income Tax Assessment Act part IVA amendments introduced in 1981.
Part IVA is a set of general anti-avoidance measures addressing schemes with a dominant purpose of creating a tax benefit. Section 177E specifically covers dividend stripping. That section exists to avoid any difficulty that might arise from identifying exactly where a tax benefit arises in dividend stripping. Dividend stripping will generally result in money to owners being taxed as dividends, irrespective of interposed steps.
Section 177E also applies to related schemes which draw off profits from a company, benefitting its owners, not just to the formal payment of a dividend. For example,
- The stripper receiving a non-recoverable loan, instead of a dividend from the target company.
- The stripper selling a worthless asset to the company.
- Owners (without a separate stripper) selling a part interest in an asset to the company, but later changing the terms to reduce its value.
Losses in the company for such related schemes may be recognised immediately in its accounts, or only booked progressively over future years, the latter being various "forward stripping" schemes. Both are caught by section 177E.