The downside of dividends

Dividends can be great — but be prepared for some headaches, especially with relation to tax and the drag on returns

et me state right upfront that I love dividends. Over the past few weeks I’ve been receiving them from stocks and exchange traded funds I hold. The money appears in my account and I can do anything with it a dinner out or, a much more adult response, reinvesting back into the market.

But dividends also come with some problems, most notably tax, but also a lag on performance.

Tax is the biggie. Dividend withholding tax (DWT) is 20% in South Africa and higher in many other markets. Now, sure, we can claim some of that foreign dividend tax back, but it’s a mission, and many don’t bother.

In contrast with the 20% DWT, capital gains tax (CGT) locally has an initial R40,000 exclusion and then only 40% of the capital gain is added to your income and taxed. So a top earner at the 45% marginal rate would pay only 18% on CGT. Somebody in the middle, with a 30% tax rate, pays on a 12% CGT rate, well below the 20% dividends tax rate.

Further, there is the drag on returns. Say I have a R20 stock and it pays a chunky 100c dividend. On the day after the last day to trade the stock falls to R19 and I receive

L80c (the 100c dividend less 20% DWT). So I am sitting on R19.80, only a modest 1% slippage, and the share price will potentially rally higher over time.

But the share price is at R19, and even if it doubles over the year until the next dividend payment, that’s R38. Without a dividend payment, that doubling would have made the stock rally to R40.

Now, no dividend may see the stock rally less, but there is an alternative: share buybacks. This is when a company uses its free cash to buy back its own shares, reducing the overall share count.

Staying with the R20 example above: let’s say there are 10,000 shares in issue, and instead of paying a dividend the company used the 100c a share R10,000 in total to buy back shares. It would have received 500 shares, which decreases the share count to 9,500, reducing it by 5%. This makes my holding of the company effectively 5% more I get 5% more of the profits and I didn’t pay any tax.

The risk is that share buybacks are done at overly elevated prices that ultimately destroy value, and we’ve certainly seen that. A listed company, and

I’m not naming and shaming it, bought back a ton of shares at R100 and a few years later the price was R30. Huge value destroyed. But it can work. Clicks has spent R7bn on buybacks since 2006, and the number of shares in issue is down by about a third. So your holding in the company is up 50%, with no tax paid.

Love me a dividend but the tax is a headache.