Dividend Policies From Tax Point of View


The decision to issue out dividends to the shareholders is usually a closely debated issue within the circles of company management. Usually, the decision to issue out dividends is not the only basic decision directors make but it is complimentary to the decision on whether to issue out dividends at all (Bhabatosh 2010, p. 233). There are significant implications to issuing out dividends, such as the implication of the movement on stock price or on the capital structure of the company. The implications of dividend issue are however not only felt by the company alone, but also to shareholders (because it has an effect on them through tax implications).

Many companies are therefore very critical when it comes to issuing out dividends and a number of them usually follow predetermined theories touching on dividend policies. Others are normally guided by individual company policies on dividend issue, while others are guided by the company’s financial cash flows, dividend clienteles, and information signaling (Bhabatosh 2010, p. 233). Despite there being different criteria for making dividend decisions, this study will focus on the clientele effect in decision-making and how it influences the tax framework of different groups of shareholders.

Literature Review

Usually, companies have different types of shareholders. Some of the most common are preferential shareholders and ordinary shareholders. When it comes to dividend payment, various shareholder groups may find a given dividend payment suitable to their investments while others may not. For instance, an investor who is out of work may find it suitable to invest in stocks that give high dividends while a person with a relatively higher financial flow may find it appropriate to avoid shares that have a high dividend rate because they attract a lot of marginal tax rates on income (Baker 2009, p. 131).

This kind of situation exposes the fact that different clientele groups normally invest in company shares for various reasons and companies can consequently capitalize on share prices and capital structures, simply by concentrating on a particular shareholder group. Many researchers observe that such forms of dividend policies adopted by various companies explain the consistencies observed in implementing various dividend policies by a number of companies (Baker 2009, p. 131).

One of the biggest disadvantages to the shareholder effect in dividend decision-making is observed from the fact that investors do not necessarily have to rely on various companies to dictate their financial cash flows (Kalay 1982, p. 1059). In other words, investors who prefer to have liquid cash can easily be able to do so by simply selling a given set of shares in his or her overall holdings. This sort of analysis is even more relevant today because there has been a crop of low-discount stockbrokers who have flooded most stock exchange markets worldwide (Kalay 1982, p. 1059). However, it does not come as a surprise that Kalay (1982, p. 1059) points out that there may be a number of taxation based shareholder groups that are normally affected by different tax frameworks.

Separately, Borges (2010) explains that the clientele effect in dividend decisions is normally based on market imperfections and tax implications because there are normally various fiscal framings that motivate investors. Farrar and Selwyn (1967) explain that because companies normally treat dividends differently, various investors are likely to experience different marginal tax implications.

This point of view is upheld because both researchers note that investors will always go out to maximize their net incomes at whatever cost. In situations where a company fails to pay dividends, investors will simply maximize their net returns from capital gains, sourced from the sale of their stocks. However, in situations where a company issues out dividends, a shareholder can easily enjoy the dividend gains, but it is important to note that both dividend and capital gains are all subject to tax (Kalay 1982, p. 1059).

In such a situation, Borges (2010) explains that investors would normally weigh the tax implications for both groups of investments and go for the option that has the lowest tax implication. For instance, if capital gain tax is relatively smaller than the dividend tax, investors would simply opt for the capital gains and leave the dividend gains.

However, in most cases, the dividend tax is normally higher than the capital gains tax and many people are normally discouraged by the high taxes. In such a case, companies should refrain from issuing dividends. This is the most prudent decision companies can make, considering many investors would prefer capital gains as opposed to dividend gains. Brennan (1970) builds on the work of Farrar and Selwyn by noting that there should be a shareholder model which encompasses the effect of taxes. With this realization, he established the capital asset pricing model which is an inclusionary criterion that encompasses the effects of taxes on capital and dividend gains. In support of this model, Brennan (1970) explains that

“For a given risk level, the investors demand higher returns on stocks with higher expected dividend yields, due to the higher taxation of dividends relative to capital gains. In other words, the investors accept lower returns before taxes, in the stocks that pay lower dividends and provide higher capital gains” (p. 417).

Black and Scholes (1974) also acknowledge that clientele effects exist and they explain that since there are different groups of shareholders in a given company; companies should vary their dividend policies to suit different groups of shareholders.

In other words, they should vary their dividend policies to satisfy the demand. Miller and Scholes (1978) also note that despite the fact that there may be high income tax of individuals when compared to capital gains, there are still various fiscal financial means which can be used to reduce the advantages evidenced in dividend gains; the implications for this assertion can be best summarized by Borges (2010) who notes that “The investors should be indifferent to dividends or capital gains, and so, there would not be reason to detect any clientele effect associated to the differential fiscal” (p. 9).

Analysis and Discussion

From the above analysis, we can conclude that firms which normally pay high dividends are normally subjecting their shareholder groups to very high taxation. Obviously, accepting dividend payments (for this group of investors) does not seem the best option for them because of the obvious tax implications, but a shift in prices cannot be assumed to be the clientele effect because it cannot be associated with the shareholder fiscal framing. The lack of shareholder effect in this scenario can be specifically attributed to the existent tax laws tied to dividend and capital gains.

In situations where shareholders don’t prefer to accept dividends, they are all supposed to pay a liberating tax benefit that is normally standardized for all groups of shareholders (and it does not increase in any given manner) (Borges, 2010).

The only manner through which the tax implications can vary is if there are instances where there are some fiscal benefits to be derived (like if specific shares are to be listed in the stock market or if the shares are of a privately listed company) (Borges, 2010). In this type of scenario, tax implications imposed are normally dependent on the performance of the shares in question, as opposed to the strategic choices adopted by the shareholders. Because the tax implication imposed on an investor is not the same for all shareholders, nor is it directly dependent on the problem, the clientele effect which is the focus of this study will not be experienced.

In the tabulation of company financial statements, it is correct to note that dividends are bound to be included as the financial profits for the company but the tax to be levied is supposed to be the same for all groups of investors. This category of shareholders is not supposed to experience the clientele effect and in the same manner, the possibility of inferring the marginal investors’ income tax is also not possible. Nonetheless, it would be wrong to say that this fact can be used to explain the link between price adjustments and the resultant financial gains derived from the dividends. The probable reason why such a developments is noted could be a market anomaly or a shift in price, previous to the day the dividend was supposed to be issued.


The comprehension of the clientele effect need not be understood from a tax point of view but also a market point of view and upon analyzing the main aim of issuing out dividends in the first place. Because there are normally different groups of shareholders, there are instances where capital gains will be more preferred to dividends. This means that companies will normally refrain from issuing out dividends if the tax implication is higher than in capital gains.

The different fiscal treatment of dividends is therefore a strong factor which affects capital gains and shareholder preferences. Comprehensively, it can be understood that the significance of clientele effects cannot be assumed in situations where dividends and capital are taxed differently.


Baker, H. (2009) Dividends and Dividend Policy. London: John Wiley and Sons.

Bhabatosh, B. (2010) Fundamentals of Financial Management. New York: PHI Learning Pvt. Ltd.

Black, F., and Scholes, M. (1974) The Effects of Dividend Yield and Dividend Policy on Common Stock Prices and Returns. Journal of Financial Economics, 1(1), 1 – 22.

Brennan, M. (1970) Taxes, Market Valuation and Corporate Financial Policy. National Tax Journal, 23(23), 417 – 427.

Borges, M. (2010) Clientele Effects In Dividends Distributions – ThePortuguese Case. Web.

Kalay, A. (1982) The Ex-Dividend Day Behavior of Stock Prices: a Re-Examination Clientele Effect. The Journal of Finance, 37(4), 1059-1070.

Miller, M., and Scholes M. (1978) Dividends and Taxes. Journal of Financial Economics, 6, 333 – 364.

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