US dividend tax doubts could prompt special payouts

Uncertainty around the future taxation of dividends in the US could result in a slew of companies making special shareholder payouts before the year end.

Increasing the taxation of dividends is one of several measures that president Barack Obama is expected to introduce in a bid to help deal with the country’s pending 'fiscal cliff'.

Legg Mason US Equity Income fund manager Peter Vanderlee points out that dividends are currently taxed at 15% generally, and a potential increase in the investors’ nominal rate of tax could have massive implications for the market.

The issue is taking shape as a key battleground between the Democrats and the Republicans, where compromise or agreement seems the most distant.

‘No-one knows what the resolution will be, it is one of the biggest areas of uncertainty,’ Vanderlee says. ‘What I do think you will see in the US is a number of companies announcing special dividends before the year end and the impact will be noticeable.’

Several companies, including American Eagle, Sycamore Networks and DSW, have already announced special dividends and more are expected.

Vanderlee sees the uncertainty around the dividend tax as one of four factors currently holding back the market.

However, he says there does appear to be greater consensus, or at least a willingness to compromise, around the other three, with both parties seemingly agreeing that the existing payroll tax break will lapse on 1 January.

Similarly, the two parties are both against sequestration (automatic spending cuts) in January, worried about its impact on the military and although there are differences on both sides over potential upper bracket income tax hikes, there does seem scope for compromise, he says.

But despite the more thorny issue of dividend tax, Vanderlee remains upbeat about the prospects for US equities and in particular income stocks.

‘We have had scenarios where dividends were taxed much higher than they are now. Between 1941 and 1986 the tax rate on dividends was at least 50% and in some cases as high as 90%,’ he says.

‘During that period though dividend stocks continued to do well and outperform the broader market. This issue may drag on into 2013, but it doesn’t change the attractiveness of equity income as a strategy for us.’ He says valuations are not stretched at 13 times next year’s earnings and although the third quarter reporting season did show a trend of slowing earnings growth, he believes this is already priced in.