Tax on dividend and retained earnings may repel investors

Sabbir Ahmed | Published: June 28, 2019 21:35:09 | Updated: July 11, 2019 15:54:06

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The proposed budget for the financial year 2019-20 was presented to the nation through the national parliament on June 13. It is the 48th budget of the nation and the first budget from the incumbent Finance Minister AHM Mustafa Kamal. Among many other things, the budget has proposed 15 per cent tax on stock dividend to shareholders distributed by any listed company. An additional 15 per cent tax has been proposed on retained earnings and reserves if it exceeds 50 per cent of the paid-up capital of the company in order to encourage distribution of cash dividend. These two proposals have stunned many small and medium investors along with other stakeholders in the business circles of the country.

Stock dividends are dividends that are issued in the form of shares in lieu of cash and given to the shareholders of a company. It is issued out of the current year's accumulated profits that can be attributed to the shareholders of the company. It needs to be noted here that all profits and reserves are not given to the shareholders. When a company has a demand for cash for expanding current businesses or has the opportunity to invest in other business areas where return on the expansion or investment is higher than the cost of equity capital, the company should expand or invest instead of issuing cash dividends. This is one of the golden rules followed by successful businesses in most countries.

Cost of equity capital is the amount that an investor is expecting from the company and the business is willing to pay so that investment can be attracted. It is a demand-supply issue. If the company does not issue the expected dividend, either in the form of cash or shares, the market price of the shares of the company will fall. Thus, in order to maintain desired market price of a share, a company is bound to issue dividends that the investors are expecting. Compelling listed companies to issue cash dividends through laws and regulations do not work. Issuance of cash dividend without being in such a position to do so may not enhance value of the shares in the market. At times, such efforts may prove to be counterproductive.      Section 12 of The Finance Bill 2019 reads, "Notwithstanding anything contained in this Ordinance or any other law for the time being in force, where in any income year the total of retained earnings, any reserve or any other equity, called by whatever name, except paid up capital exceeds fifty per cent of the paid up capital of a company registered under [Company Act 1994] and listed to any stock exchange in Bangladesh, tax shall be payable at the rate of fifteen per cent on the amount of such excess of the company in the aforesaid income year."

The Finance Bill proposed imposition of taxes not only on retained earnings but also on other reserves or any other equity. In a statement of financial position (balance sheet) there may be many types of reserves. These can include: capital reserve, share premium, revaluation reserve etc. Distribution of some of these reserves among shareholders is prohibited by Companies Act and by International Financial Reporting Standards. Examples of such prohibited reserves are: 'share premiums' and 'revaluation reserve'. Financial statements of listed companies are prepared in compliance with the Companies Act, Securities and Exchange Ordinance, Securities and Exchange Rules, International Financial Reporting Standards and other applicable laws and regulations. The Finance Bill fundamentally contradicts with the age old laws and regulations of the land.

Retained earnings are the profit after tax of a company that has not been distributed among the shareholders. It is an accumulated balance reserved for meeting the requirements of reducing debts, acquiring plant and machineries, investments in new ventures, etc. Retained earnings are always a balance of profit kept after paying taxes and issuing dividends (stock or cash). A good company should always maintain a healthy amount of retained earnings in order to meet appetites for growth, expansion and paying-off loans.

Retained earnings also acts as an umbrella in during rainy days. A company cannot earn and grow smoothly forever. During the tough times, when the company will not earn enough to meet expectations of its stakeholders, retained earnings can save the day. It can also be used for paying dividends and making strategic investments even during those difficult times, in order to keep the pace with the market. Otherwise the company would lose in the race.

Share value in the market does not necessarily depend on cash dividend. Value of a share can even increase in a market when the company has not issued either cash or stock dividend. In reality, share value in the market depends on current and/or future earning capacity of the company or growth potential. A good investor has the ability to estimate potential of a company by analysing information provided to the public by the company through annual report, price sensitive information and other information. S/he purchases shares considering both growth potential and dividend pay-out ratios. Dividend pay-out ratio is calculated considering both cash and stock dividends.

A company's dividend policy is formulated based on some complex internal calculations made by senior level management members and approved by the board of directors. Laws and regulations of the land should not force listed companies to deviate from its own meticulously computed dividend figures. If listed companies are compelled to deviate from dividend policy. This can result in poor performance of the company and lower its potential to exploit future growth opportunities.

Imposing tax on stock dividends and retained earnings will not necessarily increase market value of shares of the listed companies. By doing so, listed companies may find themselves in a strained situation, which is likely to force them to take exit routes like selling sponsor shares or by delisting. In order to make the capital market stronger, policymakers should come up with strategies that will attract more successful and promising companies, who are not enlisted yet, to the capital market. Hundreds of well-performing companies with businesses in Bangladesh would like to be listed in the capital market just so that they can avail the facilities being provided to the listed companies and get greater capital inflows. But due to many prevailing legal and operational hindrances, they do not try to be enlisted. The legislators, government and regulators should create a congenial environment so that more such companies can become enlisted. Additionally, increasing the number of good shares at the bourses will strengthen the market and help at regaining small and medium-sized investors' lost confidence.

Listed companies are the only companies, who are the most transparent business organisations in the country and are the highest contributors to the national exchequer. A handful of listed companies have paid advance individual income tax, advance corporate income tax, withholding tax, advance trade VAT, VAT, statutory duty, regulatory duty and customs duty.


Sabbir Ahmed is an FCA.


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