Despite my enthusiasm for tax shelters, I didn’t get religious about taking up my annual ISA allowance until 2003.

As a result I hold a lot of unprotected shares that are liable for tax on dividends and on capital gains.

More fool me!

If you’re a higher-rate taxpayer, you can’t escape being taxed on dividends outside of tax shelters, short of earning less income to take you down a tax bracket. Rather counterproductive.

A better solution is to invest in non-dividend paying shares outside of tax shelters and to hold your income shares inside them.

But it’s not as good a solution as using tax shelters for everything in the first place!

With capital gains, you have more flexibility. As a semi-active investor, I’ve been using my annual CGT allowance to defuse taxable gains. I’ve then used the proceeds to fund next year’s ISA allowance.1

I’ve also offset gains with losses (like all investors I definitely have my share).

In the past I’ve even turned to VCTs for tax relief, though I wouldn’t recommend it. Some wealthy individuals might also consider Enterprise Investment Schemes.

Meet an investor who never trades

There is another way to deal with capital gains. It’s a method of tax avoidance beloved of Warren Buffett, who has touted the strategy many times.

The idea to sit on your gains – i.e. not sell them – for as long as you can, in order to put off crystallizing your tax bill.

You may be surprised by how much this can reduce the tax you pay.

Let’s consider a hypothetical investor. His name? I don’t know – Indolent Eric.

Indolent Eric receives £10,000 from an insurance company, because he was too lazy to wear his seat belt during a turbulent aircraft landing and so was bumped on the head by a passing slice of cheesecake.

“What shall I do with the loot?” Eric asks his friend, Flamboyant Freddie. “I really can’t be bothered with all this bother.”

Freddie suggests Eric buys shares in a particular investment trust. This trust doesn’t pay a dividend.

Eric does what Freddie recommends, mainly because he can’t muster up the energy to research anything else. He then forgets all about it.

Naturally, Eric doesn’t use tax shelters – it sounds too much like hard work.

Let’s say Eric doesn’t look at his shares for 20 years, and that over that time they deliver a 10% annual return.

That’s the same return, conveniently for our purposes, as Flamboyant Freddie, who buys and sells shares in a normal account and pays taxes. It’s also the same as Canny Christine, who holds her investments in an ISA. (You may remember these characters from my earlier article on how tax reduces your returns).

Since Eric does not trade his shares and they pay no dividend, he pays no tax over the years. The trust’s share price – and thus his holding’s value – just zigzags higher over the two decades.

No tax to pay (yet) for 20 years of doing nothing

A quick calculation reveals that after the 20-years are up, Eric’s investment is worth £67,275.

That’s exactly the same amount as Canny Christine, who traded shares and received dividends to get to her 10% per year return – but who did it in an ISA so also paid no tax.

So far so good for Eric’s lazy strategy.

Flamboyant Freddie also generated a gross 10% annual return trading shares, but he paid taxes every year.

Freddie therefore ends up with just £42,479, which is much less than his untaxed friends. (See my previous article for the maths).

Deferring capital gains reduces the final tax bill

Indolent Eric’s investment has done well, but he has a problem. He’s too tired to go to work anymore, and he needs a luxury waterbed to laze about on all day once he quits.

Only now does Eric remember his investment! He logs in via his iPad 13 and sees his shares are now worth £67,275.

Naturally he rushes to sell (over a period of weeks, punctuated with three-hour TV sessions and a bout of hibernation).

When Eric eventually does sell, the ‘rolled-up’ capital gain that has been accruing over the decades finally becomes due.

Let’s say Eric pays tax on capital gains at 20% – a fictitious rate I’ve chosen to keep the maths simple.2

Eric doesn’t pay tax on the £10,000 he first invested, only on the gains, so:

• Taxable gain = £67,275 minus £10,000 = £57,275

• CGT tax due is 20% of £57,275 = £11,455

• After-tax sum = £67,275 minus £11,455 = £55,820

Eric’s final pot of £55,820 is a pretty good result from doing nothing for 20 years.

More pertinently, shoot back up the page and you’ll be reminded that tax-paying Freddie – who earned the same 10% return per year, but who paid tax every year – ended up with £42,479.

By delaying paying tax for 20 years, Eric ends up with 31% more money than Freddie even after he settles his tax bill – despite earning the same 10% per year return!

Deferring capital gains: Another miracle of compound interest

How did this happen?

Well, Eric has effectively had a loan from the taxman every year that he delayed paying tax – a loan equivalent to the tax he would have paid that year.

Each year’s ‘loan’ has gone on to compound alongside his initial investment. Even though this pseudo-loan and the gains on it are taxed at the end of 20 years, the maths mean it all adds up to a higher tally.

Like Warren Buffett, I think that’s a pretty good deal for doing nothing – if you can find a share you’re happy to hold for 20 years.

Doing nothing will obviously reduce your trading costs enormously, too.

You might even see a better result, depending on your circumstances. In some cases it might be possible to pay a lower rate of tax on gains in the future than you would have paid in previous years.

For example, when you begin to sell down your holding, you might start liquidating just a portion of your rolled-up investment each year – an amount that keeps you under the annual capital gains tax threshold – in order to release funds without paying tax on them.

Alternatively, you might pay a lower rate of capital gains tax because your annual income fell when you retired.

Remember, too, that tax policy can and does change.

Even though the UK government no longer treats long-term capital gains more favourably than short-term gains via lower tax rates, I wouldn’t be surprised to see this change again in the future, for instance.

Taxi!

The bottom line is there’s plenty of ways to legally and easily avoiding paying tax on your investments, and that doing so can make a big impact on your returns.

For all but the wealthiest, ISAs and pensions are the easiest way to do this. Using them needn’t change how or what you invest in – so you’re not letting tax concerns interfere with your other investing priorities.

Beyond that, you can use CGT avoidance strategies, such as the one I’ve outlined here, to further reduce the tax you pay.

Even if you’re an active share trader with holdings outside of ISAs and pensions who can’t abide the idea of owning a share for a month let alone years, you can consider spreadbetting to avoid paying tax.

Best of all, none of these tax avoidance methods involve dodgy off-shore schemes, or paying an adviser to put you into an opaque product you don’t understand.

Work out your real tax bill

Do you think I’m too determined to avoid being taxed on my share gains?

Well, if you pay tax on your investment gains or income, try sticking the amount you hand over into a compound interest calculator, then set it to grow for two or three decades.

You’ll find that a significantly bigger number is returned.

That’s what paying tax on your share gains is really costing you!

1. Sadly I am saving and growing my money faster than I can fill my ISAs, so I will never catch up now. Learn from my former folly! [↩]
2. I am fully aware of the real-world CGT rates. Please see my comments in my first article on paying tax on investments to understand to why I am using this arbitrary rate. [↩]

Good reads from around the web.

I am grateful to a Monevator reader who tipped me off about this new TED video on the “psychological bias in financial decision making”.

It’s much more fun than it sounds. Watch and see!

It’s not a classic, but it is a very enjoyable walk through psychological flaws (except when he pronounces “buoy” as boo-y instead of boy).

And anything that warns you about bouncing giddily into marriage as well as financial bubbles is fine by me.

[continue reading…]

The first article in this series emphasised that dividends are best understood through cash flows rather than through stated earnings, which are intangible since they are simply an accountant’s opinion.

Using the cash flow framework also helps us better understand dividend policy – how companies decide when and how much to pay in dividends.

In the mix

When we boil it down, companies can do four things with their cash flow:

1. Save it (cash and equivalents, pay down debt)

2. Spend it (acquisitions and so on.)

3. Reinvest it (new projects, expansion projects)

4. Distribute it (dividends, buybacks)

With a finite amount of cash flow each year, companies must decide how much cash each of these buckets receive. These decisions are driven by, among other things, the company’s stage in its growth cycle, its financial health, the tax environment, and what its shareholders want.

Capital allocation is the number one responsibility of a company’s leadership team. Strong capital allocators can compound a company’s growth rate and create more shareholder value; conversely, a team of poor capital allocators can lead a once-solid company into a sluggish existence.

Ultimately, we want to identify companies with management teams that have made wise capital allocation decisions in the past.

A company that is generating high returns on equity, for example, and can reinvest all of its cash in projects that produce returns well above the cost of equity should, in theory, do just that — reinvest all the cash.

Investors should want this, too, in lieu of a dividend, as it maximises shareholder value.

If the company can take the cash and invest it at 20%-plus returns, so be it!

More money, more problems

These are rare cases, however, and more often than not companies in the mature and mature-growth stages do not have enough value-enhancing projects for all of the cash they generate.

When this happens, the company’s board considers alternative uses for the extra cash flow.

In a situation where the board expects the extra cash flow to be a one-time event, they may declare a special one-time dividend or buyback shares. On the other hand, if they expect there will be extra cash flow year after year, they may establish a regular dividend programme where a portion of the company’s cash flow is returned to shareholders periodically throughout the year.

If these sound like over-simplified examples, you’re right. Dividend policy decisions are normally not so straightforward, but it’s important to first understand the core theory behind why companies pay dividends.

In the real world, shareholder preference and peer behaviour can complicate the process.

Pleasing the masses

Three important theories on dividends can help us understand why different companies’ shareholders have varying interests in dividends:

1. Dividend irrelevance

2. Tax aversion

3. Bird-in-hand

Dividend irrelevance

The dividend irrelevance theory is based largely on the important research done by Miller and Modigliani who reached the conclusion that in a world of no taxes, no investment costs, rational investor behaviour, and infinitely divisible shares that dividends should be irrelevant to shareholders.

If an investor wants cash, the theory maintains, he or she can simply sell a few shares and create their own dividend.

This theory might sound naïve given all the unrealistic assumptions it involves, but many investors subscribe to it! Institutional owners in particular, who tend to have a larger number of shares, can more easily create their own dividend without incurring a high percentage of trading costs, and thus may prefer lower dividends.

Such “homemade” dividends make less sense to individual investors, due to the more prohibitive trading costs.

Assuming you want to keep trading costs below 1% and that you pay £10 commissions, you’d need to sell at least £1,000 worth of your position each time to create your own dividend and keep costs in check. Whilst not out of reach for some wealthy individual investors with large positions in a particular share, it’s certainly less realistic for the average investor.

Tax aversion

Like trading costs, taxes reduce realised returns. Naturally, then, the tax aversion theory states that investors with higher tax rates should prefer to own shares that pay lower dividends or none at all.

This can be particularly true in countries where the capital gains rate is well below the dividend tax rate. In such a circumstance, it stands to reason that companies that pay high levels of dividends should attract investors in lower tax brackets or tax-exempt institutional investors.

Bird-in-hand

The bird-in-hand theory was developed by Myron Gordon and John Lintner and takes its namesake from the proverb that “a bird in hand is worth two in the bush.”

As the proverb suggests, an investor should prefer to have cash in hand today rather than uncertain capital gains down the road. As such, investors place a higher value on dividends than future capital appreciation.

In addition, the more-certain cash from dividends, the bird-in-hand theory contends, reduces the cost of equity that investors place on the share. The lower the cost of equity, all else being equal, the higher the value of the share.

Of the three, dividend-loving investors most frequently subscribe to the bird-in-hand theory. Understandably so.

Still, it’s important to recognise that the majority of a company’s shareholders may not have the same sentiment, and may prefer the company reinvest in its operations, to buyback shares, or to make an acquisition instead.

Policies are not created equal

Once a company has decided that it will pay a dividend, it can either adopt a (what I’ll call) “firm” or “loose” dividend policy.

A firm dividend policy is one in which the company spells out in detail its plans for future payouts (i.e. “a progressive payout with a target dividend cover of at least 2 times”).

Conversely, in a loose dividend policy the company does not explain its decision-making process behind the dividend payments.

All else being equal, dividend-focused investors should prefer to own companies with a firm dividend policy because they provide more transparency.

If a firm does not explain its policy, there may be less commitment from the board and the framework for deciding each year’s payout can change year to year, leading to greater uncertainty.

Dividend policy in summary

A company’s dividend policy provides tremendous insight into its relationship with shareholders, and can help us better understand management’s strategy for enhancing shareholder value.

If a company has a loose dividend policy, lacks a track record of paying dividends, and has consistently bought back shares at high prices, it might be best to look elsewhere for dividend income.

You can bookmark all The Analyst’s articles on dividend investing. The archive will be updated as new dividend articles are posted.