Dividends, dividend taxes, and tax optimisations
Optimise your dividends flow
In the past 12 months, there have been a total of 114 dividend distributions across 41 of the companies held in my Coffee Can Portfolio1. Of these 41 companies, 10 companies paid annual dividends, 11 paid half-yearly and the remaining 20 paid quarterly dividends. Collectively, this makes up about 2.46% of the amount I invested.
Do you know the only thing that gives me pleasure? It's to see my dividends coming in.
These companies paid out only 38% of their profits last year, so the remainder of the 62% of their profits, along with undistributed earnings from previous years, have been retained by the business to invest in opportunities that will hopefully pay us shareholders more dividends in the future.
Looking back at these companies over the past 10-15 years period time frame, the dividends have grown at a blended rate of about 9.4% or so. The companies that have grown their dividends the most include OpenText (TSE:OTEX), Visa (NYSE:V), Mastercard (NYSE:MA), Amgen (NASDAQ:AMGN) & Tencent Holdings (HKG:0700), each growing their dividends by over 20% p.a. in the past few years. Another 16 companies have compounded their dividends by a rate of 10-19.99% p.a in the past.
Thought Experiment
As a thought experiment, let's assume that the companies in our portfolio did nothing but compound their dividends by about 7.5% (a reasonable discount of about a fifth on the actual historical rates of 9.4%), then here are the cumulative dividends that are expected to be returned for every £100 invested today:
in 5 years: £15.36
in 10 years: £37.41
in 19 years: £104.07
and after receiving that we still will retain an asset that will be able to spin out a cool £10.45 in the 20th year and growing still from there on. Remember this is without any reinvestments from our side. The monies that you receive along the way are yours to keep. If you choose to reinvest it back, you will get the opportunity to earn more returns off of those reinvestments, but even without that, its a pretty good deal. Ladies and Gentlemen, this is the true power of compounding and the magic of equity investing!
But is this thought experiment realistic?
I don’t know. I don’t think compounding of the dividends will be consistently 7.5% or more. Some years will be good and some will be bad. Some of the companies in this mix are going to have years of misfortune, while others are going to see sunnier days. However, with a portfolio of 41 dividend companies, the collective outcomes will look more like the past than otherwise. However, no guarantees - let’s see what happens. Hopefully yours truly is around and as excited to be blogging 20 years from know to come back and regale you with the story of he (and his wife) got rich!
The true investor... will do better if he forgets about the stock market and pays attention to his dividend returns and to the operation results of his companies.
Taxation on Dividends
Like every other aspect of money generation, dividend has fallen prey at the hands of lawmakers as a tool for taxation. Dividends are paid out after taxes are paid by corporations generating them, so in theory dividend taxes are essentially a second tier of taxation, but very often either because they have lower taxation rates on corporations, or just want to squeeze out an extra dollar, pound or rupee, governments have focussed their aim at dividends for extra taxes.
Dividends can either be taxed after the shareholders receive it, or can be taxed before you receive it (called “Withholding Tax”).
Being taxed before you receive dividends or after have material difference to your tax outflows. Taxes that are paid after your receive it is in the jurisdiction of where you pay taxes - i.e. your residence, whereas withholding taxes are determined by the jurisdiction of the company - i.e. where it is domiciled. Being taxed solely in your tax jurisdiction keeps things simple as you can plan it as part of your tax optimisations, but when taxes are deducted before it becomes part of your tax jurisdiction, things can be extra painful.
In small number of cases, the difference between taxes before and after might be the same, but in most practical cases, being taxed before the dividends reach out leaves you with no tax optimisation options. For investors like us who invest in multiple jurisdictions, it is important to be aware of these subtleties.
Here are some dividend tax withholdings rates in various countries:
Australia - 30%*
Canada - 15%
Japan - 15.32%
Switzerland - 35%
Spain - 19%
United States - 30%**
Some countries like Singapore and UK, thankfully don’t withhold taxes on dividends.
* Unless they are franked, in which case it is reduced by the extent it is franked.
** US taxation is a bit more complicated. The 30% rate is reduced to 15% if held by foreign investors in countries with double taxation avoidance treaties, such as UK, but not in other countries like Singapore, and reduced further to 0% under special circumstances, such as held in a pension account in the UK.
Tax Wrappers
Many countries offer tax wrappers such as 401K, Roth IRA (in the US), ISAs, SIPPs and Pensions (in the UK), Supplementary Retirement Schemes (in Singapore) etc, all promising no taxes on dividends and gains. While the premise is right that the governments don’t tax you within their jurisdictions, it doesn’t prevent you from being charged a withholding tax on foreign investments, which fall outside of the jurisdiction of the countries offering these schemes. So it is important to be aware of this and look for opportunities to optimise your tax outflows.
Optimisations
Due to historical reasons, between my wife and I, we have a grand total of 5 brokerage accounts:
A simple joint account (no favourable tax treatment)
One ISA for me and one for my wife - all gains are tax free but withholding taxes apply
One SIPP account2
One corporate account in Singapore under a corporation we both control3
Now, I have realised that each of these 5 brokerages have different withholding tax arrangements and post-withholding tax treatments. So I try to optimise my holdings in each case. Here is a summary of my findings (not to be confused with tax advice):
USA: Hold it in SIPP in the UK - pay 0% dividend withholding taxes
UK
1st Pref: Hold in an ISA or SIPP (no withholding and no tax otherwise)
2nd Pref: Buy under the Singapore corporate account (no tax paid now, but deferred when money withdrawn from the corporation in form of dividends)
Japan, Canada, Spain & Australia - Fully Franked dividends
Any account except Joint Account
Switzerland & Australia - Unfranked dividends
Hold in Joint account. All withholding can be offset against UK taxes. So you get something back for your deductions.
ETFs
Hold in an ISA or SIPP (no withholding and no tax otherwise)
This is obviously cumbersome to get right - the money needed to invest is not neatly available at the right location to execute this strategy successfully all the time, but I use this rubric to optimise taxes as much as possible.
Summary
Dividend growth investing is wonderful. Taxes are bad and you should do your best to reduce your taxes by choosing where you hold your investments. I hope you find your sweet spot, both with compounding wealth through dividend growth, as well as through gaining an extra inch through tax optimisations. Happy Investing!
(Nothing is this post should be construed as tax advice. Consult a qualified tax advisor before making any tax related decisions)
The remaining 9 holdings paid no dividends in the intervening period.
SIPP in the UK, or “Self Invested Pension Plan” or Pension in short, offers great tax advantages while contributing to it and as the pot grows through dividends and gains. However, all pension monies are subject to taxes when you withdraw from it at retirement. The effective marginal taxation rate may be lower, but it depends on how you get paid out of it in retirement, while you carry the risk of a future government turning hostile towards these savings. To add to the flip side arguments, there is added inconvenience of not being able to use these cashflows till retirements, which despite my greying hair, is far far away. There are no free lunches when it comes to taxation.
While we can use this corporate entity to optimise taxes today, we will still be liable for taxes on any monies we take out of this entity, depending on the tax rules of the day. As of today, any dividend paid out by this entity will attract between 7.5% to 38.5% depending on our income levels. There are no free lunches when it comes to taxation.