Obama's Dividend Assault: Silver Lining for Private Equity?

[1] Among the proposals in the 2013 budget, Team Obama wants to increase the tax rates on dividends received by the "rich." Obama defines "rich" to include families that earn $250,000 annually (and single individuals that earn $200,000).

(Any higher thresholds would substantially reduce the amount of taxes raised from increased taxes on the "rich." As government's thirst for revenue intensifies, expect the threshold to drop. It's all relative. A family that earns $150,000 is living large compared to a family that earns $50,000. And an individual that earns $75,000 is sampling the good life compared to an individual that earns $25,000.)

[2] In today's Wall Street Journal, the editors took aim at President Obama's "assault" on dividends. (Sub. required; thanks to Paul Caron for the link.)

Mr. Obama is proposing to raise the dividend tax rate to the higher personal income tax rate of 39.6% that will kick in next year. Add in the planned phase-out of deductions and exemptions, and the rate hits 41%. Then add the 3.8% investment tax surcharge in ObamaCare, and the new dividend tax rate in 2013 would be 44.8%—nearly three times today's 15% rate.

Keep in mind that dividends are paid to shareholders only after the corporation pays taxes on its profits. So assuming a maximum 35% corporate tax rate and a 44.8% dividend tax, the total tax on corporate earnings passed through as dividends would be 64.1%.

The numbers are pretty shocking, but consistent with Obama's core philosophy. Obama is campaigning in 2012 as a populist Robin Hood. As many have noted, the 2013 budget is a political document at its core.

[3] I'm actually more interested in the "knock on" effects of the dividend tax increase. The WSJ editors argue that increased dividend tax rates will "make stocks less valuable." Maybe so, but probably not.

The WSJ article includes a graph that tracks reported dividend payments from 1990 through 2009. The graph suggests that corporations increased dividend pay outs in response to a dividend rate cut in 2003. Let's assume that the relationship is causal, i.e., the decrease in tax rate on dividends caused corporations to increase dividend pay outs.

What happens if tax policy changes, and dividend tax rates are increased (for those "rich" families that earn $250,000 annually and their distant cousins, the mega-millionaires and uber-billionaires)?

If there is a causal relationship between dividend tax rates and corporate distributions, we'd expect corporations to reduce distributions. However, corporations have two ways to return cash to shareholders. They can pay dividends, which is arguably good for retail investors on fixed incomes (traditionally, "widows and orphans"). And they can engage in stock repurchase transactions, which is arguably good for other investors who want capital appreciation without dividend income (and current tax leakage).

A dividend tax increase does not impact the cash from operations available for distribution to a corporation's shareholders. It simply impacts the form of distribution. Ironically, this flexibility at the corporate level makes static budget forecasts unreliable. A dividend tax rate increase may raise immaterial revenues if corporations shift gears and increase stock repurchase activity. So what's the point? Political distraction. And, if nothing else, President Obama gets to wear his Robin Hood tights and cape for his political admirers.

[4] Finally, let's assume that higher taxes on dividend income do, in fact, take some air out of the market for public equities. In other words, assume that Obama's assault on dividends "make stocks less valuable." Would this be bad for the "tens of millions" of Americans that own stock "through pension funds"?

In fact, lower equity valuations would probably benefit pension funds and their individual beneficiaries. Ironically, lower equity valuations may provide a silver lining for their private equity advisors.

I won't get into a full-blown discussion of the relationship between pension funds and private equity. Suffice to say, despite all the hype about private equity, a substantial majority of the capital for private equity managers is invested by pension funds.

Unlike high-income individuals, pension funds generally pay no income tax on dividend income (or interest income, or other forms of passive income). If increased dividend tax rates decrease equity valuations, private equity managers will have "cheaper" opportunities to deploy their investment capital. They can improve the performance of portfolio companies, strip out operating cash flows through tax-exempt interest and dividend payments, and flip investments at slightly lower earnings multiples.

Big pension funds win. Private equity fund managers win. Only small individual retail investors lose. But what else is new when government interferes with capital markets?

Yahoo Evaluating Cash-Rich Split Offs

The Wall Street Journal (sub. required) has reported that Yahoo Inc. is considering a disposition of its stakes in Alibaba and Yahoo Japan through cash-rich split offs. Yahoo owns a 43% stake in Alibaba, a Chinese search engine, and a 35% stake in Yahoo Japan.

The split-off transactions would make Yahoo a more attractive target for a subsequent acquisition by a private equity group or strategic investor (e.g., Microsoft). The market has speculated that Yahoo's complicated relationships with Alibaba and, to a lesser extent, Yahoo Japan, have discouraged potential suitors from offering a marriage proposal.

So what is a "split off" transaction? Why does the WSJ article describe the proposal as a "cash-rich split off" transaction? Can the tax lawyers save the day for Yahoo and its beleaguered long-term shareholders?

Spin Offs, Split Offs and Split Ups

Section 355 of the Internal Revenue Code governs "spin off" transactions, "split up" transactions and "split off" transactions.

• A "spin off" occurs when a distributing corporation (let's call it "Distributing") distributes the stock of a controlled subsidiary (let's call it "Controlled") pro rata to its shareholders. Following a spin-off transaction, the shareholders of Distributing also own stock of Controlled.
  
  
• A "split off" is similar to a "spin off," but with a twist. A "split off" occurs when Distributing redeems shares from one or more shareholders -- but not all shareholders -- in exchange for stock of Controlled. Following a split-off transaction, some of the historic shareholders of Distributing continue to own stock of Distributing. However, other historic shareholders own stock of Controlled. The latter group "trades" its interest in the overall Distributing business for a more direct interest in the Controlled business.
  
  
• In a "split up" transaction, Distributing engages in more than one business, for example, Business A and Business B. Distributing redeems stock from some shareholders in exchange for stock in a corporation that owns Business A. Distributing redeems stock from other shareholders in exchange for a stock in a corporation that owns Business B. Distributing is like the head of the Hydra. Following a split-up transaction, Distributing has disappeared, and its former shareholders go their own separate ways with stock in Corporation A (which owns Business A) and Corporation B (which owns Business B).
  

Yahoo's proposed dispositions of Alibaba and Yahoo Japan would be structured as "split off" transactions. As noted, Yahoo is a shareholder of Alibaba and Yahoo Japan. If the parties implement the "split off" proposal, Alibaba and Yahoo Japan would be the distributing corporations. Alibaba and Yahoo Japan would redeem their stock currently owned by Yahoo in exchange for stock in a controlled subsidiary. Following the transactions, Yahoo would cease to own any shares in Alibaba and Yahoo Japan. Instead, it would own stock in a corporation formerly owned and controlled by Alibaba and Yahoo Japan, respectively.

To qualify under Section 355, the split-off transactions contemplated by Yahoo must satisfy a number of technical conditions. If those conditions are satisfied, the split-off transactions would be non-taxable to the distributing corporations (Alibaba and Yahoo Japan) and to its shareholders (Yahoo itself). Section 355 thus permits a corporation to "shuffle" the form of its investment in a lower-tier corporation, without triggering income tax on any appreciation in the stock of such corporation.

Cash-Rich Split Offs

Now we're getting to the real action. Yahoo may be able to exchange its stock in Alibaba and Yahoo Japan for stock of a new corporation. But what does that accomplish? The market is already penalizing Yahoo for its unwieldy legal structure, which includes large but non-controlling stakes in Alibaba and Yahoo Japan. Would a split-off transaction address the market's concerns?

For Yahoo's shareholders, I have good news and bad news.

Good News

The good news is that Yahoo could effectively "monetize" its investments in Alibaba and Yahoo Japan through a cash-rich split off. By "monetize," I mean that Yahoo could convert its stock in Alibaba and Yahoo Japan into stock of new corporations whose principal assets are cash or other liquid securities. Although each of the new corporations must be engaged in a historic (five-year) trade or business after the split-off, up to two-thirds of its assets may be composed of cash or other liquid securities.

If the parties implement cash-rich split offs:

• Immediately before the split offs, Yahoo would own 43% of the stock of Alibaba and 35% of the stock of Yahoo Japan, respectively; and
  
  
• Immediately after the split offs, Yahoo would own 100% of stock of two new corporations. The first corporation would have a historic (five-year) trade or business formerly conducted by Alibaba, and a bucket of cash or other liquid securities. The second corporation would have a historic (five-year) trade or business formerly conducted by Yahoo Japan, and a bucket of cash or other liquid securities.
  
  
• Then Yahoo's shareholders and its pointed-headed tax lawyers would pop some champagne and haul out their dancing shoes. Well, maybe the shareholders would haul out their dancing shoes.
  

You might be curious whether Alibaba and Yahoo Japan could simply redeem Yahoo's shares for cash. Why does Yahoo need an army of pointed-headed tax lawyers to monetize its investments in Alibaba and Yahoo Japan? Alas, life is not so simple under current U.S. tax rules. The redemption transaction (exchange of stock for cash) would be taxable to Yahoo. Yahoo would incur U.S. tax expense and its after-tax cash proceeds would take a corresponding haircut. So bring on the tax lawyers!

Bad News

Now for the bad news. Unlike a corporation that owns 100% of a business, Yahoo owns a large, non-controlling stake in Alibaba and Yahoo Japan. Yahoo would require cooperation of the boards of directors of each company to implement a cash-rich split off transaction. Each board (including Yahoo's) would have a fiduciary duty to ensure a "value for value" exchange. It might be very difficult to negotiate a valuation that makes everybody happy. That said, if the tax savings to Yahoo were sufficiently material, Yahoo may be able to "share" some of that savings with Alibaba or Yahoo Japan to bridge any gaps in the numbers.

The parties would be required to navigate the various conditions of Section 355. For the most part, those should be manageable. The biggest hurdle would probably be Section 355(g), which was enacted in 2006 to diminish the appeal of cash-rich split offs. Section 355(g) limits the "investment assets" of a controlled corporation to two-thirds of the fair market value of all its assets. For such purposes, "investment assets" include cash and other liquid securities. To comply with the limitations of Section 355(g) any cash-rich split off would need to include material business assets of Alibaba and Yahoo Japan, respectively.

Finally, Alibaba and Yahoo Japan would need to "stuff" the controlled corporation with cash or liquid securities. Such an effort may require external financing, which may or may not be palatable to the directors of Alibaba and Yahoo Japan. The tax tail is not going to wag the dog unless the parties can round up financing to make the cash-rich split off work.

Repatriation?

Another hurdle for Yahoo would involve the repatriation of cash from its new subsidiary companies. Although I can only speculate on the transaction form, Yahoo is likely to own stock in a new foreign subsidiary following a split off from Alibaba or Yahoo Japan. As described above, the foreign subsidiary would have a historic (five-year) trade or business, and a large amount of cash and liquid securities.

If Yahoo repatriates the cash by causing its new subsidiary to pay a dividend, the dividend could be taxable to the U.S. group. Yahoo may or may not have sufficient foreign tax credits to offset the resulting U.S. tax liability. Any limits on repatriation may reduce the attractiveness of the split-off idea.

Alternatively, after the dust has settled on the split-off, Yahoo may be able to liquidate the foreign subsidiary and repatriate cash in the liquidation transaction. Such a liquidation would also be taxable to the extent of the foreign subsidiary's earnings and profits.

In either case, a portion of the distributing corporation's earnings and profits would be allocable to the controlled corporation immediately before the tax-free split off. Under the mechanical allocation rules, the new corporation may inherit a very small earnings pool from Alibaba or Yahoo Japan, respectively. If the earnings pool is small, a liquidation transaction may be a viable repatriation option for Yahoo. In any case, tax nerds and Yahoo shareholders will stay tuned for developments in the Yahoo story.

* * * * *

For more on cash-tax split offs, two articles by the ubiquitous Robert Willens are worth a read. See "Liberty Media and News Corp. Will Be Parting Ways," 114 Tax Notes 697 (Feb. 12, 2007), and "Can STI Efficiently 'Monetize' Its KO Stake," 120 Tax Notes 601 (Aug. 11, 2008). He even mentions Yahoo! in this interview (published Saturday, October 22).

Moe Money, Moe Problems

In today's Wall Street Journal, Randy Noonan offers a portrait of an American success story, Moe the Millionaire.

Moe is an insurance salesman with a minority equity interest in his employer, a mid-size insurance business organized as a C corporation for tax purposes. Moe is retirement age (around age 65, having worked in the insurance business for 40 years). His ending salary, including bonus, was $200,000. In the year he retired, Moe tagged along with a sale of the insurance business, selling his minority interest at an $850,000 gain.

Moe's net worth in the year before retirement was:

Cash in bank: $100,000. Investment in business to be sold: $950,000 [cost basis $100,000]. Value of Moe's home: $450,000 [cost basis $95,000]. Total assets: $1,500,000.*

* Noonan posits that Moe would receive $75,000 in annual pension benefits from the insurance company's defined benefit pension plan, but does not include the "value" of the pension benefit in the calculation of Moe's net worth in the year before retirement.

The year of his retirement, Moe recognized $1,050,000 in total income: $200,000 in salary and bonus; and $850,000 in capital gain from the sale of his interest in the insurance business. Noonan inquires:

Is Moe the "millionaire" that Obama wants to tax? Is it "fair" that his once-in-a-lifetime capital gain of $850,000 be taxed at top tax-bracket rates? Even assuming that the current 15% capital-gain rate would be raised to only 25% for this one-time millionaire (so that his tax rate would not be less than those "middle class" taxpayers), the tax would still be $212,500, more in tax than Moe ever made in salary and bonus in any one year.

A few observations:

[1] Big picture, Noonan is framing the correct issues. The political left believes that we should increase taxes on the "wealthy." The left sometimes defines the "wealthy" as "millionaires and billionaires" (the Buffett view). President Obama takes it further, consistently defining the "wealthy" as married couples earning $250,000 and single individuals earning $200,000 in a year.

I'm unaware of any data that suggests a high proportion of married couples earnings $250,000 (or individuals earning $200,000) are "millionaires and billionaires." I'm sure that Obama would concede that an individual's taxable income during a given year is not a proxy for his or her "wealth." And an individual's "wealth" is not necessarily reflected in his or her taxable income during a given year. I will explore this basic theme in a later post (or posts).

[2] Back to Moe the Millionaire. I believe that Noonan was mistaken in assuming a 25% tax rate on the $850,000 capital gain. President Obama wants to tax a millionaire's entire income at a 30% or higher federal effective tax rate. Tack on another 5% to reflect state income taxes, and the tax leakage on $1,050,000 in income is around $368,000. In other words, Moe would bring home around $683,000 after the payment of taxes on his retirement-year income.

When the dust settles, Moe is still a millionaire, but not by much. His liquid assets of $783,000, if invested conservatively, might yield around $40,000 annually before taxes. Almost everyone on both sides of the political would agree that this is a modest pre-tax income, even if the recipient is a "millionaire" on paper.

From a tax perspective, the main "problem" here is the lack of income averaging. Arguably, Moe should not be penalized for an extraordinary one-time gain. I'm sympathetic to Moe's plight, but I'm hesitant to endorse income averaging because I favor tax reform that will streamline -- not further complicate -- the tax code.

[3] Despite framing the correct issues, Noonan's hypothetical contains a couple of flaws. The first relates to his assumed savings balance upon retirement. Noonan stipulates that Moe earns $200,000 in salary and bonus after 40 years in the insurance business. Let's assume his salary increased no slower than the rate of inflation between year 1 and 40. He purchased a modest home for $95,000 decades ago, and had a $100,000 bank account the year before retirement.

Moe must have suffered from a drug or shopping addiction, because he should have had more than $100,000 in a bank account upon retirement. Noonan stipulates that Moe made "regular but modest" charitable contributions at church (deductible for tax purposes). Moe would have paid taxes at an effective tax rate around 20% (perhaps 25% including state income taxes). During the decade before retirement, with a six-figure income, 20% effective tax rate, "modest" charitable donations and negligible housing costs, Moe's savings account should have increased substantially.

Moe's net wealth is foundational to Noonan's analysis, so Noonan should have been more careful with his assumptions about Moe's spending and savings profile.

[4] Noonan also fumbles with respect to Moe's pension benefits. According to Noonan, the insurance company's defined benefit plan will provide Moe with $75,000 annually. Noonan characterizes $75,000 as "enough to live on but only just."

We know that Moe lives in a relatively affordable community, because his home value in the year of retirement is $450,000. Moe owns his home outright, so has relatively low costs associated with outright home ownership (maintenance and property taxes). He's retired, so he won't have commuting expenses and a number of other expenses associated with life as a working stiff. He's presumably eligible for Medicare and Social Security. All in all, $75,000 in annual pension benefits should provide a comfortable existence for our retired friend.

Morever, the pension benefits reflect a substantial "asset" that we should not disregard in computing Moe's net wealth. However, in fairness, the political left disregards the value of defined benefit pensions when focusing on "income as a proxy of wealth." So I can't be too critical in this instance.

[5] Enough tax for a Friday post. Noonan's portrait of an American success story was almost certainly moe-tivated by a success story from the 1990s. Let's kick it to Notorious B.I.G:

The Buffett Bandwagon (Part Two)

Warren Buffett recently published a lecture on tax policy in the New York Times. I discussed Buffett's article here, and a response from the Wall Street Journal here. Today is my last day beating this dead horse.

The Double Taxation Dilemma

In sum, Buffett's main concern is the preferential tax treatment of capital gains for "millionaires and billionaires." Unlike the WSJ, I agree that we should tax capital gains at the same rates as ordinary income. That remains a topic for another day. For now, a relatively quick observation, beginning with Corporate Tax 101.

Most public companies are C corporations, and most of those C corporations pay some U.S. tax on their earnings. The earnings are taxed a second time when the C corporations pay taxable dividends to their shareholders. We refer to this tax law mechanic as "double taxation."

(Likewise, if a shareholder disposes of her shares at a gain which reflects the increased value resulting from the corporate earnings, the gain is subject to tax, resulting in an effective "double tax" on the shareholder. This entire double-tax "problem" could be solved if we treated all corporations as flow-through entities, taxed shareholders on their interest in corporate earnings, and gave shareholders a basis increase for the underlying earnings. Yet another topic for a later post.)

Under current tax rules, qualified dividends and long-term capital gains are subject to preferential tax rates. As the WSJ correctly observes, the lower tax rates reflect a crude attempt to blunt the impact of the "double taxation" dilemma. If a C corporation pays tax at a 40% blended federal-state tax rate, it seems like an overreach to tax dividends at ordinary income rates (35% under current rules). So far, so good.

At this point, the WSJ oversimplifies the commercial and tax landscape. It is true that some amount of capital gains reflects sale of stock in public C corporations (resulting in double taxation). However, I suspect that a large amount of capital gains are derived from the sale of other assets.

For example, if I purchase a bond, and the value of the bond increase because Treasury rates decline, capital gain from the sale of the bond would qualify for a preferential tax rate. However, unlike the shares in a C corporation, which derive their value from the after-tax earnings of the corporation, bonds reflect the valuation of pre-tax cash flows. The WSJ argument falls over when you introduce capital assets other than shares in a C corporation. We don't have a "double taxation" dilemma to solve!

As I'll discuss later, I would tax capital gains at the same rates as ordinary income. In connection with that change, I would reform the tax code to treat all business entities (including public C corporations) as flow-throughs. This one-two punch would eliminate the "double taxation" dilemma. More to come on all of the above.