Chapter 1 Introduction 1.

0 General Introduction This chapter starts by discussing the definition and meaning of tax capitalisation and in particular shareholder dividend tax capitalisation. Section 1.1 considers what is meant by tax capitalisation, with reference to implicit and explicit taxes. It discusses the different interpretations of shareholder dividend tax capitalisation, briefly discusses previous literature that has produced conflicting results and conclusions and concludes by discussing the implications. Section 1. introduces the research !uestions for the thesis, the setting for this study and discusses the scope and organi"ation of this study. Section 1.# concludes the chapter by setting out the contributions made by the thesis.

1.1 Dividend Tax Capitalisation Section 1.1 is split into two$ section 1.1.1 discusses the definition, provides an explanation of shareholder dividend tax capitalisation and briefly introduces some of the related previous literature. Section 1.1. discusses the implications of shareholder dividend tax capitalisation.

1.1.1 Definition and Explanation %ne of the main !uestions when studying the influence of tax on capital mar&ets is whether taxation affects share prices. If a shares price is determined by the amount and timing of expected future cash flows then the tax treatment of those cash flows, in theory, should influence the shares price. 'iller (1)**+ suggested that in perfectly competitive mar&ets, ex,ante after tax ris&,ad-usted returns of all securities should be identical$ implying that changes to the tax treatment across shares and cash flows will lead to

different pre,tax rates of return. Scholes and .olfson (1)) + define these differences in pre,tax rates of return as implicit taxes. /xplicit taxes are taxes paid directly to the government and are the difference between an assets pre,tax and post tax rate of returns, whereas implicit taxes arise because the pre,tax investment returns available on tax favoured assets are less than those available on tax disfavoured assets i.e. benchmar& fully taxed asset. 0enerally if there is a choice from two assets that give rise to identical pre tax flows but the cash flows from one asset are taxed more favourably than those from the other asset, taxpayers will bid for the right to hold the tax favoured asset. 1s a result the price of the tax favoured asset increases relative to the tax disfavoured asset and the return to the tax favoured asset will decrease compared to that of the tax disfavoured asset. Shac&elford and Shevlin ( 221+ use municipal bonds as an example of implicit taxes. The interest earned on such bonds is tax,exempt$ therefore taxable investors are willing to pay more for the municipal bonds than e!ually ris&y alternative investments. Implicit tax is therefore defined as either$ the difference (relative to the benchmar& asset+ in an assets pre,tax rate of return resulting from its favourable3unfavourable tax treatment or e!uivalently$ the difference in an assets price resulting from its favourable3unfavourable tax treatment. This second definition of the implicit tax concept, referring to the pricing of shares is referred to as 4tax capitalisation5 (6olland, 227+. Tax capitalisation is the effect of taxes on prices when current prices are lower than they otherwise would be because of future explicit taxes on those assets. %ngoing research in the area of 4tax capitalisation5 investigates whether share prices reflect shareholder level taxes. Shac&elford and Shevlin ( 221+ state that one of the most active areas in tax research is whether shareholder level taxes (dividends and capital gains taxes+ affect share prices because the existing evidence is mixed and remains controversial. 8ersonal taxation can affect shareholders preferences between receiving their return on

capital in the form of dividends or capital gains. It is the differential tax treatment of dividends and capital gains that provides the setting in which to observe the taxation effects on price. Shareholder level tax capitalisation relates to when this differential tax treatment is directly reflected in share prices. Shac&elford and Shevlin ( 221+ summarise the potential relationship between dividend taxes and share prices as producing three view points9 The 4Traditional :iew5, where any additional tax costs of paying dividends are offset by a reduction in agency and other non,tax costs. 4The Irrelevancy :iew5, where the marginal investor is tax exempt and would not therefore be prepared to bear taxes through a tax induced reduction in share price ('iller and Scholes, 1)*;+. 4The <ew :iew5, where dividend taxes are fully capitalised into share prices.

In addition to the different interpretations listed above, many different ways of testing for the presence of shareholder dividend tax capitalisation have been used, which are discussed in more detail in the literature review (chapter =+. The utilisation of these different methodologies has resulted in an ongoing shareholder dividend tax capitalisation debate in the >S, where different groups of researchers have produced conflicting results and conclusions. %ne group of researchers, which includes 6arris and ?emsley (1)))+, 6arris et al. ( 221+ and @ollins and ?emsley ( 222+ have developed and tested The <ew :iew$ the claim that shareholder dividend tax is capitalised fully into share prices at a level which is independent of the timing of dividend payments. @ollins and ?emsley ( 222+ extend the model to include capital gains taxes and estimate that a high proportion of capital gains taxes are capitalised into share prices. 1nother group of researchers, which includes Ahaliwal et al. ( 22#a+ and 6anlon et al. ( 22#+ !uestion the validity of the first groups underlying assumptions and fail to replicate their general

findings. The lac& of consensus in the >S raises the issue of the position with respect to >? share prices, particularly in the context of differences between the two countries tax systems and specific tax changes in the >? that provide a testable setting for shareholder dividend tax capitalisation$ the Binance (<o. + 1ct 1))* and the Binance 1ct 1));$ discussed in chapter . The changes to the >? tax system as a result of the Binance (<o. + 1ct 1))* and the Binance 1ct 1)); provided a research setting to study the effects of shareholder dividend taxation for a number of >? authors$ Cond et al. ( 227, 22*+, Cell and Den&inson ( 22 + and 6odg&inson et al. ( 22E+. These are discussed in the literature review (chapter =+$ although the >? body of research on the effects of shareholder dividend taxation is much smaller than the more vigorous >S debate, a lac& of consensus in the >? also becomes apparent.

1.1.2 Importance and Implications The relationship between shareholder,level taxes and firm value and whether shareholder level taxes are capitalised into share prices, has fundamental implications for understanding why firms pay dividends and how taxes influence capital structure choices. There are potential implications for the allocation of resources, and for investment decisions. If stoc& prices ad-ust to incorporate shareholder level taxes, then these taxes affect a firmFs cost of e!uity capital. Share prices will vary with changes in the expected tax treatment of dividends and capital gains and with changes in the tax status of investors, thus price changes will have to be considered as an implication3cost of shareholder level tax changes and firms will need to consider their shareholders tax positions in forming dividend policies. 6olland ( 227+ points out that a further implication of the existence of shareholder dividend tax capitalisation is that the contrasting view of tax and dividend

clienteles is not viable. @lientele theory e.g. Ahaliwal et al. (1)))+,1 suggests that firms can ignore the tax preferences of their shareholders as the shareholders ma&e the necessary ad-ustments by investing in firms whose dividend payout is consistent with their tax preferences. The presence of shareholder level tax capitalisation affects decision ma&ing. 'aydew ( 221+ suggests that the more taxes affect decision,ma&ing and distort economic behaviour, the more they reduce economic efficiency. In particular, when taxes affect prices, they can lead to substitution effects that generate deadweight costs or an excess burden of taxation. This section is summarised as follows$ tax, accounting and finance researchers have long been interested in whether shareholder,level taxes affect share prices and there has been a long stream of literature that examines whether shareholder dividend taxes affect share prices and four decades of extensive research in this area has yet to produce a consensus. The issue of shareholder dividend tax capitalisation has been evident for years, but it is more recently that the shareholder dividend tax capitalisation debate has ta&en off, arguably because of conflicting and controversial results from both the >S and the >? produced by differing methodologies. This lac& of consensus, coupled with the fact that the implications of shareholder dividend tax capitalisation are far reaching thus implies a need for more focused and extensive research in this area.

1.2 esearch !uestions" #ettin$" #cope and %r$ani&ation This thesis attempts to add to the understanding of this area of tax based accounting research. Specifically, the study tests for evidence of shareholder dividend tax

Ahaliwal et al. (1)))+ find that when firms initiate a dividend the proportion of the e!uity held by institutional investors who have tax induced preference for returns in the form of dividend increases.

capitalisation in the >? and attempts to answer the !uestion$ to what extent is shareholder dividend taxation capitalised into >? share pricesG The common element lin&ing the ma-ority of the >S models is that they are derived from the basic %hlson (1))7+ valuation model. %hlson demonstrates that given, certain restrictive assumptions, firm value can be modelled by the boo& value of e!uity (C:+ and the level of net earnings (<I+. The model predicts that C: and <I are positively related to e!uity value$ however issues of shareholder dividend tax capitalisation are li&ely to affect the relative importance of C: (6arris and ?emsley, 1)))+, explained in the literature review (chapter =+. >sing an extended version of the %hlson model and the identified setting$ the 1))* abolition of the tax credit repayment to >? tax exempt investors, the study explores the relationship between ': and the components of a firms net assets (H/ and IS@+. The following research !uestions were set out to answer the main research !uestion9 To what extent is shareholder dividend taxation capitalised into >? share pricesG Is there a hypothesised change in the relationship between ': and the components of a firms net assets (H/ and IS@+ due to the 1))* tax changeG Is this relationship stable over timeG Is this relationship stable over !uintiles, based upon proxies for the mar&ets assessment of the li&elihood that there will be repayment of the tax creditG 6ow do this studys conclusions compare to those of previous research in the >? and in different tax settingsG 6istorically, tax law changes in the >? have resulted in opportunities to test theories and the >? provides a very rich setting for tax research due to its dynamic nature and the opportunity to utili"e policy reforms in order to isolate the causal impacts of tax changes. The previous section introduced$ Cond et al. ( 227, 22*+, Cell and Den&inson ( 22 + and

6odg&inson et al. ( 22E+ who specifically studied the effects of shareholder dividend taxation from recent >? Heforms. This thesis also utili"es the unusual aspect of the >? tax system prior to Duly 1))*, whereby a ma-or group of shareholders (>? resident tax exempt shareholders, predominantly pension funds and insurance companies that managed assets relating to pension funds+ had a more favorable tax treatment for dividends in comparison to the tax treatment of their capital gains. Cetween the years 1)*# and 1))* shareholders receiving a dividend usually received a tax credit of e!ual value to the 1dvance @orporation Tax paid by the company on that same dividend, to set against their tax liability. These >? resident tax exempt shareholders also received the refund of the tax credit even though their tax liability was "ero, resulting in the favorable tax treatment. In Duly 1))* repayment of the dividend tax credit was abolished for these tax exempt shareholders. This was a ma-or change in dividend taxation in the >? as the change was restricted to these important classes of investors and evidence suggests at this time that these were the marginal investor in >? e!uity mar&ets. @hapter examines in detail the >? tax system, discussing the history of both shareholder

level taxes and corporate taxes before focusing on the Binance (<o. + 1ct 1))* and the Binance 1ct 1)); and the changes set out in these relating to the imputation system, around which this study revolves. The chapter then considers how the tax changes in the two Binance 1cts may have affected different groups of taxpayers (different shareholder categories+ before concluding with a section discussing the >S tax system. Bor completeness, the discussion throughout this chapter relating to the various taxes is not restricted to the sample period of the study. @hapter # is a brief overview of the institutional framewor& in place over the sample period. This chapter has been included to provide an overview of the structure of the Iondon Stoc& /xchange, discussing its
The identity of the marginal investor is discussed in the literature review (chapter =+. In theory the marginal investor is the investor who trades at the margin and is therefore the price setting investor.

structure, performance and operation and any changes over the sample period. The brea&down of shareholders by tax status over the sample period is also identified. @hapter = reviews the prior literature on shareholder dividend tax capitalisation. It encompasses the history of the different research methods used, the various refinements and the conflicting results and conclusions. The %hlson (1))7+ model is examined in detail in the literature review, along with the 6arris and ?emsley (1)))+ extension of the %hlson (1))7+ model, which was arguably the paper that started the debate in the >S. The literature review then discusses the limitations and criticisms of this and related models as highlighted by previous researchers. ?emsleys ( 221a, 221b+ responses to these

criticisms are also discussed. In addition chapter = reviews the small body of >? evidence on this issue before identifying the evidence on the identity of the marginal investor over the sample period. Scholes and .olfson (1)) + conclude that any un3favourable tax treatment of asset returns will be priced into the asset at the marginal investors tax rate. 6odg&inson et al. ( 22E+ state that shareholder level tax considerations are only important when they impose costs3benefits on the marginal shareholder, therefore influencing their pricing decisions, thus the identity of the marginal investor is an important concept. @hapter 7 forms the empirical section of the study. The first part of this chapter outlines the various estimation methods used in the study, focusing purely on econometric and statistical issues. The following sections explain the model used in the study and the data sample used. Birstly, the %hlson (1))7+ model is applied to the >? data, to provide a standard of comparison and as a prelude to extending the model. The extended model includes a number of control variables in order to address and attempt to circumvent the limitations and criticisms put forward by previous researchers (Ahaliwal et al. 22#a, 6anlon et al. 22#+ and to relax some of the restrictive assumptions of the %hlson model. In addition the sensitivity of the results was assessed by9 (i+ using a range of deflators to

control for scale factors, (ii+ using two3three time variants of the dependent variable to ensure e!uity prices fully reflect the latest accounting information, (iii+ using a mixture of cross,sectional models, pooled data and panel data models, (iv+ using a variety of different measures to identify outliers and any influential observations, (v+ using both %rdinary Ieast S!uares and 0enerali"ed Ieast S!uares estimation techni!ues and (vi+ estimating the models over H/3C: !uintiles and dividend payout based !uintiles. 6ypotheses, to directly test for the evidence of shareholder dividend tax capitalisation in the >?, based on the setting of the 1))* tax change are then discussed at the end of this chapter. Hetained earnings are used to capture future dividends (6arris and ?emsley, 1)))+ and the hypotheses are based on comparing the retained earnings coefficients to the coefficients on other boo& value components and on a comparison of retained earning coefficients pre and post 1))* because of the differing tax conse!uences. @hapter E presents and discusses the results. This chapter summari"es the descriptive statistics, before discussing the results of the empirical investigations and additional analyses. Hesults of relevant robustness tests are also presented and discussed. @hapter * discusses the implications of these results, comments on inherent limitations of this study and provides a conclusion$ attempting to answer the research !uestions as set out at the start of this section.

1.' Contri(ution of #tud) In this section the contribution of this study to the existing literature is discussed. 1s Shac&elford and Shevlin ( 221+ point out, the prior evidence is mixed and remains controversial on whether shareholder level taxes affect share prices and the >S shareholder dividend tax capitalisation debate adds to this ambiguity. 1part from the papers discussed in chapter =, there is only a limited amount of research focusing on this

issue in a >? setting and this study is based on a uni!ue situation where empirical evidence tends to agree on the identity of the marginal investor (Cell and Den&inson, 22 , 6odg&inson, et al. 22E+. The previous >S literature suggests that the marginal investor does pay taxes, for example 6arris and ?emsley (1)))+ assume that the marginal investor is a high rate taxpayer. In contrast, this study, supported by empirical evidence as outlined in chapter = assumes that the marginal investors in the >? are resident tax,exempt shareholders (predominately pension funds and >? insurance companies tax exempt business+. 'aydew ( 221+ reviews the previous >S literature and states that theoretical and empirical studies in accounting, finance and economics all implicitly assume that the marginal investors are pensions that do not pay investor level taxes, thus supporting the assumption made in this study. The contribution of this study is therefore composed of the following elements9 The thesis ta&es advantage of a uni!ue environment3setting to conduct an independent test for shareholder dividend tax capitalisation, thus an independent test in a new setting, where empirical evidence tends to agree on the identity of the marginal investor. The thesis investigates whether >? data can resolve some of the inherent issues in previous >S studies. :arious hypotheses were devised and investigated appropriate for the setting and appropriate robustness tests of these hypotheses. 1lthough results were not une!uivocal, the thesis provides substantial evidence in support of shareholder dividend tax capitalisation, and finally 1lthough the thesis is not able to completely resolve the debate from the >S, the findings offer very important insights on the issue of shareholder dividend tax capitalisation in the >?.

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