Last week, when South Africa hiked the dividend withholding tax up to 20%, most people assumed that it was for ‘parity’. Which it is and it isn’t. Unfortunately, dividend withholding taxes are a form of tax that is only vaguely understood. So let me try and explain it.

Dividend Withholding Tax: Governmental Skepticism

Because SARS and the Treasury are suspicious of business people, they are generally concerned about tax avoidance. In the business world, it’s called ‘tax efficiency’ – but that term doesn’t carry the same political sting as ‘avoidance’. It seems that revenue authorities would rather you structure your tax affairs in the same way that government structures its departments: extravagantly.

The trouble is, we’re not at all like government departments. We don’t spend as much as possible in order to justify a bigger budget allocation next year. We don’t get ministerial prestige and power correlated to the size of our tax spend. And revenue authorities know that. So instead, governments tend to view taxpayers as privileged tax delinquents.

Which is why we have dividend withholding taxes.

Dividend Withholding Tax: The Parity Problem

Here is the theory:

1. Let’s assume that the people who get paid high salaries are also able to structure their packages to be tax efficient.
2. They have two choices:
   1. Either they can work as employees, and pay personal income tax; or
   2. They can entrepreneurially set themselves up as a company, and pay company tax on most of their earnings (and only pay personal income tax on what they pull out of that company as a salary).
3. Because companies are the primary investment vehicles into an economy, most governments don’t charge them the same tiered tax rates that they charge individuals. Instead, companies pay a lower fixed corporate tax rate (in South Africa’s case, 28%).
4. The government’s problem: if those high earners decided to contract themselves out, and pay themselves in dividends, then that might mean that they’ll pay less tax!
5. I mean: once you’re earning more R200,000 a year or so, it’s either increasing personal tax rates (up to 45%), or a 28% company tax. Which would be quite a saving!
6. So Treasury’s solution is to make dividend declarations subject to a withholding tax. It’s meant to ‘correct’ for the difference between the higher rates of personal income tax, and the (generally) lower rate of company tax.
7. Which seems fine right?

The trouble is: tax legislation is full of regulations that prevent any ‘personal service companies’ from being treated like companies. Basically, if the tax authorities see any evidence of you structuring your affairs to be an outside contracting company, then they’ll demand that the contractor/would-be-employer treats you like an employee.

Which means that the dividend withholding tax is not really about this kind of parity. Most tax structures that could result in this ‘non-parity’ are already dealt with. And about the only situation where this tax structuring might exist is where you’re the shareholder-owner of your company, and you earn dividends from it.

So why do we have dividend withholding taxes?

Essentially, they are a form of double-taxation. Or you might call them a wealth tax.

Here’s how most dividend taxes are paid:

1. I earn an salary every month.
2. That salary is taxed.
3. From my after-tax salary, I frugally try to put some money away in a unit trust.
4. The unit trust earns dividends.
5. I then pay dividend tax.
6. The net dividends are then invested in the unit trust.
7. The unit trust earns more dividends on my behalf.
8. I then pay more dividend tax.
9. I die.
10. My heirs continue paying dividend tax on their inheritance.
11. And so on.

So this is not really about ‘parity’ for remuneration. This is about the extra income earned from savings. That is: the withholding tax is a tax on after-tax income savings.

And you get taxed 20% on your dividends, from day 1, without any regard for your other income.

But recall something else: those dividends are being paid from a company’s after-tax profits. You lose 28% when the profits are earned, followed by an extra 20% of the after-tax profit. Meaning that the effective tax rate on any equity-invested savings is 42%. To put that into numbers:

1. Let’s say that the earnings of my shares are R100.
2. The company then pays tax of R28.
3. They then declare a dividend of the remaining R72.
4. R14 is paid over as a dividend withholding tax.
5. So by the end of it, I only receive R58 of those earnings.

It doesn’t matter if I’ve earned no income that year. It doesn’t matter if my total income falls below the tax threshold. That hit is immediate and flat-rated.

It’s like a triple-tax, really. Your savings were taxed (at personal tax rates); your savings’ earnings were taxed (at company tax rates); and the residual return then gets hit with a dividend withholding tax.

And does it work?

This is one of my biggest gripes. If government’s concern is wealth inequality, then why put in place a policy that so strongly incentivises it. If you are faced with a choice between:

1. Taking a dividend (and paying the 20% withholding tax); or
2. Reinvesting the earnings in the same business, and saving the tax;

then you would probably aim to do the latter.

Especially if you’re wealthy enough not to need the money right now. And what you get is these massive build-ups of wealth in those company bank accounts. That wealth then gets allocated into more investments for those non-dividend-distributing corporates. Those corporates do big deals, and cycle the money through a steady chain of asset acquisitions and disposals. You end up with these monolithic corporates dominating the business landscape.

It’s like inserting a blockage into the investment flow.

And who does it prejudice?

If you’re a big listed company, then investors get around this type of thing by just buying and selling shares. They don’t need dividends – they can recover them by selling the shares at prices that takes into account the locked-in value of undistributed dividends. And those companies just grow and expand and increase the capital wealth of their shareholders.

Meanwhile, it prejudices all the other unlisted companies (which is most of them). The ones that can’t just ‘sell their shares’ this afternoon. And so capital gets locked into these privately-owned companies, without a cheap or easy way to re-allocate it. And because most of South Africa’s job creation comes from these businesses (and not the listed companies), making their capital reallocation more expensive (and less likely) is putting that at risk.

It also makes their ‘cost of new investment’ higher – because any potential investor will know that any equity extraction will be 33% more expensive going forward (that was the size of the dividend tax hike). So why not rather hand their money to a listed corporate instead?

Rolling Alpha posts opinions on finance, economics, and sometimes things that are only loosely related. Follow me on Twitter @RollingAlpha, and/or please like the Rolling Alpha facebook page at www.facebook.com/rollingalpha.