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By Alex Bryan

While there's been a lot of talk about the looming "fiscal cliff," rarely does even a highly partisan political divide prevent politicians from cooperating at the last minute to find some sort of temporary solution. Sure, the resolution may neither be prudent nor long-term in scope, but most can logically predict that something will be done. With that said, regardless of how the cliff is resolved, we believe investors should care more about how we'll be paying for the spending that will be incurred. There is a good chance that tax hikes are right around the corner, and those will directly hit most investors' pocketbooks if enacted.

Tick, Tick, Tick ...
If Congress does not take any action, starting on Jan. 1, the government will tax all dividends at ordinary income rates instead of the preferential 15% treatment for qualified payouts. On top of that, as part of the Health Care and Recognition Act of 2010, investors whose income exceeds $200,000 or $250,000 for single and joint filers, respectively, will be subject to an additional 3.8% Medicare surtax on all dividends, interest income, and capital gains. This new tax will remain in effect even if Congress extends the Bush tax cuts.

As a result, the top dividend tax rate could increase to 43.4% from 15%. Taxes on long-term capital gains are also scheduled to rise for most investors to 20% from 15%. (This rate will decrease to 10% for investors in the 15% income tax bracket.) However, with the Medicare surtax, the top rate will increase to 23.8%.

While we can't predict the outcome of the election, there is a good chance that these tax hikes will remain in place for investors in the upper income tax brackets. The Medicare surtax almost certainly isn't going away. Rather than trying to determine whether the tax changes will take effect, a more relevant question may be how to be prepared if they do.

Choose Your Poison
The scheduled tax changes would create an imbalance between dividend and capital gains tax rates, potentially creating an opportunity for tax arbitrage. Because dividend tax rates would exceed capital gains tax rates for most investors, share-buyback programs become a more tax-efficient method for companies to distribute cash to their shareholders. Although it is unlikely that companies will cut their dividends to improve tax efficiency, this creates an incentive for them to increase their share-buyback programs in lieu of raising their dividends to distribute excess cash in the future.

Consequently, investors relying on dividend growth may be disappointed. Funds that target companies with a history of increasing their dividends, such as Vanguard Dividend Appreciation ETF (VIG), may be left with a more concentrated portfolio in the future as fewer companies continue to raise their dividends. Similarly, heavyweight dividend funds, including iShares High Yield Equity (HDV) and Schwab U.S. Dividend Equity ETF (SCHD), may not sustain their current dividend yields as dividend growth stagnates.

It is true that in the 1960s, when tax rates were much higher than they are today, companies paid out a higher percentage of their earnings in dividends. However, share repurchases were uncommon during that time. A firm that continues to increase its dividends will be worth less on an aftertax basis than it would be if it had retained the cash or used it to repurchase shares. Even if some companies do not alter their payout behavior to maximize aftertax value, investors looking for cash distributions may be better served by firms with healthy share-repurchase programs.

In a share repurchase, the issuer buys back its own shares in the open market, either with cash from its balance sheet or by raising debt, reducing the number of shares outstanding. Classic finance theory suggests that the act of repurchasing shares does not increase the value of a company's stock. Although there are fewer shares outstanding, the company also has less cash or more debt, which reduces the total value of the company's equity by an offsetting amount.

For example, consider a company that has a market cap of $1,000 and 100 shares outstanding, with each share trading at $10. The company repurchases 10 shares in the open market at fair value of $10 a share, which reduces its market cap to $900 and the number of shares outstanding to 90. Each share remaining is still worth $10. In the absence of taxes, information asymmetries, and market frictions, a $1 dividend on the original 100 shares in this example would leave shareholders with the same wealth per share because the value of each share declines by the amount of the dividend. However, in the real world where there are taxes, information asymmetries, and market frictions, there are some critical differences between dividends and share-buyback programs. Most important, in contrast to a dividend where all shareholders get hit with taxes, in a share-buyback program, only those investors who sell their shares back to the issuer receive a cash distribution and recognize taxes on capital gains. This makes share repurchases a more tax-efficient method to distribute cash even when capital gains and dividend tax rates are the same because investors can defer the tax liability.

There is also some evidence that share-repurchase programs can have a real impact on a company's share price. This is an intuitive result if investors have differing views about a company's fair value, varying degrees of tolerance for risk, and short-sale restrictions that affect a large number of investors, such as mutual funds. Together these conditions create slightly downward-sloping demand that allows share repurchases to have a temporary positive impact on share prices. When a company reduces the supply of shares, the least optimistic investors sell their shares, leaving more-optimistic investors to set the share price. This effect is likely to increase as the supply of shares decreases because with fewer shares the differences between investors are likely to be greater. Yet, a share-repurchase program does not increase a company's fundamental value even if it increases the company's share price. In fact, if the program increases the company's share price, it effectively transfers wealth from the shareholders who stay to the shareholders who sell, resulting in a lower fundamental value per share. In the long-run, this effect dissipates as new information causes investors to reassess the firm's fundamental value.

Share-repurchase programs also send a weaker signal to the market than traditional dividend increases. Dividend increases can send a strong signal to the market about management's confidence in its company's future prospects because it is costly for a company to raise its dividend if it cannot meet it, as there is a negative stigma associated with cutting a dividend. Share-repurchase programs do not send as strong of a signal to the market because failing to fully execute the announced buyback does not have the same negative stigma as cutting a dividend. Consequently, these announcements are less binding than traditional dividends.

Yet, according to Ford Equity Research, companies that have followed through on their share-repurchase commitments have outperformed the market by a wide margin. This may be similar to the observed outperformance of high-dividend-paying stocks. Similar to a traditional cash dividend, a stock-repurchase program can address some of the agency problems that excess cash can create. It does this by constraining managers' capacity to engage in value-destructive empire-building. Companies that pursue a disciplined policy of returning capital to shareholders, regardless of the method, may outperform precisely because they undertake fewer marginal investments. In light of the benefits that distributing cash to shareholders creates, investors should not be scared away from these types of companies if the new tax laws go into effect. However, it may be worthwhile to give a stronger weight to share buybacks to take advantage of their superior tax efficiency.

Investors can prepare for the upcoming tax changes by moving high-dividend-paying funds and stocks to tax-sheltered accounts and by looking for companies with regular share-buyback programs. PowerShares BuyBack Achievers (PKW) offers a great way to gain access to companies with healthy share-repurchase programs. It targets U.S.-listed companies that have reduced their total shares outstanding by 5% or more over the previous year. Top holdings include IBM, Intel (INTC), Home Depot (HD), and Walt Disney (DIS). Since its inception in 2006, PKW has generated an annualized return of 4%, compared with 2.4% for the S&P 500 with comparable risk. This fund offers a similar dividend yield to the S&P 500. However, when the tax changes go into effect next year, it could be an effective dividend-replacement fund, as firms substitute share buybacks for dividend increases.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

Source: Dividends Or Share Buybacks? A Taxing Dilemma