The Dividend Dilemma
May 1 2006, 3:35 pmThe Third GOAL Group Report on the
Securities Withholding Tax Reclamation Market
GOAL Group, May 2006
Management Summary
Key Findings
- $10.5 billion (€8.5bn) of investors’ rightful returns from their foreign shares and bonds were wasted in the latest financial year because withholding tax on dividends and income is not being properly reclaimed. This represents around a quarter of withheld tax on foreign securities
- The United States ($1.76bn/€1.43bn) is the biggest annual loser from unreclaimed withholding tax on foreign securities, followed by the UK ($1.19bn/€963m), France ($774m/€626m), Luxembourg ($761m/€616m) and Germany ($706m/€571m).
- Since GOAL Group’s first report on unreclaimed tax on foreign securities in 2003, increases in the amount of withholding tax unreclaimed are greatest in France (161%), the United States (113%), Ireland (113%) and Luxembourg (105%). The average growth over this period in unreclaimed tax globally was 81%
- The problem is likely to increase as dividend payments become more popular and a more significant element of shareholder returns
- Also a rising proportion of portfolio investment devoted to foreign securities means that lack of tax reclamation needs urgent attention from fund managers and custodian banks
- Investors are becoming increasing rigorous in their scrutiny of investments and are putting pressure on fund managers to provide greater transparency
- Tax reclamation rates, rules and timings vary widely around the globe, making the reclamation process very complex. However, automated systems are now available to take the cost and manual complexity out of the reclamation process. Fund Managers and pension funds are becoming increasingly aware of the existence of such systems and are beginning to include the requirement for such automated facilities as a standard part of their custodian services RFPs
- Leading custodians have recognised the market opening represented by effective tax reclamation services, both for their FM clients, and as an interbank services opportunity. Automated reclamation facilities have now made the provision of such services highly profitable, in a market climate where other revenue streams are declining
- It is estimated that the global market for withholding tax reclamation services by custodian banks is worth $863m (€698m)
Introduction
Since the late 1990s, equities investment has been through significant peaks and troughs. Hyped to unsustainable values in the dotcom boom, the post-millennial stock market crash then wiped billions off portfolio values, reaching an absolute nadir in the early part of 2003. Since that time, equities have recovered, although only passing the December 1999 high of $39.6 trillion in the same month in 2005. Growth is once again strong, but apparently more sustainable and logically based on solid results rather than unrealistic futures. Institutional investments, which fled into fixed income instruments during the stock market crisis, have now rebalanced their portfolios back into equities, using the fairly steady growth since 2003 to offset at least some of the losses they sustained in the previous couple of years. However, investors now require a greater element of short-term gain from their equities holdings – in the form of dividends – in contrast to the heavy reliance on capital gains that typified equity returns from before the millennium.
The importance of dividends
A watershed moment arrived in 2003 when Microsoft announced its first ever dividend. Since then, dividend payouts have steadily increased in popularity. Standard and Poors recently reported strong dividend growth in the US and expects it to continue, with one senior analyst quoted as saying, “For the remainder of 2006, we expect a continuation in both dividend increases and initiations among S&P 500 constituents, resulting in another double-digit gain in dividend payments.[1]” This is just one recent commentator emphasizing the importance of dividends to shareholder returns.
A couple of years ago, research by Dresdner Kleinwort Wasserstein[2] delivered some key figures that firmly puncture the popular notion that long-term equities gains come from capital growth. The bank’s study told us that: in Europe since 1970, 70% of total equity returns have been derived from dividend yield; and between 1950 – 2000, the average contribution by Europe (excluding UK) of dividend yield to total equity returns has been 62%. The research then goes on to state that the bank sees dividend yield once again becoming the greater proportion of equity returns in the future.
These findings were corroborated in an article the same year[3] which noted that, “Companies have responded to investors, who have learned to focus more on dividends in the low-inflation, bear market environment of the last three years, when “value investing” has made a comeback. Underlining this new awareness, a recent study by the London Business School entitled Global evidence on the equity risk premium explores, among other areas, the importance of the dividend to long-term returns, something that seemed to be lost during the bubble years.”
Awareness of the importance of the dividend to long-term equity earnings is now receiving regular mention with, for instance, one commentator recently remarking, “Indeed, dividends remain a key pillar of support for outperformance of European equities. On average, European dividend income is still higher than the 2.5% short-term interest rate currently targeted by the European Central Bank.[4]”
Cross-border Investing
Not only are equities back in fashion, but interest in cross-border investing is also on the rise. According to the statistics from the International Monetary Fund and from global stock exchanges, the market capitalisation of global equities rose 39% between 2001 and 2004, whereas the value of cross border equities investments rose 67% over the same period.
So cross-border shareholdings have risen at something approaching double the market rate, showing that fund managers have increased the proportion of foreign shares in their portfolio. The market capitalisation of the global equities markets (excluding investment funds) is currently around the $44 trillion mark. By comparison cross-border equities holding are currently valued at about $10 trillion, making the average proportion of foreign shares in a fund manager’s equities portfolio in the region of 20-25%.
Fixed-income
The subject of this GOAL study covers cross-border investment in all securities – equities and bonds. The fixed-income market has been very much the beneficiary of the equities market’s crisis of confidence in 2003-2005, with the value of bonds listed on global markets rising from $15.4 trillion in 2002, to over $26 trillion in 2004. Whether growth in issuance will continue, and how strongly, is a moot point. In the absence of equity market capital a few years ago, corporates turned to the debt markets. They are now, as a consequence, carrying much more debt than before, and there has to be an upper limit to sustainable leverage. Nevertheless, the outlook for the bond markets at today’s level looks healthy, with one commentator on the global market noting that, “The mid- to long-term outlook still remains one of guarded caution. We have a new man at the helm of the Federal Reserve. Gearing is still extremely high in the financial markets. Central banks are walking a tightrope between over-tightening and allowing the uncertainty over commodities prices to fan inflation expectations. Hence, bonds still remain a good bet, once the FED rate gets closer to 5%.[5]”
Withholding Tax and Reclamation Rates
To summarise so far, then, more and more companies are now paying a dividend. Those who have historically done so are looking to increase the dividend payout year-on-year. And according to Standard and Poors, this trend is expected to continue through 2006 and beyond.
Holding foreign shares is also becoming more popular with fund managers. Global market capitalisation increased 39% between 2001 and 2004, but foreign equity holdings increased 67% over the same period. This shows that fund managers are increasing the proportion of their portfolio made up by foreign shares.
Bond market issuance has increased markedly since the global stock market nadir of 2003. This increase in debt securities may not continue to grow at the same rate in future years, but has introduced a new balance into the fixed-income vs. equities portfolio balance.
At all events, dividends on foreign shares and yield from foreign bonds are subject to withholding tax[6]. This is a tax on earnings that the country’s tax office (the country in which the share or bond is issued) deducts at source, a proportion of which can be reclaimed by the owner of the shares/bonds.
However, GOAL’s research shows that around 25% of that reclaimable tax is left unreclaimed. This amounts to some $10.5bn of shareholder returns that are being wasted – left unreclaimed in a foreign country’s tax system. This represents an 81% increase in the annual amount wasted compared with 2003 when GOAL last conducted an analysis of the situation.
Pressure on FMs and Custodians
With the increasing popularity of both dividend payments, and cross-border securities, the unreclaimed tax will continue to rise unless fund managers’ service providers – often custodian banks – improve reclamation levels. Increasingly savvy investors, in markets where high yield investments are harder to come by, are putting the fund management community under growing pressure to maximise their investment returns.
As a result of all these factors, dividend yields have become a far more highly scrutinised element of the investor’s portfolio, with consequent pressure on fund managers to devote greater attention to maximise this element of return in the portfolios they are managing. The significance of unreclaimed withholding tax on cross-border securities holdings has therefore risen to a prominence it has not enjoyed since the late ‘eighties and early ‘nineties. Back then, however, technology was not available to automatically perform the highly complex task of reclaiming withholding tax, a process which has to incorporate up to date information, formats and procedures from a multiplicity of different legislatures around the globe. In contrast to the last such period of attention enjoyed by the faithful dividend, technology solutions are now widely available to automate the process of withholding tax reclamation, making it an economic – indeed profitable – process for custodians, and a ‘must have’ for fund managers under pressure from their investor clients.
Methodology
GOAL Group combined its own proprietary information on withholding tax reclamation rates with a wide range of global sources on foreign portfolio investment and dividend payments in different markets around the world. This information was then used, along with up-to-date information on the complex picture of withholding/reclaimable rates by country, to calculate actual sums left unreclaimed, both globally, and for individual countries with the larger investor communities.
Sources
- GOAL Group proprietary data
- Global Stock Exchanges
- The International Monetary Fund
- The OECD
- The Bond Market Association
- Global top 50 banks
- The Federal Reserve
- The European Central Bank
- The Bank of England
- The Investment Management Association
- The World Bank
- Moody’s
- Bloomberg
- Standard and Poors
- Citytext
- International Financial Services Association
- Institute of International Finance
Graphs
[1] Standards and Poors, S&P Increases Indicated Dividend Rate on the S&P500, February 2006
[2] Dresdner Kleinwort Wasserstein, DrKW launches new Pan-European Income Service Research, Jan 2004
[3] CFO Europe, Payback Time, March 2004
[4] State Street Global Advisors, Forecasts, Second Quarter 2006
[5] State Street Global Advisors, 2006 – Diverging Global Bond Markets, December 2005
[6] See, for instance, definitions at www.goalgroup.com, or at http://www.ubs.com/1/e/ubs_ch/wealth_mgmt_ch/company/c_tax/backtax.html
