BoCom's bonus-share tax hit
29 September 2011
Bank of Communications Co., Ltd. (BoCom, 3328) has recently demonstrated a nasty wrinkle in China's tax code which other listed companies based in the mainland (whether incorporated in the PRC or elsewhere) should beware of. With its final results for 2010, BoCom announced a dividend of CNY0.02 per share and a bonus issue of 1 new share for every 10 shares held but, as we will explain, shareholders received only 40% of the declared dividend and lost the rest to taxation.
As many investors will know, China now operates a dividend withholding tax, normally at 10% on the amount of distributed profits. Since 1-Jan-2008, this applies to any "Tax Resident Enterprise" (TRE) regardless of whether it is incorporated in the PRC or elsewhere. This withholding tax is reason enough not to pay dividends but instead to make share repurchases in the market, where there is no withholding tax (unless China charges the company for distributing its profits in this way). Companies which continue to pay dividends rather than return cash by share repurchases are subjecting their investors to avoidable tax and thereby reducing net returns. If profits are instead distributed by share repurchases, then shareholders who want cash flow from their investment could instead sell a few shares in the market each year rather than get taxed on dividends.
But that's not the main topic of this article. The problem is with BoCom's "bonus issue", which was also taxed. Bonus issues normally have absolutely no impact on the economic value of an investment, other than the logistical costs of making them, such as printing a circular and share certificates. They are equivalent to stock splits - for example a bonus issue of 1 new share for each share held is equivalent to a 2-for-1 stock split, as the number of outstanding shares doubles in both situations and the share price halves, leaving the investment value unchanged and making the whole thing rather pointless, as we said on our article Truly pointless bonuses and splits (27-Dec-2010).
In the BoCom case, there are now 11 shares for every 10 shares which existed prior to the bonus issue. On the balance sheet, there is an internal transfer from the distributable profit to the "share capital" line, but the amount of that depends on the "par value" of the shares which has nothing to do with the market value of the shares. Put simply, "bonus issues", despite their name, are not a bonus at all. More traditionally, this type of bonus issue is known as a "capitalisation issue", because of the internal transfer from retained profits to share capital. There is no external transfer of value. Some companies instead make an internal transfer from "capital reserve" (also known as share premium) to share capital, without touching the retained profit account. It appears that China has not been taxing bonus issues made from capital reserves, so BoCom could have done that. One example is the 10 for 10 bonus issue by China National Building Material Co Ltd (3323).
But BoCom has interpreted the tax code to mean that each shareholder actually "received" a distribution worth the par value or CNY1 for each bonus share. Since the bonus ratio was 1:10, that equates to CNY0.1 for each existing share. So BoCom deducted a 10% tax of CNY0.01 from the dividend on each existing share, in addition to the CNY0.002 tax on the cash dividend. Altogether then, the tax was CNY0.012 on a cash dividend of CNY0.020, which amounts to a 60% tax on the dividend, leaving shareholders with just CNY0.008 per share. Indeed, if BoCom had not paid a cash dividend, it would not have had any way to "charge" shareholders for the tax on the bonus issue.
BoCom had 56.26bn shares outstanding before the bonus issue, so the result is that additional tax of up to CNY562.6m has been paid to the Government. The Government is also the largest shareholder, holding 26.52% through the Ministry of Finance, so it benefits from this arrangement - the more bonus shares it causes the bank to declare and issue (through its representation on the board), the more tax it collects - an obvious conflict of interest. BoCom made a net profit of CNY39,042m in 2010, so that is equivalent to a 1.44% reduction in earnings. The exact amount of excess tax cannot be determined, because TREs who are shareholders are exempt from the withholding tax on received dividends and instead have to pay it when they distribute dividends to their non-TRE shareholders, and so on up the chain.
Webb-site calls on the Chinese Government to clarify its tax treatment of bonus issues, to state that there will be no withholding tax on bonus issues, because they are not a distribution of value, whether they are achieved by an internal transfer from capital reserve or retained profits. In the meantime, we urge all Tax-Resident Enterprises to stop declaring bonus issues of shares out of their profits, because these bonus issues destroy shareholder value by paying unnecessary tax to the Government.
China's policy on taxing dividends in general is misguided - not a single Yuan of GDP is created by dividend distributions, and companies which either retain their profits or use them to make share repurchases or acquisitions will never have to pay the tax. Using the cash to make repurchases is sub-optimal for capital allocation because it results in companies participating in the market for their own shares by their repurchases, when it would be better to just distribute dividends and let investors determine the market price and reinvest their dividends as they wish. Taking a typical company which pays out 40% of its post-tax profits in dividends, the 25% corporate tax rate and the 10% dividend withholding tax are equivalent to a 28% tax rate on pre-tax profits (0.75*40%*10%=3%). It would be better and fairer for China to set its corporate tax rate at 28%, or thereabouts, and abolish dividend withholding tax.
© Webb-site.com, 2011