We correct the Financial Secretary's latest gaffe and explain why a further tax on corporate profits in the form of a dividend tax would necessitate a steeper salaries tax, a capital gains tax, a tax on worldwide investment income and ultimately a loss of economic output and revenue. It is a myth that dividends are tax-free.

The dividend tax myth
5 March 2013

Every once in a while in Hong Kong, an uninformed member of the public, or a socialist and impoverished journalist or a populist politician, alleges that tycoons or business owners don't pay tax "because dividends are tax-free" and lobs the idea of a dividend tax into the public arena without being aware of the consequences. In this article, we will explain, step by step, how a dividend tax would necessitate both a steeper rate of salaries tax and a capital gains tax, how investment taxes would necessitate a tax on worldwide investment income of HK residents, and how taxing residents on their investments could drive them overseas and out of the tax net, along with their spending.

The "dividends are tax-free" myth

On a "Financial Secretary Call-in" show on RTHK Radio 3 on Friday (1-Mar-2013), there was the following exchange between a caller and Financial Secretary John Tsang Chun Wah (listen here):

Caller: "I think this dividend issue is quite a significant one, in that a lot of people set up companies in which the companies pay them dividends rather than salaries and for that they escape paying any tax at all"
Financial Secretary: "OK I know that, I know that"

The caller can be forgiven for his ignorance, but not the Financial Secretary for endorsing this popular misconception. He really should know better. He could have explained that salaries reduce taxable profits, while dividends are paid out of taxed profits, and therefore a tax on those dividends would result in additional taxation of profits. The word "dividend" literally means to "divide" profits amongst shareholders and comes from the Latin word "dividendum" (things to be divided).

But instead, he earlier suggested that we don't have a dividend tax because of building up the asset management industry and jobs, which is barely relevant to this issue. High-tax-and-spend jurisdictions like the UK and the US, with massive budget deficits, do have substantial asset management industries - indeed, after imposing investment taxes, their governments then force their citizens to institutionalise their savings by granting tax breaks for pension plans and various types of funds. They also exempt homes from capital gains tax and generally incentivise home ownership resulting in housing crashes.

So let's explain why the Financial Secretary is wrong. Imagine two identical private companies, Company-A and Company-B, each running a successful business, owned by their respective Chairman. Each company produced $5m profit before tax and before paying either a bonus or a dividend to the Chairman. Company-A pays her a $5m bonus, resulting in no taxable profits, while Company-B does not, but pays profits tax and then pays out all its taxed profit as a dividend. Here are the numbers:

As you can see, there is a slight difference in tax paid, because the rate of profits tax at 16.5% is higher than the "Standard Rate" of salaries tax at 15%, but other than that, the outcome is the same. The chairman-owner will of course choose the optimum path. This is why, in our alternative budget, we called for a flat and equal rate of salaries tax and profits tax, so that the taxman gets his fair share either way.

A dividend tax implies steeper salaries tax rates

If HK were to impose, say, a 10% tax on dividends, then that would mean that the effective tax rate on profits would rise from 16.5% to 24.85% (being 1-0.835*0.9). Any business owner would then rather pay herself a big bonus, reducing her company's profit to zero, and only pay 15% salaries tax, as in Company A. The only way to neutralise the choice would be to increase salaries tax to 25% and thereby remove the incentive to pay out corporate profits that way.

If we did that, though, then there are other ways around it - simply use the taxed profits to buy back shares rather than pay dividends, or the company could lend the money to the director indefinitely. This would necessitate a whole panoply of anti-avoidance legislation and loopholes, as has been necessary in other jurisdictions.

A dividend tax implies a capital gains tax

For listed companies, the issues are similar. They could stop paying dividends on which their HK holders will be taxed, and instead just buy back shares of the same value as the dividend they would have paid, thereby legally avoiding dividends tax. Companies which previously had a dividend yield of say 3% could just buy back 3% of their shares instead. Shareholders who need, say, a 3% cash flow from their investment to fund their living costs could just sell 3% of their shares each year in the market. So to counter that, the Government would then need to introduce a capital gains tax on disposal.

That would be rather crude, because if a company's share price has gone down since the investor's purchase, then no capital gains would arise, so investors would be inclined to sell losing positions to capture losses, and offset those losses against the gains on sale of winning positions. Over time, this would distort capital allocation because people generally have more gains than losses, so they would hang on to gaining positions to avoid the tax. So then the Government would start tinkering with taper-relief, reducing gains tax rates based on the holding period. There is no end to how complex this can become.

Ultimately, capital gains, being changes in share prices, represent a change in the net present value of future profits of a company. Those profits will be taxed wherever they are generated, so a capital gains tax, like a dividend tax, amounts to additional and accelerated taxation of those future corporate profits. This becomes obvious when you consider that a share which pays out a dividend normally drops in price by the value of that dividend, because part of those future profits are no longer in the price but in your hands.

Taxing HK-resident investors implies world-wide income tax

Taxing dividends and gains on HK investments has broader implications, because residents could simply decide to invest overseas instead - for example, by buying shares in Singapore-listed companies. It would also encourage HK-listed companies to move their listings overseas. If you don't believe that, then consider the Jardine group of companies, listed in HK until 1994, which are mainly traded in Singapore, although their primary listing is in London. They left for different reasons, but others could join them.

So to counter the tendency of HK investors to buy overseas shares to avoid tax, and to deter companies from shifting their listings, the HK Government would have to tax residents on their worldwide dividends and gains, abandoning the territorial source principle of taxation that it has adhered to since 1841.

Taxing HK-resident investors would drive them overseas

HK-resident investors would then face a simple choice. They don't have to live here to invest here, so they could simply move overseas, perhaps to Singapore, which does not tax people on dividend income and capital gains, carry on investing in HK stocks but spend their money in the local economy rather than in HK. Those residents who have already transferred their assets to offshore trusts would probably be exempt anyway, unless we start taxing overseas investors on HK investments - but if we do that, then we can be even more confident of driving away listed companies to a place where their foreign shareholders will not be taxed, such as London or Singapore. Keep in mind that most listed companies are not incorporated here, so we can only really tax their HK businesses at the profits tax level.

Adding to surpluses

The result of all this in the short term might be more revenue that the Government doesn't actually need, given its humungous reserves which were accumulated from long-run surpluses, so then there would be pressure to redistribute it to those who don't need it (for example, on a non-means-tested pension), or to squander it on projects like high-speed trains to Shenzhen. In the longer-term though, HK simply can't afford to take a much bigger tax bite out of the economy without driving away business, talent and profits.

© Webb-site.com, 2013

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