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Dividend investors, beware U.S. tax risks Add to ...

The spectre of increased taxes on dividends and capital gains, courtesy of the U.S. fiscal cliff, should put investors on high alert for further market selloffs like Wednesday’s post-election drubbing, according to analysts.

The fiscal cliff refers to the series of automatic U.S. budget cuts and tax increases that go into effect on Jan. 1 if politicians can’t reach an agreement on curbing the deficit.

There is widespread fear about what will happen if a deal is not in place by the end of the year. The fiscal tightening that would result from hitting the cliff is equal to about 4 per cent of GDP, a large enough hit to almost certainly cause the U.S. economy to slip back into recession.

But the fine print on tax increases that could result from a failure to reach a deal should also alarm investors – even those in Canada, who aren’t directly affected by the possible changes, but own U.S. equities.

Dividends are currently taxed at the favourable rate of only 15 per cent under temporary changes introduced by former president George W. Bush. Should there be no deal, they’re slated to be taxed as ordinary income, causing rates for top income earners to vault higher, to about 40 per cent. Similarly, taxes on long-term capital gains, now ranging from nothing at all to 15 per cent, would rise to 20 per cent.

The tax changes “could be quite an increase,” observes Paul Ashworth, chief U.S. economist at research firm Capital Economics.

The potential tax hikes could explain why dividend payers were uncharacteristically one of the big losers in Wednesday’s post-election downdraft, as the Dow Jones industrial average tumbled almost 313 points. Stable, large companies with high payouts, such as power utility Duke Power Co., pipeline operator Williams Cos. Inc. and telephone company Verizon Communications Inc., are often able to resist the full impact of market tumbles, but not this time. All had losses in line with the overall market.

The slide in dividend stocks strongly suggests that if the cliff’s recessionary vibes aren’t bad enough, worries about the two most important taxes for investors could further spook markets and continue to prompt selloffs in the weeks ahead.

That is because some investors might try to lock in capital gains this year at the lower rate by dumping stocks or by culling dividend payers from portfolios. Some shares, such as those in Apple Inc., have had multiyear rises and might be vulnerable to an attempt to lock in profits. The iPad maker tumbled 4.3 per cent on Wednesday, a much larger loss than the overall market’s 2.4 per cent slide.

Mr. Ashworth said worries about capital gains taxes, in particular, could cause a “wave of selling” toward year end if a deal isn’t in the cards.

If taxes on dividends rise, shares of high yielding stocks “would fall precipitously,” predicts David Taylor, who oversees a pair of IA Clarington funds with substantial U.S. holdings.

Mr. Taylor figures the stocks most vulnerable would be REITs, pipelines, utilities and securities structured as master limited partnerships. These offerings return much of their profits to investors directly through payouts – often set at yields of 5 per cent or higher – and are designed to appeal to income-hungry investors.

“I think they could be hurt significantly because [investors] don’t buy them for appreciation. They’re only buying them for the distribution,” he said.

Mr. Taylor says the best way for investors to dodge the dividend impact is by selecting companies that can return money to shareholders through stock price appreciation as well as through dividends. In this group he counts companies such as miner Freeport-McMoRan Copper & Gold Inc., oil refiner Valero Energy Corp., tech company Honeywell International Inc., banker JPMorgan Chase & Co. and fast food purveyor McDonald’s Corp.. All of them have yields in the 2- to 3-per-cent range.

To be sure, fears about the fiscal cliff may be overblown.

“Not very many people expect the dividend tax rate” to go back up by the full extent projected in a worst-case scenario, says Alan Auerbach, economics professor at the University of California, Berkeley.

He says all the worries may prove groundless. “Right now, there is a game of chicken going on about who will blink first, but eventually something is going to be worked out,” he predicts.



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