Many companies offer their shareholders an alternative to receiving dividends in cash, allowing the shareholders at their option to enrol in a dividend reinvestment plan (DRP) and to take up newly created shares instead (or to take a mixture of cash and shares).
When these plans first became popular such shares were generally offered at a discount of 5 to 10 per cent of the market price at the time, which made them very attractive to small investors. In more recent times the rate of discount was more likely to be in the 1 to 5 per cent range. Some issues are even being made at no discount at all.
In a volatile market this means that shareholders would often have been better off buying existing shares on the market on a day when prices were down than participating in a DRP where they have no control over the issue price.
No brokerage or other charges are incurred.
Such issues can be attractive to both parties. The company gets money for expansion at a modest administrative cost and at the same time the company cements shareholder relations.
Such semi-automatic capital raisings also reduce the need for conventional rights issue and thus avoid the pressure on market prices which such issues normally create.
The facility can also suit investors who wish periodically to make modest increases to their total portfolios in an economical way and who prefer to build up their existing holdings rather than increase the total number of companies in which they hold shares.
DRPs are also attractive to persons with a family trust designed to accumulate income for some years – for example, until a child or grandchild reaches a certain age.
It should be emphasised that participation in a dividend reinvestment plan is quite voluntary. Enrolment for all or a defined part of a holding normally requires the signature of the shareholder on an appropriate application form.
Investors can withdraw at any time, up to the books closing date for a particular dividend. Naturally, companies also have the right to suspend or close plans on giving appropriate notice to their shareholders.
One minor disadvantage of participation in dividend reinvestment plans used to be the creation of odd lots with its attendant extra costs, but this concept has now been abolished.
However, an ongoing negative is the need for plan members to keep detailed track of the issue dates and issue prices of dividend reinvestment plan shares to enable compliance with the capital gains tax (CGT) legislation.
Shares for each dividend create a separate “parcel” for CGT purposes, so that a long term investor disposing of these can be involved in a lot of arithmetic – either personally or indirectly through the fees paid to an accountant.
On a separate aspect, it is, of course, also possible that the market value of the new shares will fall below their issue price, notwithstanding the buffer often provided by any discount granted at the time of issue. But the risk of that happening is no different in character from that applying to the original holding or to any other shares.
A further disadvantage can be the need for shareholders to write to the company if they ever change their minds and wish to withdraw from a plan or change the level of their participation.
A more serious disadvantage in some cases and for some investors is that a non-cash dividend can result in a tax obligation without providing the necessary liquidity to meet it – especially in the case of unfranked dividends.
This comes about because all shares issued under dividend reinvestment plans are regarded as new shares purchased with the dividend proceeds. The dividends, despite not being received in cash, are thus taxed either as franked or as unfranked dividends in the usual way. Where franked they have the normal imputation credits associated with them.
Appropriate franking details must be set out on the plan statements issued by the companies concerned. On any subsequent disposal the plan shares would for capital gains tax purposes be treated as having been purchased at the time of the dividend distribution for a consideration equal to the dividend which was not taken in cash.
The discount at which dividend reinvestment plan shares are usually issued does not constitute assessable income at the time of issue. However, it does result in a lower acquisition cost for the new shares and this will result in a correspondingly higher taxable capital gain on any subsequent disposal.
The dividend used to acquire new shares under a dividend reinvestment plan has no effect under the social security income test, as the income from shares is assessed under the deeming rules. However, the value of the additional shares needs to be counted in the usual way for assets test purposes.
Some companies with a need for more capital, especially in the current climate, would prefer it if all their shareholders participated in their dividend reinvestment plans. As this is not really practicable they accordingly make arrangements with an underwriter for the placement of any shares which would have been available to those of their shareholders as elected not to participate in the plan.
This stgice retains the voluntary nature of the plan for individual investors, while simultaneously preserving the company’s cash flow. Its availability is also a useful encouragement to a high pay-out ratio, creating a “win-win” situation.