The Effect of Taxes on Dividend Policy of Banks

International Research Journal of Finance and Economics ISSN 1450-2887 Issue 19 (2008) © EuroJournals Publishing, Inc. 2008 http://www.eurojournals.com/finance.htm The Effect of Taxes on Dividend Policy of Banks in Nigeria Mr. Matthias A. Nnadi Researcher in Coventry University Business School, UK Assistant Lecturer in the Department of Business Education Rivers State University of Science & Technology, Port Harcourt, Nigeria E-mail: mattnnadi@yahoo.com Tel: +44(0) 7815611658 Mrs. Meg Akpomi Senior lecturer in the Department of Business Education Rivers State University of Science & Technology Port Harcourt, Nigeria Abstract The study explores the impact of taxes on the dividend policy of Nigerian banks. It underscores the theoretical assumptions of the M&M theory. The study identified pattern of past dividends, concern about maintaining a target capital structure, current degree of financial leverage, shareholder needs for dividend income, legal rules and constraints; such as impairment of capital, the desire to send favorable signals to investors, the desire to conform to the industry’s dividend payout among factors influencing dividend policy of banks. The analyses of the study show a significant correlation between taxes and dividend structure of the banks and also suggest that profit is a major variable in the formation of dividend policy of the organizations. This is supported by the hypothesis, which showed significant effect of profit on dividend and a positive correlation between profit, tax and dividend. The finding corroborates the postulations of some financial theorists and recommends capital gains in lieu of dividend for high taxpayers and that an adoption of a dividend policy by banks particularly in Nigeria should be strictly considered based on the unique circumstances of the bank and not necessarily based on age long traditional factors often formulated by academics. Keywords: Dividend policy, Capital gain, Dividend income, Clientele effect & taxation. JEL Classification Codes:E, G & N. 1. Introduction A lot of controversies regarding taxes and dividend policy have attracted many academic interests. Financial theorists such as Brennan (1970), Masulis & Trueman (1988) have stipulated that taxes affect organizational corporate dividend policy. If this speculation were true, changes in corporate dividend payout would be expected whenever the government changes its income tax policy (Wu, 1996). However, this does not always apply especially in especially in the banking business. Linter (1956) had asserted that the major determinants of dividend policy are the anticipated level of future earnings and the pattern of past dividend. International Research Journal of Finance and Economics - Issue 19 (2008) 49 This discrepancy may have underpinned Modigliani & Miller (1961) theory, which provided a platform for the enormous debates and researches on dividend policy. The banking sector is of interest in this research because of the because of the structure of its dividend as revealed in the study. Dividends are usually paid to owners or shareholders of business at specific periods. This is apparently based on the declared earning of the company and the recommendations made by its directors. Thus, if there are no profits made, dividends are not declared. But when profits are made, the company is obligated to pay corporate tax including other statutory taxes to the government. This is an essential corporate responsibility particularly profit making companies. The taxes no doubt reduce the profits available at the disposal of the organizations, either to be retained or distributed as a dividend to shareholders of the company. For decades, several postulations and assumptions have been made regarding whether such taxes paid by organizations actually affect their pattern of dividend policy. Dividend policy is the trade-off between retaining earning and paying out cash or issuing new shares to shareholders. Some firms may have low dividend payout because management is optimistic about the firm’s future and therefore wishes to retain their earnings for further expansion. It is hard to deny that taxes are important to investors. Although, dividend affects the shareholders tax liability, it does not in general alter the taxes that must be paid regardless of whether the company distributes or retains its profit (Brealey, Myers & Marcus 1999). Conscious of these assumptions, surrounding dividend policy, and this study is directed at evaluating the effects of taxes on the dividend policy of banks in Nigeria. 2. Some Theoretical Models to Explain Dividend and Tax. Corporate dividend policy has captured the interests of financial economists and has been an issue of intensive theoretical models and empirical examinations over the last few decades (Frankfurter & Wood, 1997). The controversy probably began with the Modigliani & Miller (M&M)(1961) theory, which classified investors into dividend clientele. It was later found in a later research that tax is responsible for marginal alterations in the portfolio composition rather than the major differences predicted by Miller & Scholes (1978). At the onset, when the M&M theory was postulated, most financial practioners and many academics greeted the conclusion that tax had a marginal effect on dividend policy with surprise (Baker, Powell & Veit, 2001). Other models such as tax adjusted model, Masulis & Trueman (1988) Model of cash payments, Farrar & Sewlyn (1967) Model of after tax income of investors, Auerbach (1979) Model of shareholders wealth and Akerlof (1970) Signal Model, information asymmetric theories, Jensen (1986) free cash flow hypothesis, Feldstein and Green (1983) theoretical dividend behavioral models and Shefrin & Statman (1984) theory of self control are all measure to unmask firms dividend policy. In a similar study of banks dividend payout, Casey and Dickens (2000) implored Rozeff (1982) model to examine dividend payout factors in which he found five variables to be very significant in dividend payout policies of firms. The variables include beta, percentage of insider ownership, past revenue growth rate, forecasted revenue growth and the number of common stockholders. Those variables are equally very useful in articulating dividend policies of banks. Chang and Rhee (1990) added that financial leverage is a crucial factor in dividend policy of firms. A firm that has a high financial leverage tends to have a high dividend payout ratio. This however depends on the tax chargeable on the dividend income being higher than the capital gains. 3. The Structure of the Nigerian Tax System The Nigerian tax is structured to reflect the nature of the business. Depending on the type of business, taxes are levied on businesses on an annual basis. This implies that all businesses, organizations and taxable persons are obligated to make a tax return to the Inland Revenue. Profits arising from transactions of companies constitute taxable income following their assessment to tax. This also includes personal income tax, which is duly imposed on individuals by the 50 International Research Journal of Finance and Economics - Issue 19 (2008) relevant tax authority in the territory where the company has its principal office, or the place of business on the first day of the year of assessment or year of commencement of business. The state Board of Internal Revenue is responsible for the administration and collection of the relevant tax in while the Federal Inland Revenue is charged with the responsibility of the company and other related taxes. These structures are governed by the Personal Income Tax Act (PITA, 1993) and Company Income Tax Act (CITA, 1994) respectively (Anyaduba, 2004). The Nigerian tax system is prudently organized in order to effectively enhance the collection of taxes and reduce the incidence of tax evasion and the subsequent loss of revenue to the government. The tax laws therefore provides for the collection of taxes at source of the taxpayer’s income. This is achieved through the Withholding tax system, which allows taxes to be deducted at the source of income. This is provided in sections 63 of CITA and 72 of PITA; where the laws recommend that income tax assessable on any company, whether or not an assessment has been made, shall if the Board (the relevant tax authority) so directs, be recoverable from any payments made by any person to such company. The income tax recovered under the provisions of the law by deduction from payments made to a company or person is usually set-off for the purpose of collection against tax charged on the company or individual by an assessment. This is however only to the extent that the total of the deductions does not exceed the amount of the assessment and in case of a company, the deduction is limited to the period in which the payment relates (CITA, 1994). The implications of the above provisions of the tax laws have been summed up by Anyaduba (2004) as follows: • The provisions are applicable to both individuals and companies who are liable to tax. • It is not limited to any particular source of income with specific reference to those mentioned in the CITA. • Any tax deducted at source on withholding tax basis is regarded as payment on the account and it is set-off against any tax assessed, due and collectible from the company or individual. The Nigerian tax laws provide that where a dividend or such other distribution becomes due from a taxpayer; person or company, payable by a Nigerian company to any other company or to any person, the company paying such dividend or making such distribution shall on the date when the amount is paid or credited, whichever comes first, deducts tax at the rate specified in the Act and shall forthwith pay over to the relevant tax authority the amount so deducted (CITA, section 62 and PITA, section 70 4. The Banking System and Taxation in Nigeria The banking system in Nigeria has undergone several reformatory processes. The Central Bank of Nigeria (CBN) regulates all the banks, which is the apex bank in the country. The 1969 banking decree required all banks to be locally incorporated and to publish their balance sheets on their Nigerian banking business only. There are also other regulations, which are aimed at stabilizing the indigenous banks for their long-term existence and committing the foreign banks more into the country’s economic improvement. Ghosh (1990) notes that the statutory transfer of 25% of profit after tax and after deducting bad debt provisions to general reserve and the increase in the minimum paid up capital, which presently is two hundred billion naira, are indicators of control of the Central Bank of Nigeria to inject control in the banking arena of the country. The peculiar aspect of the taxation of banks is that in addition to the company tax payable at the normal rate of 30%, banks are required to pay the excess profit levy. This is a levy of 10% on the excess profit of the bank, which was introduced in 1978. However, with effect from 1989-tax year, the excess profit levy tax became 15%. According to Aguolu (2000), the excess profit is the difference between the total actual profit of the bank and the normal profit of the bank computed by applying the following specified percentages. International Research Journal of Finance and Economics - Issue 19 (2008) 51 These percentages are usually applied to the capital employed by the bank as at the end of the accounting year: 40% of paid up capital; 20% of capital reserves, 20% of general reserves and 20% of long-term loans. The total is regarded as the normal profit of the bank. The various components of the capital employed may have their divergent meanings. Thus, paid up capital may comprise of the bank’s paid up ordinary and preference shares where applicable. The capital reserves will also include the share premium account, surpluses on revaluation of fixed assets and amounts set aside out of profit for the issue of share capitals. While the general reserves are undistributed profit apart from the statutory reserves. The long-term loans are those with repayment periods in excess of five years (Banks and Other Financial Institutions Decree, 1991). 5. Summary of Literature The literature review has attempted to identify crucial factors in dividend policy formulation by firms. It has also excavated some significant and recurring effects of tax on the dividend policy of firms as found by vast number of researchers in the subject. Dividend payments have been examined and interpreted by various institutions based on the impact it exudes on the firms. It is a diametric factor as it portends different signals to different interest groups. For managers, it is a way of maintaining or increasing the share price and thus attracting investors. The shareholders read different meanings to it as it signals a lot depending on the clientele. It could show an indication of future strength and builds confidence in investors. It could also be a nightmare because of the attendant tax liability. Different factors have been examined as warranting various dividend dispositions by firms. It ranges from capital availability, the industry norm, expected earning of the firm, capital project execution, profit and liquidity of the firm and various other factors as amplified in the literature. Managers avoid reduction in dividend because of the sticky signal it sends to the investors and shareholders. It may be a hallmark of incompetent management or a tip of an iceberg of future failure. It is difficult to divorce dividend policy formulation of firms from the tax effect it attracts. Many literatures existing in the sphere of the impact of tax on dividend policy are superfluous as their diverse opinions are. The M&M theory, which posit on the irrelevance in a tax-less society is remarkable fictitious on its assumption of taxes. Tax is a recurrent factor in most economies. Taxes undeniable affect investors and the firm especially in the dividend policies. This research is thus another step in revealing the effect particularly in the banking sector of Nigeria. 6. Methodology Secondary data obtained from the financial reports of the banks over a period of 5 years was used. The study population consists of 50 banks in Nigeria that are quoted in the Nigerian Stock Exchange (NSE). With the Federal Government of Nigerian’s capitalization structure of the banks to capital requirement of twenty five billion naira (about two hundred million dollars), banks are coarsed into merging; resulting in reduction in the number of banks operating in the country. The study sample was selected using the systematic sampling technique. The choice of the systematic sampling technique is in order to get convenient samples that will be an adequate representation of the study. This has the advantage of eliminating possible bias particularly in a survey (Smith, 1997). A major weakness of this technique according to Jankowicz (2000) is the inherent problems of changes that may occur during the study in which the study population is affected by those changes. The banks selected are based on the number of branches across the thirty-six states in the country. The banks have at least a branch in each state of the country and are grouped in the new generation banks whose financial statements are publicly available. They also have employees numbering over eight hundred and fifty each. 52 Research Questions International Research Journal of Finance and Economics - Issue 19 (2008) The following research questions were drawn to guide the study 1) What is the relationship between taxes and dividends? 2) How does profit affect dividend policy? Statement of Hypothesis The hypothesis to be tested in this study is tripod as it relates to profit, tax and dividend. The research has as one of its objectives, the examination of the effect of taxes on the dividend of banks in Nigeria. The results of the previous researches seem to suggest a strong correlation among tax, profit and dividend and therefore streamline the focus of the study. However, despite the conflicting and mixed evidence in the literature concerning the extent of the relationship between profit and tax, the resulting impact is expected to be very significant. Therefore, a test of the null hypothesis will permit an examination of the significant level of the expectations. Ho: There is no significant effect of profit on dividend and tax of banks in Nigeria. In line with previous researches and body of literature reviewed, the present study has an expectation that tax impact strongly on the dividend policy of banks in Nigeria. In particular, the evidence tends to purport the expectation that dividend and tax are strongly correlated. 7. Data analysis The descriptive statistics table shows the mean and standard deviation of tax and dividend in the M&As in the banking sector. The means of the tax and dividends are 43.96 and 65.07 respectively while the standard deviations are 41.25 and 68.05. This demonstrates that both the tax and dividends of the banks are well centralized. Table 1: Descriptive statistics Mean 43.96 65.07 Std. Deviation 41.25 68.05 N 50 50 Tax Dividend In order to establish any relationship between tax and dividend, the Pearson correlation coefficient was used in correlating the variables. Table 2 is the correlation table and shows that tax and dividend have a significant positive correlation 0.927. Table 2: The correlation between Tax and Dividend Tax 1 . 50 .927(**) .000 50 Dividend .927(**) .000 50 1 50 Tax Dividend Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N ** Correlation is significant at the 0.01 level (2-tailed). 8. Test of the Hypothesis Null Hypothesis: There is no significant effect of profit on dividend and tax of banks. In order to verify the assumptions on the relationship among profit, tax and dividend, the standard multiple regression analysis was used and the results are shown in the tables below. International Research Journal of Finance and Economics - Issue 19 (2008) Table 3: Model 1 (Constant) Tax Dividend 53 Standard Multiple Regression Unstandardized Coefficients B Std. Error -328 580 .201 .151 .124 .047 Standardized Coefficients Beta .332 .657 t -.006 1.329 2.631 Sig. .996 .232 .039 Collinearity Statistics Tolerance VIF .140 .140 7.126 7.126 a Dependent Variable: Profit The multiple regression table shows the linearity of the variables. However, the t-figure of 1.329 for tax indicates an insignificant correlation of profit and tax. But the t-figure of 2.631 of dividend shows a significant correlation of profit and dividend. This is also shown in the beta values. The tolerance figure of 0.140, which is below zero, indicates that the variables are in linear. (Pallant, 2000). The standard coefficients indicate that the values of the variables have been converted to scale for ease of comparison. The beta value gives the contribution or relevance of each of the independent variables. The highest beta figure is 0.657, which indicates that dividend has a strong correlation with profit rather than the tax, which has a less beta value of 0.332. Table 4: ANOVA table Sum of Squares 129 716 136 Df 2 6 8 Mean Square 645 119 F 54.1 Sig. .000(a) Model 1 Regression Residual Total a Predictors: (Constant), Tax, Dividend b Dependent Variable: Profit However at 0.05, the result is not statistically significant as shown in the ANOVA table, indicating that profit does not significantly affect tax of the banks. Therefore the null hypothesis is true, as the standard regression analysis shows no significant effect of profit on tax but establishes a significant correlation between profit and dividend of the banks. 9. Conclusions and recommendation The following conclusions can be deduced from the findings of the study: 1) Dividend structures of companies are basically influenced by various factors. The factors though may be similar in most organizations or industries, but they are uniquely determined by the nature of the company. Due to the susceptibility of the profit of banks, their dividend policy is often to maintain a low but steady payout. 2) Foremost among the determinants of the dividends structure are the liquidity position of the company. This is a function of the profitability of the company. Organizations that have investment projects will rely on their after tax profit. Thus, the availability of alternate investment opportunity shapes what the dividend will eventually be. 3) Dividend clientele is a very formidable factor in the consideration of a dividend policy. Managers are more inclined to formulate policies that suit the investors’ interest. Recommendations The following recommendations are made based on the results of the study. 1) Adoption of a dividend policy by the banks particularly in Nigeria should be strictly considered based on the unique circumstances of the bank and not necessarily based on age long traditional factors often formulated by academics. This is essential in order to maintain a steady and reasonable policy. 54 International Research Journal of Finance and Economics - Issue 19 (2008) 2) Due to the susceptibility of the banks profitability to economic changes in the country, it is unrealistic to seek to formulate a dividend policy that follows a constant payout. However, a low, reasonable and realistic policy should be adopted. 3) Hence differential taxation of dividend might affect the equilibrium assets price, rational investors should be interested in the profit after tax of the firm. 4) Consideration should be given to the needs and expectation of the shareholders in streamlining a dividend policy. When shareholders are akin to tax saving or minimizing tax liability, it is reasonable to consider policies that allows for tax savings such as scrip dividends. 5) Banks should encourage capital gains and lay structure that will prompt their shareholders to opt out of cash dividend especially in a developing country like Nigeria where investors are not comfortable with investment income tax. International Research Journal of Finance and Economics - Issue 19 (2008) 55 References [1] [2] [3] [4] [5] [6] [7] [8] [9] [10] [11] Aguolu, O. (2000) Taxation & Tax Management in Nigeria. Enugu; Meridian Associates Akerlof, G. 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