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IJMF
11,1
The effects of a tax dividend
cut on payout policies:
Canadian evidence
2 Manon Deslandes
Received 26 May 2014
Department of Accounting, University of Québec at Montréal,
Revised 18 July 2014 Montréal, Canada
Accepted 17 October 2014
Suzanne Landry
Department of Accounting Studies, HEC Montréal,
Montréal, Canada, and
Anne Fortin
Department of Accounting, University of Québec at Montréal,
Montréal, Canada

Abstract
Purpose – The purpose of this paper is to examine whether the significant dividend tax rate reduction
for individual investors in Canada in 2006 affected firms’ payout policies.
Design/methodology/approach – Using regression models, the authors examine the impact
of the 2006 dividend tax cut on dividends and share repurchases in Canadian listed firms from
2003 to 2008. The authors also ran a multinomial logit regression to examine choices between
payout policies.
Findings – Following the tax cut, firms increased their dividend payouts, with larger increases for
firms in which shareholders benefited from the reduced tax rate. However, the 2006 tax cut appears to
have had no negative effect on distributions through share repurchases. After the 2006 dividend tax
cut, firms owned by shareholders subject to dividend taxes were more likely to use a combination of
distribution mechanisms than share repurchases only, dividends only, or no payouts.
Practical implications – Shareholders’ tax preferences are an important factor for firms to consider
when designing payout distribution policies. Following the 2006 dividend tax cut, firms increased their
dividend payouts.
Social implications – The findings provide tax regulators with insight into how firms react to tax
reform. They suggest that firms adapt their payout policy in the face of: a noteworthy dividend tax cut
(6.2 per cent); a dividend tax cut that does not encourage tax arbitrage; and a dividend tax cut that does
not economically favour dividend payment over share repurchases.
Originality/value – The paper considers the 2006 dividend tax rate cut in Canada, which presents
a number of significant features that allow capturing the effect of a tax cut on payout policies.
Keywords Dividend payout, Dividend tax rate change, Payout policy, Share repurchase,
Tax clientele
Paper type Research paper

1. Introduction
In the USA, dividends have been disappearing since 1978 as firms become dramatically
less inclined to pay them (Fama and French, 2001). At the same time, open market
repurchases are increasingly popular (Grullon and Michaely, 2002), a trend that
International Journal of Managerial
Finance is expected to grow as more countries adopt enabling regulations. Nevertheless, it is
Vol. 11 No. 1, 2015
pp. 2-22
© Emerald Group Publishing Limited
1743-9132
The authors gratefully acknowledge funding provided by the Roland-Chagnon Professorship of
DOI 10.1108/IJMF-05-2014-0081 Accounting and Taxation, HEC Montreal, and the Université du Québec à Montréal.
unclear whether this trend can be generalized to other markets or whether the taxation Effects of a
system, more specifically dividend taxation, contributes to explain it. In this paper, tax dividend
we examine whether the significant dividend tax rate reduction for individual investors
in Canada in 2006 affected firms’ payout policies from 2003 to 2008. The 2006 tax cut
cut on payout
reduced the dividend tax rate by more than 5 per cent. policies
To our knowledge, the only studies to examine both dividend and share
repurchase decisions and to consider tax as a possible explanation of payout 3
policies in Canada are by de Jong et al. (2003), Kooli and L’Her (2010), Baker et al.
(2012, 2013). In their survey of the 500 largest non-financial Canadian firms, de Jong
et al. (2003) find that payout type depends on behavioural and tax preferences of
shareholders, and firms are less likely to use dividends if they have executive stock
option plans. In a study of Canada’s payout policies from 1985 to 2003, Kooli and
L’Her (2010) conclude that different types of firms use dividends and repurchases
differently, that Canadian dividend-paying firms substitute share repurchases for dividends,
and that the 2000 capital gains tax rate cut impacted the choice between dividends and
share repurchases. In their Canadian survey, Baker et al. (2012) examine the decision not to
pay cash dividends and find that stock repurchases are not substitutes for dividends and
that taxation is not a first-order determinant of dividend policy. In their examination of
cash dividends and stock repurchases in Canada, Baker et al. (2013) report that the
percentage of dividend-paying firms declined until 2001 and subsequently increased
until 2006. This trend is inconsistent with the tax explanation, because the 2000
capital gains tax cut should have induced firms to repurchase shares rather than
pay dividends (Baker et al., 2013).
Our study contributes to the literature in several ways. We complement previous
studies by examining the impact of tax reform on payout policies. Chetty and Saez
(2005, p. 792) note that the “effects of dividend taxation on dividend policies
and corporate behaviour more generally remain disputed, largely because of the lack
of compelling tax variations, and therefore of a fully convincing research design”. The
present study redresses this problem by focusing on the 2006 dividend tax rate cut in
Canada, which presents a number of significant and instructive features. First,
at W 5 per cent, this cut was likely to impact corporate behaviour. Second, as it was not
previously announced, corporations did not anticipate the cut. Third, unlike tax
reforms examined in other studies (e.g. Brown et al., 2007, on the 2003 Jobs and Growth
Tax Relief Reconciliation Act – the 2003 US tax reform; or Pattenden and Twite, 2008,
on the Australian tax reform), which targeted dividend and capital gains tax rates,
Canada’s 2006 dividend tax cut applied to dividends only[1]. It is therefore easier to
capture the effect of the tax cut on payout policies. Finally, unlike the 2003 US tax
reform, Canada’s 2006 dividend tax rate cut was permanent. Korinek and Stiglitz (2009)
suggest that a temporary tax change encourages tax arbitrage, as firms attempt to
gain benefits for their shareholders[2]. The significant and permanent tax rate cut in
2006 therefore provides an opportunity to empirically validate de Jong et al. (2003)
posited taxation effect on payout policies, namely, that a firm’s choice between
dividends and repurchases is influenced by shareholders’ tax preferences.
Comparing distribution decisions before and after the tax cut, we observe that firms’
payouts increased significantly after the cut. This suggests that a dividend tax rate cut
impacts distribution decisions (consistent with Chetty and Saez, 2005; Brown et al.,
2007; Pattenden and Twite, 2008). Specifically, our regression model results indicate
that the 2006 dividend tax rate cut for individual investors (from 31.3 to 25.1 per cent)
induced firms to increase their dividend distributions, and that this increase was
IJMF greater for firms with a larger ownership percentage of shareholders who were subject
11,1 to dividend taxes. These results are consistent with Chetty and Saez (2005), Brown et al.
(2007), and Blouin et al. (2011). However, the 2006 dividend tax cut for individual
investors did not encourage firms to reduce their share repurchases. In the choice
between payout policies, we observe that shareholders’ tax preferences are important
considerations in the design of payout policies (consistent with de Jong et al., 2003;
4 Moser, 2007). Specifically, the larger the firm’s percentage of ownership by
shareholders who are subject to dividend taxes, the more likely they would be to use
share repurchases over dividends only or over a combination of distribution
mechanisms. We also find that, after the 2006 dividend tax rate cut, firms were more
likely to use a combination of distribution mechanisms over share repurchases only,
pay dividends only, or make no payouts. Our findings have important implications for
tax regulators, as they provide insight into how firms react to tax reform. They suggest
that firms adapt their payout policy in the face of: a noteworthy dividend tax cut
(6.2 per cent); a dividend tax cut that does not encourage tax arbitrage; and a dividend
tax cut that does not economically favour dividend payment over share repurchases.
In particular, following the 2006 dividend tax rate cut for individual investors,
firms not only increased their dividend payouts, they also maintained their share
repurchase programmes.
The remainder of this paper is organized as follows. Section 2 describes the taxation
of payout distributions in Canada. Section 3 reviews the related literature and presents
our hypotheses. We discuss our data and methodology in Section 4. Section 5
presents the empirical results, and Section 6 concludes the paper.

2. Taxation of payout distributions in Canada

We focus on the effect of the dividend tax disadvantage on payout policies in Canada.
We begin by discussing the taxation of dividend income and capital gains in
Canada. As in the USA, taxpayers are required to pay taxes based on their sources of
income and their status. Whereas individuals are subject to taxes on all income sources
(e.g. dividends and capital gains), several Canadian institutional investors may be
either exempt from taxes on all income sources (e.g. pension funds) or not taxed on
dividend income (e.g. Canadian corporations). Income earned by mutual funds is either
taxed to the mutual funds or to the underlying shareholders. Similarly, income
generated on shares (e.g. dividends or capital gains) held by independent investment
advisors (e.g. brokers) is also taxed to the underlying shareholders. If these underlying
shareholders are more likely to be subject to individual income tax rates, as assumed
by Moser (2007) and Blouin et al. (2011), mutual funds and brokers should be more
sensitive than other institutional investors to changes in the dividend tax rate. For
individual Canadian taxpayers, the top marginal tax rate on dividend income decreased
from 32.3 to 24 per cent between 2000 and 2008[3],[4]. The largest reduction was in
2006, from 31.3 to 25.1 per cent. Since 2000, capital gains have been taxed at lower rates
than dividend income[5]. At the start of 2000, the top marginal tax rate on capital gains
was 36.6 per cent. At the end of 2000, it was 23.2 per cent, where it has remained since.
Hence, the tax disadvantage of dividends compared to capital gains was 8 per cent
up to 2005, but only 2 per cent in 2006 and 2007, and merely 1 per cent in 2008.
Share repurchases are usually made through normal course of issuer bids
(Ikenberry et al., 2000; Baker et al., 2013), which are regulated by the laws of the stock
exchange where the firm trades. They benefit from a special tax rule and are
consequently taxed as capital gains[6],[7]. If, as reported by de Jong et al. (2003), firms’ Effects of a
payout choice is influenced by investors’ tax preferences, Canadian firms should tax dividend
have preferred share repurchases over dividend payments before 2006. After the 2006
tax reduction, when the tax dividend disadvantage was considerably reduced, they
cut on payout
should have preferred share repurchases less. policies

5
3. Related literature and hypothesis development
Previous studies concur that investors show a strong preference for cash dividends,
and that this preference reflects individual behavioural biases (Shefrin and Statman,
1984). Tax clientele theory posits that tax-advantaged shareholders should prefer
investing in high dividend-paying firms, whereas tax-disadvantaged shareholders
should prefer investing in low (or non-) dividend-paying firms (Miller and Modigliani,
1961). Furthermore, DeAngelo et al. (2008) suggest that individuals’ behavioural biases
could reasonably be classified as clientele theories, and that firms should tailor their
payout policies to accommodate shareholders’ demands. Consequently, a dividend tax
cut should influence firms’ payout policies. However, the results are mixed on the
ability of tax clientele theory to explain payout policy.
For instance, from their extensive literature review, DeAngelo et al. (2008) conclude
that motives such as managerial signalling, clientele demands, and tax deferral
strategies have only a minor influence on payout policies. This is consistent with
Brav et al. (2005) survey of financial executives of US public firms. They conclude that
although dividends were greatly tax-disadvantaged compared to share repurchases in
2002, tax considerations played only a secondary role. Similarly, Baker and Powell
(2000), Baker et al. (2001), and Baker et al. (2007), in their surveys of managers of
dividend-paying firms listed on the NYSE, NASDAQ, and TSX, respectively, suggest
that shareholders’ tax preferences do not influence dividend policies. Moreover, Baker
et al. (2012), in a survey of Canadian managers of non-dividend-paying firms listed on
the TSX, observe that tax considerations are at best a second-order determinant.
Conversely, de Jong et al. (2003), in their study on Canadian executives, conclude that
the payout decision is determined by free cash flow, and that the choice of payout
mechanisms is influenced by shareholders’ tax preferences. Chetty and Saez (2005) find
that an unusually large number of firms initiated or increased their regular dividend
payments in the year following the 2003 US tax reform, which included a large tax cut
on individual dividend income. They also suggest that the total payout rose
significantly in the subset of firms that initiated dividends after the reform. Pattenden
and Twite (2008) examine changes in corporate dividend policy after the Australian
tax reform, which introduced a dividend tax rate cut, and find that firms subsequently
increased their dividend payouts and were more likely to initiate dividends. Jacob and
Jacob (2012) investigate corporate payouts in a panel of firms from 25 countries
and show that the higher tax rate on dividends than capital gains corresponds closely
with firms’ propensity to pay fewer dividends.
In their examination of the relationship between firms’ shareholder tax clientele
and dividend payout policy, Seida (2001) finds a positive association between higher
dividends and increased post-dividend trading, interpreted as evidence of tax clientele
effect. Moser and Puckett (2009) and Jun et al. (2011) find a dividend tax clientele effect
on institutional investors. Lightner et al. (2008) find support for a shareholder clientele
effect in dividend-paying firms following the 2003 US tax reform. Ayers et al. (2002)
report a negative relationship between share values and an increase in the individual
IJMF income tax rate, which they interpret as a tax clientele effect. Dhaliwal et al. (2003, 2005)
11,1 and Li (2007) examine the association between the dividend tax disadvantage
and firms’ share value (or return required by shareholders), and find that shareholders
require lower penalties to compensate for the tax disadvantage when the current
shareholders are not disadvantaged by a dividend tax. Hence, a dividend tax rate
cut for individual investors would diminish the shareholders’ required rate of return
6 in firms whose shareholders are subject to dividend tax. Therefore, the effect of a
dividend tax rate cut on a firm’s dividend policy would depend on the sensitivity
of its shareholders to dividend taxes.
Furthermore, Blouin et al. (2011) show that firms with individual shareholders
increased the dividend portion of their total payout following the 2003 US tax reform.
Henry (2011) examines the existence of tax-based dividend clienteles in Australia,
focusing on the tax-based preferences of five shareholder categories, including both
domestic and foreign-domiciled shareholder classes, and finds that the degree
of tax benefit associated with dividend payments is a strong explanatory factor for
clientele effects. Desai and Jin (2011) also examine the association between
shareholders’ tax-based preferences and firms’ dividend payment behaviour. They
conclude that investors are concerned about the tax consequences of firms’ payouts,
and that firms consider investors’ tax preferences in their payout decisions. In sum,
the results on the dividend tax effect on a firm’s payout policy are mixed, and further
research is needed to clarify this issue.
Our first hypothesis concerns the relationship between a dividend tax rate cut
and a firm’s dividend payout policy. If, as argued by de Jong et al. (2003), the payout
choice is influenced by shareholders’ tax preferences, the 2006 dividend tax rate cut
should have encouraged firms to pay more dividends even when stock repurchases
were still slightly tax favoured. Our first hypothesis is as follows:

H1a. A dividend tax rate reduction for individual investors should induce firms to
increase their dividend distributions.

H1b. A dividend tax rate reduction for individual investors should induce firms to
increase their dividend distributions if the ownership percentage of
shareholders who are subject to this tax rate is high.

Chetty and Saez (2005) report that the dividend tax cut introduced in the 2003 US tax
reform did not induce firms to simply substitute dividends for share repurchases.
However, Brown et al. (2007) suggest that firms that initiated dividends after the 2003
US tax reform were more likely to reduce their repurchases. Oswald and Young (2004)
examine open-market share repurchase activity in the UK and conclude that share
repurchase decisions are not driven by investors’ tax considerations. Conversely, Moser
(2007) reports that the tax dividend disadvantage affects a firm’s choice of payout
mechanisms. He further suggests that in times of high tax disadvantage, US firms are
more likely to repurchase shares, and this association is affected by the tax sensitivity of
the firms’ shareholders. As discussed above, de Jong et al. (2003) conclude that the choice
between dividends and share repurchases as the payout mechanism depends on
shareholders’ behavioural and tax preferences. For instance, they report a positive and
significant association between share buy-backs (SBBs) and “tax preference for SBBs”.
Our second hypothesis concerns the relationship between a dividend tax cut and a
firm’s repurchase payout policy. If firms consider investors’ tax sensitivity in their
choice of payout mechanisms, we would expect firms to have decreased their share Effects of a
repurchases following the 2006 dividend tax rate reduction. Our second hypothesis tax dividend
is as follows:
cut on payout
H2a. A dividend tax rate reduction for individual investors should induce firms to policies
decrease their distributions through share repurchases.
7
H2b. A dividend tax rate reduction for individual investors should induce firms to
decrease their distributions through share repurchases if the ownership
percentage of shareholders who are subject to this tax rate is high.

4. Data and methodology

Data
Our initial sample is derived from all the Canadian firms listed in the Compustat
database for at least one year from 2003 to 2008 (2,002 firms). Our study period begins
in 2003 to avoid capturing the effect of the 2000 capital gains tax rate cut and to provide
three years of data before the dividend tax cut (PRE period). It ends in 2008 in order to
obtain a period of similar length after the tax cut (POST period)[8]. We exclude firms
that were subject to different tax and other regulations that may impact payout policy
and distribution decisions. These firms include income trusts (306 firms), financial
firms (SIC 6,000 - 6,999: 191 firms), and mining, oil, and gas firms (SIC 1,000 - 1,499: 758
firms). Income trusts pay cash distributions and returns of capital to unitholders, but
these payouts are not dividends. Financial firms operate in a regulated environment.
Mining, oil, and gas firms benefit from a special tax regime. For instance, these resource
companies have access to a flow-through share mechanism that allows them to
renounce Canadian exploration and development expenditures to shareholders. We
also exclude firms that were not incorporated in Canada (36 firms) and firms for which
data to compute the tax sensitivity variable were not available (186 firms). From the
remaining 525 firms and 2,357 firm-year observations, we then exclude all firm-year
observations with no revenue (for instance, start-up firms) or with a negative book value
of total equity (186 firm-year observations)[9] and outliers (42 firm-year observations)[10].
The final sample comprises 494 firms and 2,129 firm-year observations.
Accounting and financial data were obtained from the Compustat database and
supplemented by financial statements published on SEDAR[11]. Data on firm
ownership, which were required to determine shareholder sensitivity to dividend tax,
were collected manually from proxy statements published on SEDAR.

Methodology
Following Fenn and Liang (2001), we consider two models to examine the effect of a
dividend tax rate cut on dividend and share repurchase policies. The first equation
captures the impact of the 2006 dividend tax cut on the distributions through
dividends, and the second captures the distributions through share repurchases:
DI V i;t ¼ g0 þ g1 POST t þ g2 TS i;t þ g3 POST  TS i;t þ g4 LDI V i;t

þ g5 EARNI N GS i;t þ g6 CASH i;t þ g7 M Bi;t þ g8 DEBT i;t

þ g9 V OLATI LI TY i;t þ g10 SI Z E i;t þ I ndustry Dummies þ ei;t (1)
IJMF REP i;t ¼ g0 þ g1 POST t þ g2 TS i;t þ g3 POST  TS i;t
11,1 þ g4 LDI V i;t þ g5 EARN I N GS i;t
þ g6 CASH i;t þ g7 M Bi;t þ g8 DEBT i;t
þ g9 V OLATI LI TY i;t þ g10 SI Z E i;t
8 þ I ndustry Dummies þ ei;t (2)
where DIVi,t is firm i’s annual total cash dividends paid on common shares to all
shareholders at time t, REPi,t is firm i’s annual total amount of common shares
repurchased at time t, POSTt is a dummy variable equal to 1 for the period 2006
and after (when the dividend tax rate cut was in effect) and 0 otherwise, TSi,t is the
percentage of firm i’s shares held by investors who were subject to the individual tax
rate at time t, LDIVi,t is firm i’s annual cash dividends paid on common shares for the
preceding period (i.e. DIVi,t  1), EARNINGSi,t is firm i’s annual earnings before
extraordinary items at time t, CASHi,t is firm i’s cash and short-term investments at
time t, MBi,t is firm i’s market value of common stock at time t over its book value (book
value of common equity) at time t, DEBTi,t is firm i’s total debt (excluding preferred
shares) at time t, VOLATILITYi,t is firm i’s volatility of earnings defined as the
firm-level standard deviation of EARNINGS over three years (t  2 to t), and SIZEi,t is
firm i’s natural log of book value of assets at time t. All independent variables except
for TSi,t, MBi,t, SIZEi,t, and POSTt are scaled by the book value of assets at time t (or
t  1 for LDIVi,t). Industry dummies are the first digit of the SIC code.
In this paper, DIV and REP are the distributions through dividends and share
repurchases, respectively, calculated following Brown et al. (2007) as the annual total
distribution (DIV or REP) amount divided by the book value of assets at time t[12].
As in Kooli and L’Her (2010) and Grullon and Michaely (2002), we take the gross
amount of share repurchases so that our variable does not take into account share
issuance during the year. Our measure does not consider the annual amount of
dividends paid on preferred shares or preferred share repurchases, which are more akin
to interest payments or debt reimbursements.
The POST period corresponds to the period after the 2006 dividend tax rate cut.
The 2006 tax rate cut should have induced firms to increase (decrease) their dividend
payout (share repurchases), which suggests a positive relationship between POST and
DIV (H1a) and a negative relationship between POST and REP (H2a).
The variable TS represents shareholders’ sensitivity to the individual dividend tax
rate. The higher the TS, the more tax-disadvantaged the shareholders when they cash
dividends. TS is defined as the percentage of stock held by investors subject to the
individual dividend tax rate, and it excludes shares held by tax-exempt and untaxed
institutional investors. In addition, it does not consider shares held by non-resident
shareholders, who are subject to different tax rules on dividend income. TS is
calculated as 100 per cent minus the percentage ( per cent) of shares held by tax-exempt
or untaxed institutional shareholders and non-resident shareholders identified in the
proxy statement[13]. As mentioned above, according to tax clientele theory, investors
who would be tax-disadvantaged by cashing dividends would prefer to invest in low
(or non-) dividend-paying firms (Miller and Modigliani, 1961). Moreover, de Jong et al.
(2003) and Moser (2007) find that shareholders’ tax preferences affect firms’
distribution mechanisms. Firms with shareholders who would be tax-disadvantaged
by cashing dividends should prefer to repurchase shares. This suggests a negative
relationship between TS and DIV and a positive relationship between TS and REP. Effects of a
H1b and H2b propose that firms with shareholders who are subject to individual tax dividend
dividend income taxes would have greater incentive to increase their distributions
through dividends and decrease them through share repurchases following the 2006
cut on payout
dividend tax rate cut for individuals. We therefore predict a positive (negative) policies
relationship between POST × TS and DIV (REP). Furthermore, consistent with prior
studies (e.g. Baker et al., 2013; Kooli and L’Her, 2010; Fama and French, 2001), 9
we consider several control variables that could affect the payout decision. Thus, we
consider a one-year lagged dividend (LDIV), annual earnings (EARNINGS), cash
(CASH), firm’s growth opportunities (measured by the market to book ratio: MB), firm’s
indebtedness (DEBT), earnings’ volatility (VOLATILITY), and firm size (SIZE).

5. Empirical results
Descriptive analysis
Table I presents sample data for the PRE and POST periods as well as the percentage
change between the periods for firms that made payouts. More specifically, Table I
presents the number and percentage of firm-years, the amounts disbursed in millions of
Canadian dollars, earnings, and the percentage of shares held by investors who are
sensitive to dividend taxation according to various categories: total paid out, total paid
dividends, total repurchases, paid dividends only, repurchases only, and repurchases
and paid dividends. Table I shows a slight increase (1.7 per cent) in the percentage
of firms that made payouts from PRE to POST. However, both the amounts paid out
and earnings increased dramatically, by 47.4 and 35.2 per cent, respectively. TS
increased by only 1.7 per cent, indicating a stable shareholder tax profile.
The percentage of firms that paid out dividends remained constant from PRE to
POST period (34.4 per cent). However, the amount paid out increased by 23.1 per cent.
TS also increased by 3.4 per cent to reach a mean of 74.6 per cent in the POST period.
The percentage of firms making repurchases increased by 17.8 per cent (from 26.3
to 31.0 per cent), with a massive 87.8 per cent increase in the amounts disbursed. The
mean TS is high at 79.4 per cent in the POST period (a 2.6 per cent increase). The mean
TS also exceeds that for dividend-paying firms (74.6 per cent in the post period).
The percentage of firms that paid dividends only decreased by 18.7 per cent and
the amount paid dropped by 12.5 per cent, indicating that firms that paid dividends
only increased the amounts they paid. The percentage of firms that paid dividends only
decreased, while the percentage of firms that paid dividends and made repurchases
increased by 28.2 per cent, indicating a change in payout behaviour for firms that paid
dividends only. The percentage of firms that made repurchases only remained stable
at 12.7 and 13.5 per cent in the PRE and POST period, respectively (a slight increase of
6.6 per cent). However, the amounts paid out increased dramatically by 29.7 per cent.
The greatest changes between the two periods are seen in firms that both paid
dividends and repurchased shares. Not only did the total number of these firms
increase by 28.2 per cent, as indicated above, they also increased the amounts of their
payouts by 83.4 per cent, with 70.0 per cent dividends and 93.9 per cent repurchases.
Although these firms are approximately equal in number as the firms that paid
dividends only (179 vs 173 in the POST period), they paid more dividends than the
latter ($CAD16,364 vs. $CAD11,100 million in the POST period). These firms also made
a higher percentage of repurchases ($CAD23,642 vs $CAD25,285 million in the POST
period, or 93.5 per cent of all repurchases).
IJMF PRE POST
11,1 2003-2005 2006-2008 % change

Observations (no. of firm-years) 1,106 1,023

Total paid out (no. of firm-years) 521 490 −5.9
Total paid out (% of firm-years) 47.1 47.9 1.7
10 $ paid out 35,777 52,748 47.4
$ earnings 69,480 93,949 35.2
%TS (mean) 75.3 76.5 1.7
Total paid dividends (no. of firm-years) 381 352 −7.6
Total paid dividends (% of firm-years) 34.4 34.4 0
$ dividends paid 22,316 27,463 23.1
$ earnings 67,543 91,564 35.6
%TS (mean) 72.1 74.6 3.4
Total repurchased (no. of firm-years) 291 317 8.9
Total repurchased (% of firm-years) 26.3 31.0 17.8
$ repurchased 13,462 25,285 87.8
$ earnings 39,050 61,807 58.3
%TS (mean) 77.4 79.4 2.6
Paid dividends only (no. of firm-years) 230 173 −24.8
Paid dividends only (% of firm-years) 20.8 16.9 −18.7
$ dividends paid 12,692 11,100 −12.5
$ earnings 30,431 32,142 5.6
%TS (mean) 72.5 71.3 −1.7
Repurchased only (no. of firm-years) 140 138 −1.4
Repurchased only (% of firm-years) 12.7 13.5 6.6
$ repurchased 1,267 1,643 29.7
$ earnings 1,937 2,385 23.1
%TS (mean) 83.8 81.5 −2.7
Repurchased and paid dividends (no. of firm-years) 151 179 18.6
Repurchased and paid dividends (% of firm-years) 13.7 17.5 28.2
$ dividends paid 9,623 16,364 70.0
Table I. $ repurchased 12,196 23,642 93.9
Sample data for the $ paid out 21,819 40,006 83.4
pre- and post-tax $ earnings 37,113 59,422 60.1
change periods for %TS (mean) 71.5 77.8 8.7
firms making Notes: $, millions of Canadian dollars; TS, percentage of shares held by investors who are sensitive to
payouts dividend taxation

Table II presents the descriptive statistics before and after the 2006 dividend tax
rate cut. After the tax cut, payouts increased significantly for both dividends and
share repurchases. VOLATILITY also increased significantly after the tax cut. Mean
EARNINGS for all firm-year observations are negative both before and after the 2006
dividend tax rate cut. However, mean EARNINGS for firms making payouts is positive
in both periods (mean ¼ 0.0426 before and 0.0363 after the tax cut; also, median ¼ 0.0476
before and 0.0513 after the tax cut, not tabulated).

Regression results
To test the effects of the 2006 dividend tax cut on payout policy, we use a Tobit
regression. Table III presents the results for the two dependent variables DIV and REP.
When we consider DIV as a dependent variable (Models 1 and 2), the coefficient for
 PRE 2003-2005 POST 2006-2008
(1,106 observations) (1,023 observations) Difference in means
Mean SD Median Mean SD Median Difference p-value

DIV 0.0063 0.0147 0.0000 0.0082 0.0195 0.0000 0.0019 0.006***

REP 0.0050 0.0162 0.0000 0.0065 0.0181 0.0000 0.0015 0.023**
TS 0.7700 0.2406 0.8497 0.7780 0.2369 0.8554 0.0080 0.440
EARNINGS −0.0433 0.2465 0.0283 −0.0673 0.3279 0.0260 −0.0240 0.058*
CASH 0.1692 0.2068 0.0826 0.1839 0.2207 0.0842 0.0148 0.112
MB 3.1541 7.6714 1.8441 3.0210 7.0065 1.6293 −0.1331 0.676
DEBT 0.1944 0.1750 0.1672 0.1869 0.1713 0.1560 −0.0075 0.319
VOLATILITY 0.0964 0.1827 0.0359 0.1164 0.2737 0.0399 0.0200 0.049**
SIZE 5.3960 2.0830 5.0778 5.4290 2.1106 5.0997 0.0329 0.717
Notes: Descriptive statistics for 1,106 firm-year observations before the 2006 dividend tax cut and 1,023 firm-year observations after the tax cut (both
distributing and non-distributing firms). DIV is the amount of dividends paid during the year. REP is the amount of shares repurchased. TS is the investors’
dividend tax sensitivity defined as the percentage of shares held by investors who are sensitive to dividend taxation. EARNINGS is the annual earnings before
extraordinary items. CASH is the cash and short-term investments. MB is the market value of common stock over its book value (book value of common
equity). DEBT is the total debt. VOLATILITY is the firm-level standard deviation of EARNINGS over three years (t 2 to t). SIZE is the natural log of assets.
All variables are scaled by the book value of assets except for TS, MB and SIZE. CASH, MB, DEBT, VOLATILITY and SIZE are measured at year end. SD,
standard deviation. *,**,***Significant at 10, 5 and 1 per cent levels, respectively. p-values represent one-tailed tests of significance for DIV and REP, two-tails
for all others

observations
Descriptive statistics
policies
cut on payout

11

Table II.
Effects of a

for all firm-year

tax dividend
 12
11,1
IJMF

payouts
Table III.
Tobit regression

of the dividend tax

rate cut on dividend
analysis of the effect
Model 1 Model 2 Model 3 Model 4
Expected sign Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value

POST + 0.0031** 0.038 0.0034** 0.026

Y2004 0.0004 0.780 0.0007 0.647
Y2005 0.0025 0.147 0.0029* 0.097
Y2006 + 0.0022 0.312 0.0027 0.236
Y2007 + 0.0014 0.535 0.0020 0.388
Y2008 + 0.0092*** 0.001 0.0098*** 0.001
TS  −0.0118** 0.023 −0.0170*** 0.001 −0.0119** 0.021 −0.0205*** 0.001
POST × TS + 0.0107* 0.072
Y2004 × TS 0.0021 0.685
Y2005 × TS 0.0083 0.248
Y2006 × TS + 0.0080 0.399
Y2007 × TS + 0.0157* 0.055
Y2008 × TS + 0.0185* 0.053
LDIV + 0.1242* 0.058 0.1244* 0.058 0.1247* 0.056 0.1249* 0.055
EARNINGS + 0.0957*** 0.000 0.0951*** 0.000 0.0973*** 0.000 0.0964*** 0.000
CASH ? 0.0076 0.542 0.0075 0.551 0.0081 0.516 0.0080 0.523
MB  0.0005* 0.086 0.0005* 0.086 0.0005* 0.063 0.0005* 0.067
DEBT  −0.0195** 0.031 −0.0198** 0.030 −0.0195** 0.031 −0.0199** 0.029
VOLATILITY  −0.1490*** 0.000 −0.1490*** 0.000 −0.1520*** 0.000 −0.1515*** 0.013
SIZE + 0.0047*** 0.000 0.0047*** 0.000 0.0046*** 0.000 0.0046*** 0.000
Intercept −0.0662*** 0.000 −0.0672*** 0.000 −0.0662*** 0.000 −0.0683*** 0.000
n 2,129 2,129 2,129 2,129
Industry dummies Yes Yes Yes Yes
Notes: Tobit regression results for the 2,129 firm-year observations to analyse the effect of the dividend tax reduction on the amount of dividends paid (DIV).
TS is the investors’ dividend tax sensitivity defined as the percentage of shares held by investors who are sensitive to dividend taxation. POST is a dummy
variable equal to 1 after the 2006 dividend tax cut. Y2004 to Y2008 are year dummies. LDIV is the lagged amount of dividends paid. EARNINGS is the annual
earnings before extraordinary items. CASH is the cash and short-term investments. MB is the market value of common stock over its book value (book value of
common equity). DEBT is the total debt. VOLATILITY is the firm-level standard deviation of EARNINGS over three years (t 2 to t). SIZE is the natural log of
assets. All variables are scaled by the book value of assets except for TS, Y2004 to Y2008, MB, SIZE, and POST. CASH, MB, DEBT, VOLATILITY and SIZE
are measured at year end. *,**,***Significant at 10, 5 and 1 per cent levels, respectively. p-values represent one-tailed tests of significance when an expected
sign is specified. p-values are calculated using standard errors clustered by firm
POST is positive and significant, whereas the coefficient for TS is negative and Effects of a
significant. Furthermore, when we include in Model 2 the variable investor tax tax dividend
sensitivity after the 2006 dividend tax cut (POST × TS), we find a positive and
significant coefficient (at the 10 per cent level)[14]. These results support hypotheses
cut on payout
H1a and H1b, that the dividend tax rate cut for individual investors would stimulate policies
firms to increase their dividend distribution, and that this increase would be larger
when the ownership percentage of shareholders who are subject to this tax rate is high. 13
To ensure that the POST variable captures the effect of the 2006 dividend tax
cut and not that of other economic events, we used time dummies (year 2003 omitted).
Model 3 shows a significant positive effect for 2008 only. This result seems to suggest
that the increase in dividends may be due to events peculiar to that year and not to the
tax cut. However, in Model 4, we replaced POST × TS by Year × TS (Y2003 × TS
omitted). The coefficients for Y2007 × TS and Y2008 × TS are both positive and
significant ( p ¼ 0.053 and 0.055, respectively, Table III). These results indicate that the
2006 dividend tax cut had an impact, because firms with higher ownership percentage
of shareholders who are subject to this tax rate increased their dividend distributions,
but with a lag since the Y2006 × TS coefficient is not significant. Our conclusions
find greater support when cash flow from operations (CFO) is used instead of earnings
(CFO mean for observations with payouts ¼ 0.0935 in the PRE period and 0.0904 in the
POST period, not tabulated). In Model 3, coefficients for Y2007 and Y2008 are positive
and significant ( p ¼ 0.065 and 0.060, respectively, not tabulated), while in Model 4,
coefficients for Y2006, Y2007, and Y2008 are significant ( p ¼ 0.094, 0.035 and 0.004,
respectively, not tabulated), and the coefficients for Y2007 × TS and Y2008 × TS are
also positive and significant ( p ¼ 0.020 and 0.047, respectively, not tabulated).
Our findings for H1a are consistent with those of Chetty and Saez (2005), Brown
et al. (2007), and Pattenden and Twite (2008), who report that firms increase their
dividend payout following a dividend tax cut. Our results for H1b are also in line
with several authors (Chetty and Saez, 2005; Brown et al., 2007; Blouin et al., 2011) who
report that firms consider their shareholders’ tax preferences when designing
distribution policies. Our findings also confirm de Jong et al. (2003) survey of managers
of Canadian firms, in which the choice of payout mechanism depends on shareholders’
tax preferences. However, these results contradict Baker et al. (2001, 2007), Brav et al.
(2005), and DeAngelo et al. (2008), among others, who conclude that taxation and
shareholders’ tax preferences have minor or no influence on dividend payouts.
As expected, LDIV and EARNINGS have a positive and significant coefficient.
CASH is also positive but not significant. Contrary to expectation, the coefficient for
the MB variable is positive and significant at the 10 per cent level. Table II presents the
mean and median for MB at about 3.0 and 1.7, respectively, suggesting that our
sample comprises low- and moderate-growth firms, which would be more likely than
growth firms to pay dividends (Fama and French, 2001). As expected, DEBT has a
negative and significant coefficient. Furthermore, the negative and significant
coefficient for VOLATILITY suggests that firms with more stable profitability use
dividends to signal strong cash-flow performance. Finally, the coefficient for SIZE
is positive and significant, indicating that larger firms pay more dividends.
H2a posits that a dividend tax rate reduction for individuals should induce
firms to decrease their distributions through share repurchases, whereas H2b posits
that a dividend tax rate reduction for individuals should encourage firms to decrease
their distributions through share repurchases if the ownership percentage of
shareholders who are subject to this tax rate is high. When we consider REP as a
IJMF dependent variable (Table IV: Models 1 and 2), we find that the coefficient for the
11,1 variable POST is positive and significant. Contrary to H2a, this result indicates that
firms instead increased their share of repurchases following the 2006 dividend tax
cut for individuals. The coefficient for TS is positive but not significant, which does not
support the argument that firms consider investors’ tax sensitivity in their decision
to repurchase shares. Furthermore, in Model 2, we find that the coefficient for the
14 interaction effect variable (POST × TS) is positive but not significant. Thus, investors’
tax sensitivity before and following the 2006 tax rate cut for individuals did not impact
the amount of repurchased shares. As expected, we find that the coefficients for
EARNINGS and SIZE are positive and significant, whereas the coefficients for MB,
DEBT, and VOLATILITY are negative and significant.
Similar to the analysis for dividends, we introduced time dummies to replace POST.
Model 3 shows a significant negative effect for 2004 and a significant positive effect
for 2008, suggesting that repurchases may have been affected by economic events
peculiar to these years. In Model 4, where POST × TS is replaced by Year × TS, none of
the coefficients is significant, confirming the result mentioned above, i.e. investors’ tax
sensitivity before and following the 2006 tax rate cut for individuals did not impact
the amount of repurchased shares.
Overall, it appears that the 2006 dividend tax rate cut for individuals stimulated
firms to increase their dividend payouts (H1a), but not to reduce their share
repurchases (H2a). In addition, investors’ tax sensitivity appears to have affected the
amount of dividends paid in the period following the 2006 tax rate cut for individuals
(H1b). However, investors’ tax sensitivity did not influence the amount of share
repurchases following the dividend tax cut (H2b). These findings reflect the tax
situation in Canada. Consistent with tax clientele theory, it appears that the 2006
tax rate cut for individuals, which decreased the tax dividend disadvantage by
6.2 per cent, induced firms to pay higher dividends so that their shareholders could
benefit from the lower rates. However, although the tax rate cut lessened the tax
dividend disadvantage, the capital gains tax rate (23.2 per cent) remained slightly lower
than the dividend tax rate (25.1 per cent). This suggests that firms that considered
individual investors’ tax sensitivity maintained their share repurchases, which are
taxed as capital gains. Hence, the 2006 dividend tax rate cut for individuals impacted
Canadian firms’ payout policies, even though this permanent tax cut simply decreased
the tax dividend disadvantage. In contrast, the 2003 US tax reform introduced a
temporary reduction in the dividend tax rate for individuals only, from 38.6 to 15 per
cent, and in the capital gains tax rate, from 20 to 15 per cent, whereas the Australian tax
reform initiated a dividend tax reduction and the taxation of capital gains. Moreover,
unlike the 2003 US tax reform, the Canadian tax cut did not stimulate tax arbitrage.
To gain a better understanding of the effects of the 2006 dividend tax cut on firms’
payout policies, we analyse the firms’ choice to not make payouts, to pay dividends
only, to repurchase shares only, or to pay dividends and repurchase shares. We ran a
multinomial logit regression[15] to examine the choice between two payout
policies. Table V, Panel A presents the results for the decision to pay dividends only
vs repurchase shares only (DIV/REP), pay dividends and repurchase shares vs repurchase
shares only (DIV&REP/REP), and pay dividends and repurchase shares vs pay dividends
only (DIV&REP/DIV). Table V, Panel B presents the results on the decision to pay
dividends only vs make no payouts, repurchase shares only vs make no payouts, and
pay dividends and repurchase shares vs make no payouts (DIV/NP, REP/NP
and DIV&REP/NP, respectively).
 Model 1 Model 2 Model 3 Model 4
Expected sign Coefficient p-value Coefficient p-value Coefficient p-value Coefficient p-value

POST  0.0046** 0.014 0.0046** 0.014

Y2004 −0.0063** 0.014 −0.0063** 0.015
Y2005 0.0015 0.632 0.0016 0.615
Y2006  −0.0015 0.670 −0.0013 0.698
Y2007  0.0013 0.343 0.0014 0.350
Y2008  0.0095*** 0.002 0.0095*** 0.001
TS + 0.0089 0.102 0.0048 0.274 0.0089 0.112 0.0018 0.427
POST × TS  0.0089 0.131
Y2004 × TS −0.0022 0.810
Y2005 × TS 0.0114 0.388
Y2006 × TS  0.0120 0.190
Y2007 × TS  0.0077 0.271
Y2008 × TS  0.0137 0.129
LDIV  0.0025 0.374 0.0026 0.367 0.0028 0.358 0.0029 0.355
EARNINGS + 0.0444*** 0.000 0.0441*** 0.000 0.0448*** 0.000 0.0446*** 0.000
CASH + 0.0102 0.151 0.0100 0.155 0.0098 0.161 0.0096 0.165
MB  −0.0013* 0.076 −0.0013* 0.076 −0.0010 0.101 −0.0010* 0.099
DEBT  −0.0589*** 0.000 −0.0593*** 0.000 −0.0599*** 0.000 −0.0603*** 0.000
VOLATILITY  −0.0307** 0.015 −0.0311** 0.013 −0.0322** 0.014 −0.0328** 0.012
SIZE + 0.0057*** 0.000 0.0057*** 0.000 0.0056*** 0.000 0.0056*** 0.000
Intercept −0.0478*** 0.000 −0.0410*** 0.000 −0.0389*** 0.001 −0.0391*** 0.001
n 2,129 2,129 2,129 2,129
Industry dummies Yes Yes Yes Yes
Notes: Tobit regression results for the 2,129 firm-year observations to analyse the effect of the dividend tax reduction on the amount of shares repurchased
(REP). TS is the investors’ dividend tax sensitivity defined as the percentage of shares held by investors who are sensitive to dividend taxation. POST is a
dummy variable equal to 1 after the 2006 dividend tax cut. Y2004-Y2008 are year dummies. LDIV is the lagged amount of dividends paid. EARNINGS is the
annual earnings before extraordinary items. CASH is the cash and short-term investments. MB is the market value of common stock over its book value (book
value of common equity). DEBT is the total debt. VOLATILITY is the firm-level standard deviation of EARNINGS over three years (t  2 to t). SIZE is the
natural log of assets. All variables are scaled by the book value of assets except for POST, TS, Y2004 to Y2008, MB, and SIZE. CASH, MB, DEBT,
VOLATILITY and SIZE are measured at year end. *,**,****Significant at 10, 5 and 1 per cent levels respectively. p-values represent one-tailed tests of
significance when an expected sign is specified. p-values are calculated using standard errors clustered by firm

Tobit regression
policies
cut on payout

of the dividend tax

analysis of the effect

repurchase payouts
rate cut on
15

Table IV.
Effects of a
tax dividend
IJMF Panel A
11,1 DIV/REP DIV&REP/REP DIV&REP/DIV
Coefficient p-value Coefficient p-value Coefficient p-value
POST −0.206 0.134 0.226 0.122 0.433*** 0.004
TS −2.186*** 0.001 −2.560*** 0.000 −0.374 0.232
POST × TS 0.488 0.272 1.654** 0.022 1.166** 0.038
EARNINGS 3.826*** 0.009 6.096*** 0.001 2.270 0.220
16 CASH −1.557 0.137 −0.905 0.387 0.652 0.499
MB 0.238*** 0.003 0.201* 0.088 −0.037 0.623
DEBT 0.489 0.647 −0.953 0.459 −1.442 0.184
VOLATILITY −8.821*** 0.002 −8.823*** 0.003 −0.002 0.999
SIZE 0.298*** 0.001 0.432*** 0.000 0.134 0.049
Intercept −4.189*** 0.002 −4.307*** 0.001 −0.119 0.800
Panel B
DIV/NP REP/NP DIV&REP/NP
Coefficient p-value Coefficient p-value Coefficient p-value
POST −0.103 0.243 0.104 0.257 0.330** 0.014
TS −0.819* 0.086 1.367*** 0.009 −1.193** 0.028
POST × TS 0.034 0.478 −0.454 0.255 1.200** 0.031
EARNINGS 5.758*** 0.000 1.932*** 0.004 8.029*** 0.000
CASH −1.189 0.207 0.368 0.498 −0.537 0.584
MB −0.021 0.599 −0.259*** 0.000 −0.058 0.577
DEBT −1.513* 0.074 −2.002*** 0.008 −2.954*** 0.010
VOLATILITY −10.282*** 0.000 −1.461* 0.073 −10.284*** 0.000
SIZE 0.553*** 0.000 0.255*** 0.000 0.687*** 0.000
Intercept −5.339*** 0.000 −1.150 0.124 −5.458*** 0.000
Notes: Estimation results of the multinomial logit model of firms’ cash flow distribution choices in a
given year. Data include 2,129 firm-year observations. Each column provides the parameter estimates
for a payout decision combination. Panel A provides the parameter estimation for the following payout
decision combinations: The first column compares firms that paid dividends only (DIV) with firms that
repurchased shares only (REP). The second column compares firms that paid dividends and purchased
shares (DIV&REP) with firms that repurchased shares only (REP) and the third column compares
firms that paid dividends and purchased shares (DIV&REP) with firms that paid dividends only (DIV).
Panel B provides the parameter estimation for the decision of paying out versus not paying out. The
first column compares firms that paid dividends only (DIV) with no payout firms (NP). The second
column compares firms that only repurchased shares (REP) with no payout firms (NP). The third
column compares firms that paid dividends and purchased shares (DIV&REP) with no payout firms
(NP). TS is the investors’ dividend tax sensitivity defined as the percentage of shares held by investors
who are sensitive to dividend taxation. POST is a dummy variable equal to 1 after the 2006 dividend
tax cut. EARNINGS is the annual earnings before extraordinary items. CASH is the cash and
short-term investments. MB is the market value of common stock over its book value (book value
of common equity). DEBT is the total debt. VOLATILITY is the firm-level standard deviation of
Table V. EARNINGS over three years (t 2 to t). SIZE is the natural log of assets. All variables are scaled by the
Multinomial logit book value of assets except for TS, MB, SIZE, and POST. CASH, MB, DEBT, VOLATILITY and SIZE
model of the effect of are measured at year end. *,**,***Significant at 10, 5 and 1 per cent levels, respectively. p-values
the dividend tax rate represent one-tailed tests of significance for POST, TS and POST × TS, two-tails for all others. p-values
cut on payout choice are calculated using standard errors clustered by firm. R2 for the six combinations ¼ 0.2478

The coefficient for TS is negative and significant for the decisions DIV/REP, DIV&REP/
REP, DIV/NP, and DIV&REP/NP and positive and significant for REP/NP. These results
indicate that firms consider individual investors’ sensitivity to dividend taxes when
deciding on payout policies. Specifically, firms are less likely to choose dividend payments
or a combination of payout mechanisms over share repurchases or no payout when their
individual shareholders are dividend tax sensitive, confirming the tax clientele effect.
 Furthermore, we find that the coefficient for the variable POST is positive and Effects of a
significant for the decision DIV&REP/NP and DIV&REP/DIV, and the coefficient for tax dividend
the variable tax sensitivity (POST × TS) is positive and significant for the decision
DIV&REP/NP, DIV&REP/DIV, and DIV&REP/REP. These results suggest that, after
cut on payout
the 2006 dividend tax rate cut, firms were more likely to use a combination of policies
distribution mechanisms than not to make payouts or to payout dividends only.
Moreover, if their shareholders were dividend tax sensitive, firms were more likely to 17
use a combination of distribution mechanisms than to use share repurchases only, pay
dividends only, or not to make payouts. These results provide support for hypotheses
H1a, H1b, and H2b, suggesting that the 2006 dividend tax cut induced firms to pay
dividends, more particularly firms with dividend tax sensitive shareholders.
The decision to use a combination of payout mechanisms reflects the dividend tax
sensitivity of the firms’ shareholders. Thus, the 2006 dividend tax rate cut lessened
the dividend tax disadvantage over the capital gains tax from 8 per cent in 2005 to
1 per cent in 2008, but did not reverse it: capital gains continued to be taxed at a lower
rate. Consequently, the decision to combine the two payout mechanisms would be very
beneficial to shareholders. Dividend payments allowed shareholders to benefit from the
lower dividend tax rate, and maintaining or adopting distributions through share
repurchases allowed them to take advantage of the low capital gains tax rate.

6. Discussion
Open market repurchases have become increasingly popular in the USA, a trend that
is expected to grow as more countries adopt enabling regulations. Nevertheless, it is
unclear whether this trend can be generalized to other markets or whether the tax
system, more specifically the dividend tax system, helps explain it. In this paper, we
examine payout policies in Canada from 2003 to 2008 in relation to the significant
reduction (6.2 per cent) in the dividend tax rate for individuals in 2006.
We find that the dividend tax rate cut impacts distribution decisions (consistent
with Chetty and Saez, 2005; Brown et al., 2007; Pattenden and Twite, 2008). Specifically,
the results of our regression models indicate that the 2006 dividend tax rate cut for
individuals stimulated firms to increase their dividend payouts, and that this increase
was larger if the ownership percentage of shareholders who were subject to this tax
rate was high (consistent with Chetty and Saez, 2005; Brown et al., 2007; Blouin et al.,
2011). However, the 2006 tax rate cut does not appear to have negatively impacted
share repurchases.
When we examine the firms’ decision to use one distribution policy over another,
shareholders’ tax preferences is revealed as an important explanatory factor in payout
policy design. However, after the 2006 dividend tax rate cut, the greater the investor
sensitivity to dividend taxes, the more likely that firms would use a combination of
distribution mechanisms over share repurchases only, pay dividends only, or make no
payouts. These findings concur with de Jong et al. (2003), who report that firms are
sensitive to their shareholders’ tax preferences when deciding on payout mechanisms.
Overall, we find that firms’ behaviour after the 2006 dividend tax cut was consistent
with the Canadian tax system. For instance, the decision to combine two payout
mechanisms, paying dividends and maintaining share repurchases, was highly
beneficial to shareholders because they could benefit from the lower dividend tax rate
and still take advantage of a low capital gains tax rate. The Canadian tax system
can therefore explain the observed payout trend.
IJMF The results of this investigation have both theoretical and practical implications.
11,1 They contribute to the on-going debate over the tax clientele effect and the effect of
investors’ dividend tax sensitivity on firms’ distribution decisions (dividends vs share
repurchases). More specifically, they support the argument that dividend taxes affect
payout policy, in view of the fact that the 2006 Canadian tax reform did not include
multiple tax changes, encourage tax arbitrage (the tax cut was permanent), or reverse
18 the tax disadvantage of dividends over capital gains. Further, the results indicate that
firms attempt to meet their shareholders’ demand for dividend income to satisfy their
annual consumption (Shefrin and Statman, 1984). Our findings have important
implications for tax regulators as they show that distribution policy can be affected by
dividend tax rate cuts lower than the 24 per cent range, as implemented in the USA, or
the 40 per cent cut instituted in Australia.
Finally, our study has some limitations. The analysis is limited to a period of three
years after the tax rate reduction. Extending the analysis period might produce
additional insights. Because the dividend tax disadvantage can be reduced by either
a dividend tax rate cut or a capital gains tax rate increase, it would be instructive to
analyse firms’ behaviour after a capital gains tax rate increase. This would enable a
deeper understanding of the interaction between the two tax rates and provide better
guidelines for tax regulators in the design of tax reforms to stimulate desired
firm behaviours.

Notes
1. The 2003 US tax reform reduced, for individuals only, the maximum dividend tax rate from
38.6 to 15 per cent and the maximum capital gains tax rate, which applies to share
repurchases, from 20 to 15 per cent. These reductions were planned to end on 31 December
2008. Under the 1986 Australian tax reform, the dividend tax rate was reduced from 58.2 to
18.4 per cent. This reform included other important tax changes, such as a reduction in
corporate and individual tax rates in 1986 and the introduction of a capital gains tax, which
was 49 per cent at the end of 1986.
2. There is tax arbitrage when a firm shifts dividend payments from high-tax periods to
low-tax periods to reduce investors’ tax burden and vice-versa.
3. Canada has an integrated tax system which is implemented as follows. Dividends received
by an individual resident in Canada from taxable Canadian corporations are subject to a
dividend gross-up and benefit from a dividend tax credit. The dividend tax cut in 2006 is the
result of an increase in the dividend gross-up and in the dividend tax credit.
4. Tax rates are the combined (federal and provincial) marginal tax for a resident of the
province of Ontario, Canada. For dividend income, the tax rate calculation takes into
account the dividend gross-up and the dividend tax credit.
5. Capital gains became taxable in Canada as of 1 January 1972. From then to 31 December
1987, only 50 per cent of the capital gains amount (inclusion rate) was taxable. In 1988 and
1989, the inclusion rate increased to 66⅔ per cent, and to 75 per cent on January 1, 1990.
The inclusion rate remained stable up to 27 February 2000, when it decreased to 66⅔ per cent
and dropped further to 50 per cent in October 2000.
6. Normal course of issuer bids (NCIBs) are regulated in order to protect firms from legal
liability for price manipulation. Before making an NCIB, firms must submit a notice of
intention to the exchange, which must specify the number of shares that the firm’s board
of directors has approved. Once authorized, the NCIB lasts for one year.
 7. Income Tax Act (R.S.C., 1985, c. 1 (5th Supp.)), paragraph 84(6)(b). Effects of a
8. The POST period includes the economic crisis of 2007-2008, which began in mid-2007. This tax dividend
crisis had a much lesser effect on Canada than the US (Haltom, 2013). cut on payout
9. Firms with no revenue are generally start-up firms, which usually do not intend to make policies
distributions. Firms with a negative book value are firms in deficit. In Canada, firms are not
allowed to pay dividends or repurchase shares if there are reasonable grounds for believing
that the corporation is, or would after the payment, be unable to pay its liabilities as they 19
become due; or the realizable value of the corporation’s assets would thereby be less than
the aggregate of its liabilities and stated capital of all classes (Canada Business
Corporations Act (R.S.C., 1985, c. C-44), Section 42 and Subsection 34(2)).
10. Firm observations with a DIV or REP in the 99 percentile were considered outliers. This
approach allows us to exclude from our sample large special dividends which may have
arisen from non-recurring events (such as the sale of financing activities by Sears Canada in
2005) and share repurchases not made through the normal course of issuer bids (such as the
“Dutch Auction” tender offer by QLT in 2006).
11. SEDAR is the acronym for System for Electronic Document Analysis and Retrieval. All
firms listed on the TSX file the disclosure documents required by regulation at www.sedar.
com/
12. We scale by the book value of assets to avoid problems with negative net income
(Zeng, 2003), net income close to 0 (Fama and French, 2002), and share market values
(Barclay et al., 2009).
13. Using proxy statements may overvalue TS because tax-exempt or untaxed institutional
shareholders and non-resident shareholders with less than 10 per cent ownership – the
required threshold for separate disclosure in the proxy statement – cannot be identified.
14. Our results remain unchanged when we add POST × EARNINGS in Models 1 and 2 in
Table III (and in Table IV respecting repurchases) to control for the decrease in earnings
in the post period and any potential change in the relationship between dividends and
earnings in that period.
15. Jagannathan et al. (2000) also use multinomial logit to compare payout choices. This method
is used to predict the probabilities of the different possible outcomes of a categorically
distributed dependent variable.

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About the authors

Manon Deslandes (PhD, HEC Montreal) is a Professor in Tax at the Université du Québec
à Montréal. Her research interests are corporate taxation, tax governance, and the effects of taxes
on taxpayer behaviour. Her research findings have been published in Journal of Accounting,
Ethics & Public Policy, Revue française de gouvernance d’entreprise, and Revue de planification
fiscale et financière. Professor Manon Deslandes is the corresponding author and can be contacted
at: deslandes.manon@uqam.ca
Suzanne Landry (PhD, University of Florida) is the Roland-Chagnon Accounting and a Tax
Professor at the HEC Montreal. Her research interests include tax planning for managerial decision
making, corporate taxation and reorganization, tax governance, taxation of owner-shareholders
and family businesses, and management performance evaluation. Her research findings have been
published in Canadian Journal of Administrative Science, Journal of Family Business Strategy,
British Accounting Review, International Journal of Managerial Finance, Journal of International
Accounting, Audit and Taxation, Journal of Accounting, Ethics & Public Policy, Journal of Small
IJMF Business and Entrepreneurship, Accounting Perspectives, Revue française de gouvernance
d’entreprise, and Revue de planification fiscale et financière.
11,1 Anne Fortin (PhD, University of Illinois at Urbana-Champaign) is a Full Professor in Ethics
and Financial Accounting at the Université du Québec à Montréal. Her research focuses on
stakeholders’ role in standard setting, accounting information and user decision making, IT
governance, innovation management, CSR, and accountants’ competency development. Her
research findings have been published in Accounting, Organizations and Society, Contemporary
22 Accounting Research, Qualitative Research in Accounting and Management, Accounting and
Business Research, Journal of Management and Governance, Information Systems Management,
Journal of Information Systems, Advances in Accounting Behavioral Research, Australian
Accounting Research, International Journal of Managerial Finance, Journal of Family Business
Strategy, Advances in International Accounting, Afro-Asian Journal of Finance and Accounting,
Sustainability Accounting, Management and Policy Journal, Journal of Accounting, Ethics &
Public Policy, Accounting Education: An International Journal, Accounting Perspectives and
Comptabilité – Contrôle – Audit.

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