April 29, 2010

Utilities Poised for Upside Despite Concerns over Higher Dividend Taxes

In 2003, Congress unified the tax rates for dividends and capital gains at 15%, but the sunset provision in the law causes it to expire at the end of this year. If Congress decides not to extend its provisions, the maximum tax rate for dividends will rise in 2011 to 39.6% from 15%, while that for capital gains will rise to 20% from 15%.

The Obama Administration is inclined to align tax rates on both dividends and capital gains at 20%. Congress has yet to enact his proposal, however.

What does this situation mean for investors? Should they reduce exposure to higher-yielding sectors such as utilities, where dividends have historically comprised over two thirds of long run shareholder returns?

To answer these questions, Hugh Wynne, senior analyst with Bernstein Research, reviewed the performance of utility stocks around prior tax-rate changes in a report released April 23.

He came to the following conclusions:

- After tax law changes that reduced the rate of taxation on dividends relative to capital gains, such as those of 1986 and 2003, utilities outperformed the broader market over both one and three year investment horizons.

- Following tax law changes that increased the rate of taxation on dividends relative to capital gains, such as that of 1993, utilities underperformed the broader market over one and three year periods.

- It is difficult to isolate the contribution of these tax-rate changes to the subsequent performance of utility stocks.

- But the relative performance of the sector was consistent in these three cases with changes in the rate of taxation of dividends relative to capital gains.

- It is not a given, though, that utilities will underperform following the scheduled increase in dividend taxes in 2011.

"Due to the relatively high predictability of the 2011 dividend tax increase - unlike other recent tax changes, it will go into effect unless Congress acts to stop it -- utility valuations appear already to discount a significant increase in the dividend tax rate," Wynne said in the report.

"It appears to us, therefore, that the market has already capitalized in utility stock prices the impact of the scheduled increase in dividend tax rates. This suggest that there may be upside to utility valuations if Congress were to extend the current dividend tax rate, or pass legislation to raise the dividend tax rate to 20%, as proposed by the Obama administration," he concludes.

In these cases, Wynne adds, the historical relationship between utilities and Treasuries implies that the valuation of utilities could rise significantly.

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