For as long as corporations have been paying dividends and trusts have been paying distributions, issuers have been seeking ways to encourage their securityholders to reinvest those cash payments into the issuer. These programs have typically taken the form of dividend or distribution reinvestment plans (DRIPs), which in their various incarnations have enabled securityholders to direct that cash dividends or distributions be used to acquire additional securities of the issuer from treasury or the open market; at the prevailing market price or at a discount, some with an ability to contribute further cash to acquire even more securities and, more recently, with an ability to direct those securities to a plan broker for subsequent sale in exchange for a premium cash payment pursuant to so-called “premium” DRIPs. DRIPs have largely been a win-win scenario, enabling securityholders to maximize their investment in an issuer in a convenient and economical way without incurring service charges or brokerage fees while at the same time representing a significant source of capital for issuers without the need to undertake a prospectus qualified offering or private placement with the associated expense and potential liability.
However, for all their benefits, there are a number of aspects of DRIPs that have materially limited participation by certain securityholders and thereby opened the door to critical thinking on alternative mechanisms to foster improved participation:
- The amount of a dividend or distribution will, generally, be included in the income of a securityholder regardless of whether the securityholder elects to reinvest such amount in new securities pursuant to a DRIP, subject to the gross-up and dividend tax credit rules normally applicable; and
- To the extent a DRIP is extended to non-residents of Canada, the fact that any such non-resident securityholder elects to reinvest dividends or distributions pursuant to the DRIP does not relieve that securityholder of liability for non-resident withholding tax applicable to the dividend or distribution. As the rate of withholding tax under the Income Tax Act (Canada) on distributions is generally 25% (subject to reduction by the terms of any applicable tax treaty, such as to 15% for most U.S. participants), withholding tax implications discourage non-resident participation in a DRIP.
The Stock Dividend Programs (SDPs) only beginning to find their way into the proxy circulars of dividend-paying issuers represent an opportunity to retain the attributes of DRIPs that have made them so popular, while addressing those two limitations.
Stock Dividend Program Mechanics and Advantages
So how does the SDP turn water into wine? By and large by replacing the concept of “reinvestment” of a cash dividend or distribution with the issuance from treasury of stock of the issuer by way of a stock dividend. While practically the result may seem similar - as an investment by a securityholder in additional securities of the issuer in the amount of the cash dividend foregone - the tax implications are considerably different.
Unlike a DRIP, where a securityholder’s tax liability is determined by reference to the market value of the securities issued pursuant to the reinvested dividend and the amount of the dividend is included in such securityholder’s income, the tax liability associated with the SDP is driven by the amount that the board of directors of the issuer determines to add to the stated capital account in relation to the securities being issued. Therefore, if the board of directors of the issuer determines to add only a marginal amount to the stated capital account for such securities, securityholders holding the issuer’s securities as capital property would not be expected to be attributed any material income.
As a result, securityholders participating in an SDP will have effectively converted their exposure to income tax in the year in which the dividend is paid into a capital gain payable at the time at which the securities acquired pursuant to the stock dividend are ultimately disposed. For “buy and hold” securityholders that may not liquidate their position in an issuer for a considerable period of time, this represents a potentially very significant deferral while also enabling such securityholder to utilize any capital losses accrued in the interim to offset those future gains.
In relation to non-resident securityholders, the implications flow from the same fundamental distinction in mechanics. Because the stock dividend is not characterized as a reinvested cash dividend, the non-resident securityholder may receive the value of the cash dividend in stock rather than a net amount after deduction of withholding tax.
To the extent non-residents of Canada would be subject to capital gains tax in Canada on the ultimate disposition of the securities acquired pursuant to the SDP, the SDP represents an enticing mechanism by which non-residents may be able to avoid significant barriers to their participation in DRIPs by receiving full value stock dividends with minimal withholding tax implications and potentially no capital gains implications on disposition.
Implementation of a Stock Dividend Program
Although there are clearly differences between the DRIP and the SDP, the most significant of which being the reinvestment in securities under a DRIP as compared to the stock dividend under an SDP as discussed above, fundamentally the programs operate in the same way and afford securityholders the same rights. For instance:
- Securityholders are able to elect whether to participate in the SDP to receive stock dividends just as they are able to elect whether to participate in the DRIP to reinvest dividends. Absent such an election in either case, a securityholder will receive the cash dividend;
- Securityholders may be able to acquire stock at a discount to the applicable trading price pursuant to the stock dividend under the SDP just as they acquire additional securities at a discount to the applicable trading price under the DRIP;
- Registered securityholders that elect to participate in an SDP or DRIP will be enrolled automatically for all successive dividend payments, unless they revoke that participation; and
- Beneficial securityholders electing through their nominees to participate in an SDP or DRIP will need to have their nominee elect to participate on their behalf every dividend period.
In order to implement an SDP, issuers will generally seek the approval of their securityholders to amend their articles in order to modify the terms of the applicable security to contemplate the stock dividend concept discussed above. As such, approval will constitute special business and either a special meeting of securityholders will need to be called or approval sought at the next annual meeting of securityholders.
It is anticipated, given the practical similarities of the SDP and the DRIP, that most issuers choosing to implement an SDP will concurrently or, following a transition period intended to enable participants to enroll in the SDP, terminate their existing DRIP. Given the relative duplication and clear benefits of the SDP as compared to the DRIP, that ultimate transition is understandable.
While the benefits of the SDP seem clear and the movement of many DRIP issuers towards this model seems inevitable over the coming months, it is of course worth sounding a note of caution. Although the SDP has been in operation in at least one case for over a year, and more issuers seem to be recognizing the huge potential it creates by proposing the adoption of an SDP to replace their DRIP at their 2012 annual meetings, there is always the potential that a taxing authority such as the Canada Revenue Agency will revisit the characterizations offered above in relation to the SDP and diminish or eliminate the tax benefits.