The 4th GOAL group report
Key Findings
– $17.39 billion (£10.72bn/€12.24bn) of investors’ rightful returns from their foreign shares and bonds were lost in the latest financial year because withholding tax on dividends and income is not being properly reclaimed.
– This represents an increase of over 50% in the annual amount lost compared with 2006 when GOAL last published an analysis of the situation
– In other words, of the total $64.4billion (£39.69bn/€45.33bn) of reclaimable tax in 2010, around a quarter is currently being left unreclaimed
– The United States ($3.16bn/£1.95bn/€2.22bn) is the biggest annual loser from unreclaimed withholding tax on foreign securities, followed by the UK ($1.65bn/ £1.02bn/€1.16bn), Japan ($1.33bn/£820m/€936m), Luxembourg ($1.25bn/£770m/€880m), France ($1.14bn/£703m/€802m), and Germany ($982m/£605m/€691m)
– The problem is likely to increase as dividend payments become more popular and a more significant element of shareholder returns
– Also a rising proportion of portfolio investment devoted to foreign securities means that lack of tax reclamation needs urgent attention from fund managers and custodian banks
– Investors are becoming increasingly rigorous in their scrutiny of investments and are putting pressure on fund managers to provide greater transparency
– Tax reclamation rates, rules and timings vary widely around the globe, making the reclamation process very complex. However, automated systems are now available to take the cost and manual complexity out of the reclamation process. Fund managers and pension funds are also increasingly aware of the existence of such systems and are beginning to include the requirement for such automated facilities as a standard part of their custodian services RFPs
– Leading custodians have recognised the market opening represented by effective tax reclamation services, both for their FM clients, and as an interbank services opportunity. Automated reclamation facilities have now made the provision of such services highly profitable, in a market climate where other revenue streams are declining
Introduction
Since the late 1990s, equities investment has been through significant peaks and troughs. Hyped to unsustainable values in the dotcom boom, the post-millennial stock market crash then wiped billions off portfolio values. Growth throughout the ‘noughties’ was followed by a similar radical depression in capital values in 2008 financial markets crisis and its aftermath. Since that time, equities have recovered strongly, although the total market capitalisation of stock exchanges around the world in early 2011 has yet to regain the peaks of $60+ trillion reached in late 2007. Growth is once again strong, but apparently more sustainable and logically based on solid results rather than unrealistic projections. Institutional investments, which fled into fixed income instruments during the financial markets crisis, are now rebalancing their portfolios back into equities, using the stellar growth of stocks and shares during 2010 to offset at least some of the losses they sustained in the previous couple of years.
Throughout the first decade of the new millennium, earnings from dividend payments have grown. Even taking into account the natural suppression of dividends paid after the financial markets crisis, in line with suppressed profits, the culture of the dividend is far stronger now, compared with the nineties, when returns were often predicated solely on capital growth.
The importance of dividends
Looking historically, a watershed moment arrived in 2003 when Microsoft announced its first ever dividend. Since then, dividend payouts have steadily increased in popularity until the financial markets crisis. Then came a natural downturn. Dividend increase announcements were in decline even before the liquidity crisis as companies relied on the greater flexibility of share buybacks to return cash to investors. One commentator has noted that in reality, dividend increases are driven not by excess cash, but instead by a good economic and market environment. Yet to award dividends solely when times are good creates the least favourable impression on investors. Analysis of dividend reduction during the recent liquidity crisis reveals that investors indiscriminately punished companies cutting dividends during the panic in the second half of 2008 but rewarded dividend reductions in the first half of 2009 as they became comfortable with companies shoring up liquidity buffers in the tough economic and funding environment. Learning from this experience, an increasing number of astute corporates are now starting to use their dividend payments as a proactive tool to manage investor opinion and enthusiasm – in other words, as an investor marketing tool.
Some years ago, research by Dresdner Kleinwort Wasserstein delivered some key figures that firmly punctured the popular notion that long-term equities gains come from capital growth. The bank’s study told us that: in Europe since 1970, 70% of total equity returns have been derived from dividend yield; and between 1950 – 2000, the average contribution by Europe (excluding UK) of dividend yield to total equity returns has been 62%. The research then goes on to state that the bank saw dividend yield once again becoming the greater proportion of equity returns in the future.
In a bull market, investors often tend to focus on capital growth and thus run the risk of overlooking dividends as a vital component of company return. Indeed, the Barclays Equity Gilt Study 2010 has exemplified that receiving and reinvesting dividends is by far the biggest source of an investor’s return in the long term. The study shows that £100 invested in equities and gilts at the end of World War II would have been worth just £5,721 at the end of 2008 in nominal terms. But by reinvesting the gross dividends, the same £100 would have grown to £92,460.
Indicators are now showing a major resurgence in dividend payments as the markets grow strongly. One major index provider in the U.S. has reported that across the 7,000+ publicly owned companies whose dividends it tracks, only 28 decreased their dividend payment during the fourth quarter of 2010, marking a continued improvement from the 74 that lowered their dividend payment during the fourth quarter of 2009. Dividend increases rose 43.8% during the fourth quarter to 696 from the 484 recorded during the fourth quarter of 2009. For the year, 145 issues have decreased their dividend payment compared to 804 in 2009, with the associated decrease of income being $2.8 billion for 2010 (versus $58.0 billion in 2009). Increases rose to 1729 from the 1191 registered in 2009 with the aggregate adding $29.4 billion in increases compared to $15.6 billion in 2009.
Similarly, investors in the UK also enjoyed the return of healthy dividend payouts last year. The FTSE 100 accounted for almost 90 per cent of UK dividends paid in 2010, but mid-cap companies have increased their payouts at a faster rate. According to a report published earlier this year by Capita Registrars , dividends from the FTSE 250 rose 16.3 per cent last year, while dividend growth from the FTSE 100 was only 6.8 per cent across the same period. Nevertheless, companies in the FTSE 250 only paid out £5.1 billion last year compared to a colossal £49.8 billion shared out by corporate behemoths in the FTSE 100.
Outlook on dividends
As 2010 has seen a healthy upswing in dividend policies, this trend is likely to continue in 2011 amid enhanced corporate confidence and economic recovery. Capita Registrars has recently raised its forecast on this year’s dividend payments from listed UK companies to £64.2 billion, nearly 8 per cent higher than the total £56.6 billion payout in 2010.
The return of the oil giant BP to the dividend list has also boosted the prospect on dividend increase in the UK. The oil group has reinstated investor payments in February this year after its suspension of dividend payout following the wake of the Deepwater Horizon accident. The oil group’s importance to income investors is substantial since it was the seventh-largest dividend player in the UK last year despite the fact that it made only one payment in 2010.
Admittedly, if and how fast the dividend markets will return to the 2007/2008 pre-crisis levels will largely be contingent on the global economic environment. But as the global economy continues to gain steam, companies will be eager to demonstrate to investors that they are well into the recovery mode in 2011 through dividend increase and investors are all the more likely to witness more dividend raise with even fewer decreases this year.
Cross-border Investing
Not only are equities back in fashion, but interest in cross-border investing is also on the rise. According to the statistics from the International Monetary Fund and from global stock exchanges, the market capitalisation of global equities rose 79% between 2001 and 2009, whereas the value of cross border equities investments rose 163% over the same period.
So cross-border shareholdings have risen at something around double the market rate, showing that fund managers have increased the proportion of foreign shares in their portfolio from around 20% in 2001, to more like 28% in 2009. The market capitalisation of the global equities markets (excluding investment funds) is currently around the $55 trillion mark. By comparison, the average proportion of foreign shares in a fund manager’s equities portfolio is in the region of 20-30%.
The United States has the largest, most diversified debt securities markets in the world and a substantial amount of global capital is being invested in the US annually. Even though both US and foreign investors did reduce their holdings of cross-border securities and foreign deposits during the financial crisis due to risk aversion, the adjustments in cross-border portfolio holdings were relatively minor compared with the substantial valuation losses that investors faced. As of June 30, 2010, foreign holdings of US securities have again risen to $10,701 billion from $9,641 billion from June 30, 2009.
Fixed-income
The subject of this GOAL study covers cross-border investment in all securities – equities and bonds. The fixed-income market has been very much the beneficiary of the equities market’s crisis of confidence in 2008, with the value of domestic bonds listed on global markets rising to over $63 trillion at the end of 2009 (the International Federation of Stock Exchanges’ latest most recent globally reliable measurement point). As banks remained reluctant to lend following the financial markets turmoil, companies competed to raise funds in the bond markets by taking advantage of historic low interest rates since at least 2005. A shift in funding strategy has been slowly emerging among companies as they begin to realise the need to diversify funding sources in light of tight credit lines. According to Investec, about £350bn of investment-grade loans mature during 2011-14 in the UK, a gigantic volume for the bank loan market alone to cover. The uncertainty around companies’ ability to refinance this record amount of debt they issued during the boom years has further prompted them to seek diversified funding channels.
While US companies have long favoured bond market funding, European companies tend to raise the majority of their finance from bank debt. However, a growing proportion of European corporate funding has come from the bond market since 2008, heralding a change in European companies’ attitude
towards bond market funding. A massive surge in European bond issuance was observed in 2009 with an increase in the average size of the offerings. Non-financial issuer bond offerings were 75 per cent bigger at $1.1 billion from $600 million whereas financial issuers sold an average $1 billion, a 56 per cent increase on the $645 million average size of offering seen over the same period in 2008.
Growing appetite in the bond markets for smaller issues, from higher risk or so-called junk-rated borrowers, has allowed a broader swathe of mid-market companies to take part in the bond market frenzy. Indeed, the UK Treasury has already been examining ways to improve access to sterling bond markets for more speculative grade borrowers.
Outlook on the fixed-income market
As the equity markets crashed in 2008-09, funds poured into the debt markets. With the huge and sudden demand, prices on the secondary market soared, and yields on the primary market plummeted. According to Barclays Capital indices, the average yield for US investment-grade bonds has fallen from about 6 per cent in June 2007 to 3.75 per cent in September 2010. Euro investment-grade bonds also showed a similar trend, with average yield falling from more than 5 per cent before the financial crisis to about 3.25 per cent. But the desire for yield has not disappeared against the background of low interest rates. Investors are continuing to receive a high premium for owning corporate bonds relative to government bonds. At the peak of 2009, investment-grade bonds were offering a six-percentage yield spread over government bonds.
There has already speculation last year about whether the flow of investors’ money into bond funds was going to slow down any time soon. Considering the absolute interest rates at all time low levels, some believe that the bond market has already reached the market top; but another school of thought opines that investors are relying on spreads (which are still much higher than the historic average) to evaluate the market, as opposed to absolute yields, and the current prices can therefore not yet reflect a market top. Indeed, the Federal Reserve just embarked on another round of quantitative easing in November last year, buying $600 billion more in Treasury bonds to push government bond yields lower to encourage borrowing and boost sluggish economic growth.
The forward outlook for earnings on gilts is now being debated between various commentators, one of whom noted, “the global savings glut (or investment dearth) has depressed gilt yields. It’s possible that, as these factors weaken, bond yields could rise without jeopardizing equities simply because the bond-earnings yield ratio returns towards normal. Even if ten year gilt yields were to rise to five per cent, this ratio would still be well below its pre-crisis levels .”
Withholding Tax and Reclamation Rates
To summarise so far, then, more and more companies are now paying a dividend. Those who have historically done so are looking to increase the dividend payout year-on-year. And according to Standard and Poors, this trend is expected to continue strongly through 2011 and beyond.
Holding cross-border shares is also becoming more popular with fund managers. The growth in foreign equity holdings between 2001 and 2009 was more than double the growth in global stock markets capitalisation over the same period. This shows that fund managers are increasing the proportion of their portfolio made up by foreign shares.
Bond market activity has increased markedly since the global stock market nadir of 2008. This increase in debt securities may or may not continue to grow at the same rate in future years, but has introduced a new balance into the fixed-income vs. equities portfolio balance.
At all events, dividends on cross-border shares and yield from foreign bonds are subject to withholding tax . This is a tax on earnings that the country’s tax office (the country in which the share or bond is issued) deducts at source, a proportion of which can be reclaimed by the owner of the shares/bonds.
However, GOAL’s research shows that around 25% of that reclaimable tax is left unreclaimed. This amounts to more than $17 billion of shareholder returns that are being lost – left unreclaimed in a foreign country’s tax system.
Pressure on FMs and Custodians
With the increasing popularity of both dividend payments, and cross-border securities, the
unreclaimed tax will continue to rise unless fund managers’ service providers – often custodian banks – improve reclamation levels. Increasingly savvy investors, in markets where high yield investments are harder to come by, are putting the fund management community under growing pressure to maximise their investment returns.
As a result of all these factors, dividend yields have become a far more highly scrutinised element of the investor’s portfolio, with consequent pressure on fund managers to devote greater attention to maximise this element of return in the portfolios they are managing. The significance of unreclaimed withholding tax on cross-border securities holdings has therefore risen to a prominence it has not enjoyed since the nineties and earlier ‘noughties’. However, technology was not available back then to automatically perform the highly complex task of reclaiming withholding tax, a process which has to incorporate up to date information, formats and procedures from a multiplicity of different legislatures around the globe.
In contrast to the last period of attention enjoyed by the faithful dividend, technology solutions are now widely available to automate the process of withholding tax reclamation, making it an economic – indeed profitable – process for custodians, and a ‘must have’ for fund managers under pressure from their investor clients.
Method
GOAL Group combined its own proprietary information on withholding tax reclamation rates with a wide range of global sources on foreign portfolio investment and dividend payments in different markets around the world. This information was then used, along with up-to-date information on the complex picture of withholding/reclaimable rates by country, to calculate actual sums left unreclaimed, both globally, and for individual countries with the larger investor communities.
Sources
* GOAL Group proprietary data
* Global Stock Exchanges
* The International Monetary Fund
* The OECD
* The Bond Market Association
* Global top 50 banks
* The Federal Reserve
* The European Central Bank
* The Bank of England
* US Department of the Treasury
* The Investment Management Association
* The World Bank
* Moody’s
* Bloomberg
* Standard and Poors
* Citytext
* International Financial Services Association
* Institute of International Finance
* World Federation of Exchanges
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