Must Stock Dividends be Taxed?

Inclusion or exclusion of stock dividends in the scope of income has been an thorny issue in financial accounting as well as income taxation, as it necessitates an elaborate analysis of corporate law, tax theory, accounting theory, and financial economics. From a shareholder's perspective, stock dividend is not any different from retention of earning and consequential no-dividend status. In the prevalent view of corporate law theorists in the United States, Germany and even Japan, stock dividend is closer to stock split than cash dividend. This development of corporate law offers an easy temptation to argue that stock dividend should not be taxed to the shareholders. This paper attempts to show that the issue of taxing stock dividend is much more complex and the assimilation to a stock split does not necessitate exclusion of stock dividend for tax purpose. It is indeed true that stock dividends, exactly like a stock split, does not enrich the shareholders. The difficulty, however, is that neither a cash dividend enriches a shareholder and yet is taxed. The issue thus turns to a more fundamental rationale of corporate income taxation and its relation with the shareholder taxation. The paper argues that the current law of levying corporate income tax and crediting it the level of shareholder taxation is based on the notion of vertical equity that all income or accumulation of wealth by a particular individual must be aggregated subject to progressive rates. Seen this way, one might advocate taxing stock dividend as it reflects accumulation of wealth in a corporate vehicle without paying an additional tax at the shareholder level. As pointed out in this paper, however, a dividend decision is at the discretion of controlling shareholder and minority shareholders do not have any chance of abusing the corporate vehicle. Moreover, taxing stock dividend cannot prevent a controlling shareholder from accumulating wealth in a corporation in the form of retained earnings. The right solution to the abuse will be a retained earnings tax or a personal holding company tax applicable to retained earnings. In conclusion, a better choice would be not to tax stock dividends. In the present circumstance of Korea, however, taxation of stock dividends may be acceptable because the current system of retained earnings tax is crippled, and the minority shareholders still have the unsophisticated perception of identifying a stock dividend to a cash dividend. As long as this perception continues, taxing cash dividend alone is likely to distort the dividend decision and harm the economic efficiency