Microsoft's decision to pay a $32 billion special dividend - by far the largest payout in corporate history - will create an opportunity for millions of American shareholders to receive income that will be taxed at low rates. But it is also likely to provide an incentive for foreign investors to sell the stock and could create tax-oriented trading in the company's shares.
By acting now, Microsoft is ensuring that high-income shareholders, a group that includes Bill Gates, its chairman and co-founder, will receive the $3-a-share dividend before a possible change in the tax laws that could more than double their tax bills on such a payout.
Sen. John Kerry of Massachusetts, the presumed Democratic nominee for president, has said that if he wins election he will propose changes in the tax laws that will exclude high-income investors from breaks enacted during the Bush administration.
"Some people say this shows Microsoft has no way to invest all that money," said Robert J. Barbera, chief economist of the investment firm ITG/Hoenig. "It seems to me there has never been an easier way to hand yourself 85 percent money, and that opportunity may have about a six-month half-life."
He was referring to the 15 percent tax rate on corporate dividends that was enacted in 2003. The previous law taxed dividends at ordinary income tax rates, which now range up to 35 percent.
Kerry has proposed rolling back that tax change as a way to stem budget deficits while preserving tax cuts that benefit middle- and lower-income taxpayers. His proposal, said Mark Garay, director of tax policy services at Deloitte & Touche in Washington, would call for raising rates on dividends and capital gains for taxpayers with incomes of more than $200,000 a year.
"The prospect of Senator Kerry becoming president could be viewed by some companies as an incentive to pay out dividends this year," said Garay, who said he could not discuss Microsoft specifically because Deloitte audits its books.
"It would be even more of an incentive," he continued, "for closely held companies whose owners will be directly affected" by large dividend payments, adding that there could be a flood of such dividends declared after a Kerry victory if there appeared to be a good chance that the tax law would be changed.
Gates said he would contribute the $3 billion he receives to the Bill and Melinda Gates Foundation, solidifying its position as the largest charitable foundation in the world. While he will thus receive no direct benefit from the dividend, he will reap tax advantages, said Robert Willens, a tax analyst at Lehman Brothers.
That is because his donations would offset his ordinary income, taxed at the 35 percent rate, leaving him to pay tax largely or only on the dividend income, at the 15 percent rate. There is a limit on charitable donations of 50 percent of a taxpayer's adjusted gross income, but donations beyond that can be carried over to reduce future tax bills for up to five years.
Were the tax rate on dividends raised back to 35 percent for high-income people, a $3 billion payout to Gates would produce a tax of $1.05 billion, or $600 million more than under the current law.
The particular dividend that Microsoft declared will create considerable uncertainty among ordinary investors because it probably - but not certainly - will be deemed extraordinary under American tax law.
Extraordinary dividends are subject to special treatment, but a rise in Microsoft's current stock price of slightly less than $2 a share would keep it from being extraordinary and would provide an incentive for both American corporations and some individual investors to leap into the stock for a short-term, tax-oriented trade.
Foreign investors, though, will have an incentive to sell the stock before the dividend is paid in November. That is because they will be subject to withholding taxes on the payout ranging up to 30 percent, although for residents of many countries with tax treaties with the United States that rate is 15 percent, the same as Americans pay.
That may affect foreign-based hedge funds in particular, said Robert N. Gordon, president of Twenty-First Securities, a New York brokerage that specializes in tax-related investing. He said foreign investors would most likely sell the stock before the dividend was paid and then, if they are bullish on Microsoft, buy it back later. The price would be expected to fall by the amount of the dividend as soon as it is paid.
Shares of Microsoft rose 54 cents yesterday, to $28.86.
The magic price under the tax law will be $30.81, Gordon said. That is because dividends are considered extraordinary under the law if the total payment in any 85-day period is 10 percent or more of the value of the stock. Microsoft will also be paying a dividend of 8 cents a quarter, so the total in such a period would be $3.08.