Question

The effect of income tax on dividend decision is

• A. No effect
• B. Direct effect
• C. Indirect effect
• D. None of these

Hint:

Remember that financial decisions are always made on a post-tax basis. Therefore, any tax that affects the returns from that decision (like dividends) will have a direct impact on the decision itself.

Answer 1

The Correct Option is B

Step 1: Understanding the Question:
The question asks about the influence of income tax on a company's dividend decision (the decision of how much profit to distribute to shareholders).
Step 2: Key Concept:
Dividend policy is a crucial financial decision. One of the key factors that influences this decision is the taxation policy of the government, specifically the tax treatment of dividends in the hands of shareholders and the tax on capital gains.
Step 3: Detailed Explanation:
Income tax has a direct effect on the dividend decision of a company in the following ways:
1. Tax Rate on Dividends: If the personal income tax rate on dividend income is high, shareholders may prefer that the company retains more of its earnings. Retained earnings can lead to an increase in the share price, resulting in capital gains for shareholders, which might be taxed at a lower rate. This directly encourages a lower dividend payout.
2. Tax Rate on Capital Gains: Conversely, if the tax on capital gains is higher than the tax on dividends, shareholders would prefer to receive more of the profits as dividends. This directly encourages a higher dividend payout.
3. Corporate Dividend Tax: In some tax regimes, the company itself has to pay a tax on the dividends it distributes. A high corporate dividend tax would make distributing dividends more expensive for the company, directly incentivizing it to retain earnings.
Because the tax implications directly affect the net returns to shareholders and the cost to the company, tax policy is a direct and major consideration in making dividend decisions.
Step 4: Final Answer
Income tax has a direct effect on a company's dividend decision by influencing the net return to shareholders and the preferences for receiving profits as either dividends or capital gains.