Merger Gains Induced by Dividend Tax Capitalization

Under certain conditions shareholders will impound dividend taxes in equity prices. We demonstrate that such a capitalization of dividend taxes may not only be seen as a value decreasing factor but also as a source of value. A mechanism which is proper to endow shareholders with gains derived from dividend tax capitalization is a corporate merger. In corporate mergers shareholders can receive financial synergies from differences in dividend tax rates across the shareholders of the acquired and acquiring firms. This Pareto-optimal synergistic gain is based on an arbitrage scheme which provides for a revaluation of future earnings with the lower dividend tax rates of other shareholder groups. The insight of our analysis also sheds light on the line of inquiry on dividend clienteles, i.e. shareholder groups characterized by their identical tax rates on dividends. The research on dividend clienteles suggests that a change in dividend policy is costly for shareholders (see Elton and Gruber 1970). It seems reasonable to suppose that such costs may incur in a corporate merger where at least one shareholder group should face a change in dividend policy. However, our finding that under dividend tax capitalization shareholders may receive financial synergies only due to differences in dividend tax rates contradicts this suggestion to some extent.