Dividend Reinvestment Plans (DRP)

Submitted by Share Trading on 30 July, 2010 - 08:51

Dividend Reinvestment Plans allows shareholders to use their dividends to buy more fully paid ordinary shares instead of getting cash for their dividends. There are many companies out there that offer the investors to get enrolled in Dividend Plans instead of receiving cash- an option that gives the investors an opportunity to acquire newly created shares. However, some companies also offer a combination of shares and cash.

At the early stages, these kinds of shares were usually offered at a 5 to 10 percent discount rate in comparison with the market price. This is why many investors found those offers lucrative. However, these days the discount rate usually remains within the range of 1 to 5 percent and sometimes you won’t even get a discount. This means in an unstable market, the shareholders would find it safer to go for the existing stocks when the price is down instead of going for the Dividend Reinvestment Plans considering that they have no control over the issue price.

Issues for which no brokerage or other charges are incurred are attractive for both sides. From the point of view of a company, it will be able to raise cash for expansion without spending too much on administrative costs and at the same time it can cement the stockholder relations. In addition to that, this kind of semi-automatic capital rising eases the necessity of conventional right issues and thus the market price doesn’t face any pressure which in many cases occurs due to such issues.

Who should go for Dividend Reinvestment Plans?

Traders who have this tendency of looking for modest increases periodically to their total portfolio without spending too much can also utilise this facility along with those who prefer to strengthen their current holdings instead of boosting up the number of companies where they hold stocks. People with family trusts designed to accumulate income for a specific period of time also finds Dividend Reinvestment Plans as an attractive option.

It is to be mentioned that taking part in a DRP is voluntary. An investor is required to sign on an appropriate application form to get enrolled for all or a particular holding. The participants do hold the right to withdraw from the plan whenever s/he wants up to the closing date for a specific dividend. The companies also hold the right to suspend or close a plan. However, they need to give notice to the shareholders to do so.

Some concerns regarding DRP

Dividend Reinvestment Plans allows shareholders to use their dividends to buy more fully paid ordinary shares instead of getting cash for their dividends.

In the past, creation of odd lots with its attendant additional costs was used to be a disadvantage of participating in Dividend Reinvestment Plans. However, that is not a problem anymore as the whole concept has been abolished. But one problem that still does exist is the need for the plan members to keep detail track of information like the date of issues and the issue price of the DRP shares in order to enable compliance with the capital gains tax (also called CGT) legislation.

A separate “parcel” is created for the shares for each dividend to deal with the CGT purposes which can get a long term trader involved in a whole lot of calculations to dispose these regardless of whether the investor deals with these issues all by himself or hires an accountant to do the job.

In addition to this, another issue that should be taken under consideration is, the market price of the new shares may slide below their issue price even though the buffer often provided by any discount granted at the same time of the issue. However, the risk involved with such an incident is very much similar to that applying to any other stocks or the original holdings.

Shareholders need to write to the company in case they change their mind regarding their participation in a plan- something that can be considered as a disadvantage by many investors. Also, in some cases an investor may encounter a tax obligation without providing the required liquidity to fulfill it. This happens especially in case of the unfranked dividends. This is considered as one of the major disadvantages of participating in a dividend reinvestment plan.

This happens because all the shares that are issued under a DRP are considered as new shares purchased by an investor with the dividends proceeds. Thus the dividends are taxed either as franked or unfranked dividends according to the usual system although the dividends were not received in cash. Where in case of franked, they come up associated with the normal imputation credit.

Some Important Things That You Need to Know About Dividend Reinvestment Plans

Companies are required to set out appropriate franking details on the plan statements. The plan shares are to be treated as being purchased at the time of the distribution of dividends for consideration equal to the dividend which was not taken in cash for capital gains tax purposes on any following disposal.

The assessable income at the time of the issuance of DRP shares are not constituted by the discount at which those shares were issued. But that does leads to a lower acquisition cost for the new stocks which will result in an equally higher taxable capital gain on any following disposal.

Since the income from the shares is evaluated under the deeming rules, the dividend used for acquiring new shares under a DRP don’t have any impact under the social security income test. But for the purpose of assets test, the value of the additional stocks is needed to be calculated in the usual way.

Companies that are in need of additional capital would like all its shareholders to take part in dividend investment plans particularly in the present climate. Since this is not that practicable, the companies make arrangement with an underwriter to place stocks which would be available for the investors as chosen not to take part in the dividend reinvestment plan.

This system allows a company to preserve cash flow and at the same time ensures that the plan remains voluntary for individual shareholders. The system is considered as an encouragement to a high pay-out ratio, creating a win-win situation for all the parties involved.

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