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Dividends: what are they, and how do they work?

May 31, 2024

8 min

Dividends: what are they, and how do they work?

Dividends are a fundamental component of the financial world and an important source of income for those who invest in the stock market. Investors often choose whether to buy a stock based on its income redistribution policies.

To succinctly answer the question ‘What are dividends? ‘, we can say that they are part of a company’s profits that are distributed to shareholders as a reward for their investment.

In this article, we will explore dividends in detail, how they work, and their tax implications. Finally, we will compare this type of redistribution with stock buybacks, a very similar and increasingly popular practice in recent years.

What are dividends? 

Dividends are regular payments made by a company to its shareholders, a way of sharing the profits or gains generated

There are different types of dividends:

  • Liquidity: the amount of dividends depends on how much the monetary underlying is worth. If, for example, it is 1€ per share and the investor owns 100 shares, the total will be 100€;
  • Allocation of free shares: in this case, dividends are distributed in the form of new shares in the company;
  • In assets: this form of distribution is quite rare and consists of other types of assets belonging to the issuing company;

The distribution of dividends is determined by the board of directors, the executive body entrusted with the management of a joint-stock company, which decides both the total amount and the dates on which dividends will be, as they say in the jargon, paid out.

How do dividends work?

To understand what dividends are, let us look at how they work, starting with a crucial component: the timing. In particular, it is important to know the differences between when they are issued, paid and detached or distributed.

Declaration date

The declaration date is when the company’s board of directors publicly announces its intention to issue dividends. The dividend amount and associated key dates are specified during this announcement. 

Ex-dividend date

This is one of the main components one needs to know to claim and understand dividends. The ex-dividend date is the crucial date by which an investor must own the shares to receive the declared dividend once it has been issued

If an investor buys the stock after this date, he/she will not be entitled to the current value redistribution. For example, if the ex-dividend date is 10 June, investors must purchase the stocks by 9 June to receive the dividend. From 10 June onwards, these are considered ‘ex-dividend’.

Record date

The record date is when the company checks its records to determine whether the shareholders are eligible to receive the dividend. It follows the ex-dividend date and confirms who owned the stock on that date. 

To draw a parallel with crypto projects, the record date is equivalent to the moment when a snapshot, a snapshot (or screenshot), is taken, recording all wallets holding such cryptocurrency, or in this case, shares, at a given time.

Using the example above, if the ex-dividend date is 10 June, the record date could be set for 11 June. This time frame allows the company to update its records and identify legitimate shareholders.

Pay date

The pay date is the day expected by all investors, i.e. when this distribution actually reaches the shareholders’ portfolios. This payment can be made by bank transfer, using the bank’s securities account, or other methods provided by the broker you use.

To understand dividends, it is important to emphasise that companies are not obliged to distribute them forever despite having done so in the past. The decision to pay out shares depends both on the company’s ability to generate profits and on its growth strategy, which may change over time. During particularly difficult times, a company might decide to reduce or suspend dividends to preserve liquidity.

Dividends represent a source of passive income for investors. If dividends are distributed in cash, investors can choose to reinvest them to buy additional shares or keep the shares they receive to increase their positions.

Knowing what dividends are and how they work also means knowing the risks associated with these instruments. For example, the distribution of large amounts of capital may not be sustainable in the long term. Therefore, investors must carefully assess the sustainability of the dividend by analysing, in particular, the payout ratio, which indicates the percentage of profits distributed to shareholders.

Tax impact of dividends

Dividends have tax implications for both companies and investors, depending on the country of residence of both parties. The former may be subject to a withholding tax, a tax withheld by the state where it is domiciled, and investors may also suffer the same fate.

However, some states may have entered into agreements allowing shareholders and companies to pay these taxes only once. So-called double taxation treaties or treaties against double taxation allow for the recovery of part of the taxes paid.

To really know what dividends are, how they work, and how they are treated in our country from a tax point of view, it is useful to distinguish between qualified and non-qualified holdings. The former occurs when an investor holds:

  • more than 2% of the voting rights that can be exercised at an ordinary general meeting or more than 5% of the share capital of a listed company;
  • more than 20 per cent of the voting rights exercisable at the ordinary shareholders’ meeting or more than 25 per cent of the share capital.

Conversely, if the voting rights are proportional to the shares held and the share capital held is below these thresholds, the shareholder’s holding is not qualified.

In any case, after the introduction of the 2018 Budget Act, this distinction is irrelevant for natural persons not registered for VAT since a withholding tax of 26% applies to all. However, it is for other types of entities since it entails changes in the percentage applied to the tax base of dividend recipients.

If you want to delve deeper into this issue, you can look at Articles 44 and 45 of the Consolidated Income Tax Act (TUIR). Beware, however, that taxation on dividends varies depending on the country of residence, the country of the company that issues them, and the intermediaries used to purchase the shares.

Difference between Dividends and Stock Buyback

To conclude this in-depth study, which seeks to answer as fully as possible the question: What are dividends, and how do they work? We can compare their issuance with a popular practice in the financial world: the stock buyback or ‘share buyback,’ which is driven by the same objective: increasing shareholder value.

A buyback involves a company purchasing part of the circulating stock, reducing the number of shares available on the market and thereby increasing the value of the remaining stock. However, the above sentence contains a simplification, as it is not certain that the price will increase as a result of the buyback. An increase in perceived value cannot always influence the relationship between supply and demand.This practice has become a constant for many companies since 2020. For those in the S&P 500, the index that tracks the performance of the five hundred most capitalised companies in the US, the amount of money allocated to buybacks has exceeded the amount redistributed through dividends.

In summary, what are dividends, and how do they work? They are a form of redistribution of a company’s profits to shareholders as a reward for their demonstrated support through capital investment.