Cisco to Congress: "Please fix the tax code"

This past Tuesday (9/14), Cisco Systems held its 2010 Financial Analyst Conference at company headquarters in San Jose, CA. The morning keynote presentation was also webcast live with a copy of the materials archived on the Scribd website.

It was yet again another impressive performance from CEO John Chambers and friends. During the presentation, management reiterated its long-term growth rate of 12-17%. However, we thought the company's discussion of the possibility of paying a 1-2% dividend to shareholders among the more notable points during the presentation. (see page 41 of the Scribd document linked above)

The dividend itself is not that big of a deal, in our view. Many of the larger technology companies have initiated a dividend in recent years, including Microsoft and Intel. It was the company's comments in discussing the dividend that caught our attention. In particular, Chambers said that initiation of a dividend would depend on action (or lack thereof) of dividend tax legislation as well as policy action (again, or lack thereof) on repatriation of foreign profits. (Nearly $30 billion of Cisco's $40 billion cash war chest is outside the US.)

We can only assume that the company will decide on a lower dividend rate if the advantageous tax rate on dividends (part of the Jobs and Growth Tax Relief Reconciliation Act of 2003) is not retained.

We understand Cisco's position. The US has employed double-taxation of dividends for far too long. Think of it this way: Let's assume you are a shareholder of Cisco. For every dollar the company pays you in dividends, it must presently earn about $1.27. This is because Cisco pays income taxes of about 21% (last three year's average) on its net income.

But it doesn't stop there. After making $1.27 and sending $0.27 to the US Treasury, Cisco sends you your $1.00. Unfortunately, that $1.00 gets taxed yet again. Yes, that $1.00 shows up on your income tax return and is hit with federal, state and local taxes. Under the 2003 tax act, you could qualify for the advantageous tax rate of 15% on that dividend. After federal taxes (we'll ignore state and local for now, in an attempt to keep this simple), you have $0.85 left to spend.

Maybe you think that's not too bad. We don't agree. A combined tax rate of about 35% is plenty in our view. Moreover, having that dollar taxed twice is insane. But we digress.

Now let's compare what will happen if nothing is done to prevent dividend taxes from increasing on 1/1/11. Back to our example. . . For every dollar the company pays you in dividends, it must presently earn about $1.27. No change here to Cisco's ~21% tax rate.

But here's where it gets uglier. After making $1.27 and sending $0.27 to the US Treasury, Cisco sends you your $1.00. That $1.00 still shows up on your income tax return and is hit with federal, state and local taxes. But now you will pay tax on it at your ordinary income tax rate. Let's say your taxable income (2010 married/joint) is above $137,300 but less than $209,250. You now pay at a rate of 28% (again, ignoring state and local taxes) and have a measly $0.72 left out of that original $1.27.

If we didn't like double taxation at the rate of 35%, you know how we feel about nearly 45%.

Think about Cisco's (and every other corporation's) choices here. They can use the money to buy back their stock. That same dollar that ends up being a $0.72 after-tax dividend to shareholders can instead be used to buy back $1.00 worth of stock. That might provide a bigger boost to shareholders' net worth than a $0.72 net dividend.

Or that $1.00 can be added to the company's huge $40 billion cash reserve and eventually used to fund growth opportunities such as new products/services or the acquisition of other companies.

Our view is that extending the lower tax rate on dividends is the minimum congress should achieve before 12/31/10. Completely eliminating the ludicrous double-taxation of corporate dividends (either by making dividends deductible to payers or tax-free to payees) is the more rational long-term solution.

This idiotic practice has been allowed to continue for far too long.