The Journal of Applied Business Research – May/June 2014 Volume 30, Number 3 Copyright by author(s); CC-BY 895 The Clute Institute The Effect Of South African Dividend And Capital Gains Taxes On Share Prices And Investor Expected Returns Francois Toerien, University of Cape Town, South Africa Matthew Marcus, University of Cape Town, South Africa ABSTRACT We examine the effect of South African taxes, specifically the secondary tax on companies (STC) and the dividends tax (DT) that replaced it, as well as capital gains tax (CGT), on investor measures of expected return and firm value. The discussion, findings, and models presented in this study are entirely original in the field of South African corporate finance research. We model the relationship between STC, CGT, and expected return and use this relationship to formulate an hypothesis of the expected behaviour of ex-ante measures of implied cost of capital for a sample of listed South African companies. We calculate these measures by formulating a unique South African version of the residual income valuation model (RIVM) and then regress derived measures of the implied equity premium on historical measures of dividend yield, ultimately concluding that investors appear to recognise the net tax benefit of dividends and capitalise this benefit into stock prices. Finally, we examine the expected position of each of these areas in light of the proposed shareholder dividend tax regime. Keywords: Dividend Taxes; Capital Gains Taxes; Cost of Capital; Residual Income Valuation Model 1. INTRODUCTION number of international studies have examined the extent to which dividend and capital gains taxes are capitalized into stock prices by investors, and how these taxes affect expected return; to date, despite the important implications thereof for the body of knowledge concerning inter alia investor behavior and stock valuations, no such research had been performed in South Africa. The recent change from South Africa’s unique system of dividend taxation to a new regime that more closely corresponds to the tax systems on which the international research is based, lends itself to globally unique research, and potentially very interesting results. From 1993 until 2012, South African companies were subject to a dividend tax called the “secondary tax on companies,” or “STC,” which operated at the company level and did not vest in the shareholder, as is the case with most dividend taxes imposed by other jurisdictions. In April 2012, STC was replaced with a shareholder-level dividend tax regime, colloquially referred to as the “dividends tax,” or “DT.” The move to DT represents a fundamental shift in how dividends are taxed, bringing South Africa in line with most foreign jurisdictions. This change in dividend tax regimes provides a unique research opportunity with respect to the effect of these and other taxes on South African markets and investor behavior. With this in mind, this article attempts to address and answer the following questions: 1. How should STC and capital gains tax (“CGT”) have been accounted for in expected return and stock valuation models? 2. To what extent did South African investors recognise the effects of firm-level STC and shareholder-level CGT when considering the effective return from, and valuation of, South African listed stocks? 3. How is the replacement of the STC regime with DT expected to change the answers to the previous questions? A