One of the provisions in the Inflation Reduction Act (IRA) of 2022 is a stock buyback tax. This tax provision stipulates that if a publicly traded company repurchases stock, net of new share issues, for over $1 million within a fiscal year, the fair market value of the net stock repurchased is subject to a 1% non-deductible excise tax.[1] The Joint Committee on Taxation estimates that this new tax will raise $74 billion from 2022 to 2031.[2]
In late December 2022, the Treasury Department issued interim guidance on how the new tax should be applied, stating that taxpayers can rely on this publication until the proposed regulations are released.[3] Most recently, in his State of the Union address on Feb. 7, 2023, President Biden called for quadrupling the tax on stock buybacks.[4]
This is a contentious issue, as highlighted by the passionate discourse for and against stock repurchases. For example, in his annual letter to shareholders, Warren Buffett stated, “When you are told that all repurchases are harmful to shareholders or to the country, or particularly beneficial to CEOs, you are listening to either an economic illiterate or a silver-tongued demagogue (characters that are not mutually exclusive).”[5]
This report discusses the increased frequency of stock repurchases and the arguments that must be considered when evaluating the stock buyback tax.[6] It also reviews key aspects of the Treasury Department’s new guidance.
Buybacks Versus Dividends
In general, as companies earn profits those funds can be retained and reinvested in the company or dispersed to shareholders by means of dividends or stock buybacks. Companies should retain earnings and use those funds to invest in new projects if the return on that investment is greater than the next best alternative available to the company or to shareholders. If investing the funds within the company does not provide a return greater than alternatives that are available in the market, then the company should return the funds to shareholders to be invested elsewhere or used for alternative purposes. If a company decides to return the cash to shareholders, it can do so by repurchasing shares or distributing dividends.
The Increase in the Use of Stock Buybacks
Since the 1980s, corporations have increasingly used share repurchases instead of dividends as a means of returning funds to shareholders. The increase in the use of share buybacks is commonly attributed to there being greater tax and financial market advantages for share repurchases than for dividend distributions, as well as a change in regulatory rules in the 1980s.
As shown in Figure 1, taken from Zeng and Luk,[7] share buybacks first surpassed dividends as a method of distributing corporate funds in the late 1990s and have remained larger in every year except 2013. Figure 1 also shows that the proportion of companies that repurchase shares has increased to 53% from 28%, and the share of firms paying dividends has decreased to 43% from 78%. This increase is related to the tax and financial benefits of share repurchases relative to dividends.
Figures 1 and 2 show that share repurchases grew rapidly until the financial crisis of 2008, then they declined significantly in 2008 and 2009. This decrease in buybacks was related to increased economic uncertainty and a reduction in profits that led firms to increase retained earnings. However, note that the decrease in share repurchases was much larger than the decrease in dividends. This highlights one of the financial benefits of share repurchases — increased flexibility in returning funds to shareholders. It is widely recognized that decreasing dividend payments is viewed as a sign that a company’s economic outlook is deteriorating and thus companies try to avoid such changes. Because of this view, share repurchases are also preferred to dividend payments since they offer corporate executives more flexibility in the decision-making process — reducing or canceling planned open-market repurchases has a less negative effect than reducing a normal dividend payment.
Figure 1 — Aggregate Dividends and Buybacks Paid by U.S. Firms and the Percentage of Firms with Positive Dividends and Buybacks in the U.S.
Figure 2 — S&P 500 Dividends and Buybacks ($ Billions)
Figure 2 shows that share repurchases increased dramatically in 2018 and 2021.[9] Further observations on the changes shown in the graph follow.
- The increase in share repurchases in 2018 was related to changes in the treatment of international income in the Tax Cut and Jobs Act of 2017 (TCJA), which repealed the deferral of tax on foreign source earnings held abroad. This led to the repatriation of a significant amount of corporate income that was returned to shareholders, at least in part by increased share repurchases.
- The decrease in share repurchases in 2020 was related to the impact of the COVID pandemic as economic uncertainty increased and profits declined, especially in the initial stages of the crisis.
- In 2021 and early 2022, share repurchases increased as the economy started to recover, and as significant amounts of government stimulus and infrastructure spending increased economic activity and improved corporate balance sheets.
How and Why Do Firms Buy Back Shares?
Zeng and Luk discuss several methods that companies can use to repurchase shares, such as open market stock repurchase offers, fixed price tender offers, Dutch auction tender offers, transferable put right offers, or direct negotiation.[10]
Primary Method: Open Market Stock Repurchase
The open market stock repurchase option is the primary method of repurchase in the United States. Zeng and Luk note that this method gained traction after regulatory changes in the early 1980s insulated companies from the risk of liability associated with stock manipulation under the Securities Exchange Act of 1934.[11]
The open market stock repurchase offer has a couple of benefits compared to other stock repurchase methods.
- First, the offer price under this method does not require a premium above the current market price of the stock.
- Second, this method is more flexible in terms of its timing, as repurchases can be spread over a two- to three-year period, and there is no obligation to fully or partially complete an announced repurchase.
However, if the goal of the repurchase requires the firm to repurchase shares quickly, such as to avoid a hostile takeover, then a fixed price tender offer or Dutch auction tender offer would be preferred.
Why Firms Repurchase Shares
There are many reasons why firms may want to repurchase shares. Hsieh and Wang discuss six reasons that firms repurchase shares including regulatory and tax issues, the agency costs of free cash flows, signaling and undervaluation, capital structure, takeover deterrence, and employee stock options.[12] This is a much broader and more balanced view than that favored by Lazonick, Sakinc, and Hopkins, who argue that “senior corporate executives have used open-market repurchases to manipulate their companies’ stock prices to their own benefit and that of others.”[13] While this may be true for a small number of firms, it does not seem to be the case for the vast majority. For example, Edmans argues that buybacks do not inflate executive pay or crowd out investment,[14] both of which were topics of a large study by Edmans and PwC.[15] Fried and Wang examine net shareholder payouts, dividends and share repurchases net of new equity issues, and show that from 2007 to 2016, firms in the S&P 500 paid out 41% of net income. They state that “during this decade investment increased substantially while cash balances ballooned. In short, S&P 500 shareholder-payout figures cannot provide much basis for the notion that short-termism has been depriving public firms of needed capital.”[16] Hemel and Polsky state that “claims that buybacks reduce corporate investment and inappropriately reward executives turn out to be poorly supported.”[17] However, there is a consensus that rules surrounding stock buybacks and executive pay packages are important and should continually be examined for potential improvements in corporate governance.
Differences between Stock Buybacks and Dividend Payments
To consider the differences between stock buybacks and dividend payments we first summarize what happens in each case.
- Stock Buybacks. When a company repurchases its own shares, there are fewer shares outstanding[18] in the open market. Because the company’s earnings and fundamentals have not changed, its earnings per share (EPS) — one of the most popular financial ratios measuring a company’s performance — rises and its total value is equal to the pre-repurchase market value minus the cost of the share repurchase program. While the EPS has gone up, the total value of the company falls by the total value of the repurchased shares.
- Dividend Payments. If the company chooses to return profits to shareholders by making dividend payments, then the value of the company falls by the aggregate value of those payments. In this case, the number of shares remains the same, but earnings per share is reduced by the amount paid out as dividends.
This implies that, in theory, the value of the company falls by the same amount regardless of whether earnings are distributed by share repurchases or dividend payments. However, there is evidence showing that in the short term, the companies that buy back their own shares yield higher returns. A possible explanation is that companies are more likely to repurchase shares that are perceived as undervalued by the market. Buffet explains this effect in his 2023 letter to shareholders:
“The math isn’t complicated: When the share count goes down, your interest in our many businesses goes up. Every small bit helps if repurchases are made at value-accretive prices. Just as surely, when a company overpays for repurchases, the continuing shareholders lose. At such times, gains flow only to the selling shareholders and to the friendly, but expensive, investment banker who recommended the foolish purchases.
Gains from value-accretive repurchases, it should be emphasized, benefit all owners — in every respect. Imagine, if you will, three fully-informed shareholders of a local auto dealership, one of whom manages the business. Imagine, further, that one of the passive owners wishes to sell his interest back to the company at a price attractive to the two continuing shareholders. When completed, has this transaction harmed anyone? Is the manager somehow favored over the continuing passive owners? Has the public been hurt?” [19]
Example: Comparing Stock Repurchase to Dividend Payment
It is helpful to work through a simple example — like the one suggested by Buffet above — of a stock repurchase and compare it to dividend payment of the same size. A simplified example that includes only two types of current owners of the stock is enough: one that wants to hold the stock (holder) and the other that wants to sell the stock (seller). This is the example shown in Table 1.[20]
Table 1 — A Comparison of Buyback Program Versus Dividend Payment
Row 1: The first row in Table 1 shows the initial value of stock for each group, assuming that the holder has 10 shares and that each share is valued at $5. This implies that each shareholder has $50 worth of equity in the company, for a total company value of $100.
Row 2: As shown in row 2, if the company earns a one-time profit of $100, then the value of each share increases to $10 from $5 and the total value of the company increases to $200.
Row 3: Row 3 shows the impact of a $100 buyback program. In this case, the shares of the seller are repurchased and the seller no longer owns equity in the company. The number of outstanding shares is reduced to 10 from 20 shares and a total equity value of $100 implies that the price per share remains at $10.
Row 4: The seller has a capital gain of $50 ($100 received from the sale of 10 shares minus $50 of original basis[21]) and is responsible for a tax payment based on that gain at his or her capital gains tax rate.
Row 5: If, after making $100 profit (row 2), the company pays out a dividend to all shareholders totaling $100 (so $5 per share with 20 shares outstanding), then the price of the stock falls by $5 and the total value of equity falls to $100 from $200. In this case, each shareholder is left with 10 shares of stock valued at $5 each.
Row 6: This row shows that each shareholder owes a dividend tax equal to $50 multiplied by the dividend tax rate, so that total taxes paid are equal to $100 multiplied by the dividend tax rate. Note that in this case the total tax payment is based on $100 of dividend income, as opposed to $50 of capital gains income if the company repurchases $100 worth of shares. This is one potential tax benefit of share repurchases compared to paying dividends.
Row 7: A share repurchase plan allows “holders” to defer taxes on their capital gains income until the shares are sold in the future, while a dividend tax is applied to the full $100 corporate profit in the year the dividend is paid. If shares are held until death, it is possible that holders can completely avoid paying the capital gains tax.
Alternatives to Taxing Share Buybacks
Change Tax Treatment of Capital Gains. One commonly stated justification for taxing share buybacks is the tax benefit derived from deferral of capital gains taxes, especially if shareholders defer the sale of shares until death (when step-up in basis[22] rules allow shareholders to use the value at the time of death as the new basis) and the capital gains tax liability is avoided completely. For those who support a stock buyback tax for this reason, an alternative to taxing share buybacks is to limit deferral instead, either taxing capital gains when accrued or not allowing a step-up in basis at the time of death. But getting rid of deferral would be administratively complex and economically inefficient. As discussed by Diamond, it would lead to higher capital gains taxes, with the potential to wipe out all real returns for some investments, and would reduce investment and economic growth in the U.S., especially in the current high-inflation environment.[23] Such a policy should not be considered unless it also exempts nominal asset price changes from taxation. Also note that the economic and distributional effects of a stock buyback tax are very different from those of deferral and thus not a good substitute based on either measure.
Treat Share Buybacks as Dividend Payments. Chirelstein argues for treating repurchases as dividend payments for tax purposes, but this is one of the least likely solutions: It is administratively complex, would lead to higher effective tax rates on capital income, and would exacerbate the problem of “trapped equity” in inefficient companies.[24]
Broader Tax Reform. The most efficient solution would be to eliminate the taxation of dividends, getting rid of the double taxation of corporate income, for income that is subject to tax at the corporate level. This could be part of a broader reform that also equalized the taxation of corporate and non-corporate income.
PWBM Calculations on Effects of Buyback Taxation
The Penn Wharton Budget Model (PWBM) discusses in detail how the excise tax on buybacks would impact the differential in the effective marginal tax rates for buybacks and dividend payments.[25] The difference in the effective marginal tax rates is a measure of the tax advantage of dispersing earnings using buybacks relative to dividends. The researchers calculate that the differential in the effective marginal tax rates is between 0 and 4.2 percentage points. PWBM’s baseline calculations suggest a difference of 0.6 percentage points (5.6% for dividends and 5.0% for buybacks) in the effective marginal tax rates, and they calculate that a 4.6% excise tax on buybacks would equalize the effective marginal tax rates.
However, these calculations are uncertain and depend on a number of assumptions that impact the tax differential such as the rate of inflation, the rate of return on corporate equity, the dividend payout ratio, share of taxable domestic equity, average period that individuals hold stock, share of capital gains held until death and the average time those shares are held, and the marginal effective tax rates on dividends and capital gains. PWBM estimate that raising the excise tax rate from 1% to 4% would raise $265 billion in revenues from 2023 to 2032.
We note that equalizing the tax treatment of buybacks and dividends by imposing an excise tax on buybacks would increase the effective marginal tax rate on equity-financed capital income, especially given that buybacks have been a primary method of returning funds to shareholders. Raising the tax rate on equity-financed capital income may reduce investment and alter the share of debt and equity finance. In addition, it may have some of the pernicious effects discussed above. Given this, it is not clear that equalizing the tax treatment of buybacks and dividends is necessarily the right goal from an economic perspective.
Economic Effects of Stock Buybacks
Expert Views
Share buybacks are not a foolproof method for boosting stock prices, and they may interact with other issues such as corporate structure and executive pay to create negative economic effects. A number of experts have written about the economic effects of share repurchase. We summarize their main points here.
- Lazonick, Sakinç, and Hopkins argue that share buybacks are dangerous for the economy because corporate executives use buybacks, financed at times with debt, to inflate shares prices temporarily to enrich themselves. In addition, they argue that share repurchases reduce profitable investments.[26] Lazonick also argues that around 1980, corporate behavior shifted from a “retain and reinvest” philosophy to a “distribute and downsize” philosophy.[27]
In both papers, the authors draw conclusions from a complex storyline based on several data series over time, such as the growth in total corporate distributions, the relationship between productivity and real wage growth, net equity issuance and several other factors. But they downplay or fail to discuss how other economic forces during the last five decades have impacted these relationships, such as women entering the labor force, a push to globalize the production of goods and services, increased competition from abroad, the explosion in government debt, rapid changes in technology and innovation, and increasing market power. - Hemel and Polsky sum up the strength of the case made by critics of stock buybacks in this way: “the contention that stock buybacks cannibalize long-term investment is doubtful at best; the claim that buybacks benefit corporate executives at the expense of other shareholders is not well-supported either.”[28] But they also argue that buybacks exacerbate the problems related to large gains earned by firm creators and the ability of multinational firms to avoid taxation by shifting revenues to tax havens and deductible costs to high tax locations.
- Alex Edmans lays out the case for stock buybacks, arguing that firms should first make all value enhancing investments available to the firm and then use surplus cash to repurchase shares.[29]
- Edmans’ view is consistent with the 2023 opinion piece by Malkiel in which the latter argues that increasing the stock buyback tax, as called for by President Biden in his recent State of the Union Address, would distort the allocation of capital in the economy and lead to reduced growth.[30] Malkiel cites an article by the Tax Foundation that shows that firms that repurchase shares tend to outperform market peers by more than 12% in the following four years.[31]
- Malkiel also cites a 2018 study by Fried and Wang that shows that while payouts to shareholders are substantial, so is the investment in research and development and capital.[32] Fried and Wang explain that this occurs because of the robust equity issuance — sale of new equity or stock — in a well-functioning capital market.
The Use of Repatriated Foreign Earnings
It is also useful to look at the period immediately following the Homeland Investment Act of 2003 (HIA). The HIA allowed companies to temporarily repatriate foreign earnings subject to a reduced tax rate of 5.25%. As shown in Figures 1 and 2 above, this was followed by a substantial increase in share repurchases from 2004 to 2007.
- Dharmapala, Foley, and Forbes argue that companies did not increase spending on investment, employment, or research and development in response to the increase in repatriated earnings.[33] They show that 60% to 92% of repatriations were used to increase share repurchases and dividends, which was technically not allowed by the law.
- However, Brennan states that he proves “that the $0.60–$0.92 range for 2005 shareholder payouts is completely incorrect. What I provide is truly a proof and not just a statistical estimate of high probability. In fact, I show that total amount of cash, whether repatriated or not, spent on shareholder payouts in that year was so small that no more than $0.55 per repatriated dollar could possibly have been spent in impermissible ways.”[34]
In this context, an important question arises: Is it efficient for the government to impose such restrictions on firms? Does it make sense? There is no reason to assume that a company that accumulated earnings overseas in an effort to defer taxes on those funds is likely to invest those funds in the most productive manner.
For example, prior to the passage of the TCJA, Apple had accumulated a large amount of deferred foreign earnings. In 2013, Apple planned to borrow money to pay dividends and finance a stock buyback.[35] The fact that Apple was going to pay a dividend to shareholders indicated that the company did not believe it had investment opportunities that warranted retaining the earnings to invest in other projects. We suggest that it is not a proper role of government to influence a company’s allocation of investment funds, especially in the absence of a market failure, given the lack of information available to government policymakers and the individual nature and circumstances facing each firm. The inevitable one size fits all nature of government policy doesn’t take these factors into account.
Many Factors Involved in Buyback Decisions
Indicator of Future Performance? There is no consensus on whether buybacks are a positive or negative indicator of future performance, as this depends on each company’s specific situation. Buybacks may signal that the company does not have productive investments in its pipeline, causing shareholders to have a pessimistic view of its growth prospects. Or, as Buffet stated in his recent shareholder letter, it could mean that managers are confident about the company’s current performance and believe the best investment is in their own shares. Pettit outlines the characteristics of share price enhancing buybacks and discusses potential pitfalls that could lead investors to interpret buybacks as a negative signal, such as Merck’s buyback in 2000 that led to a 15% decline in share prices within a month. His analysis examines the size and method of the proposed buyback, whether it is financed with debt, management’s participation in selling shares, and other news that may come out at the same time.[36]
Timing of Stock Buybacks. Likewise, there is no consensus as to when a company is most likely to repurchase its shares relative to market performance. Some researchers believe share buybacks are more popular when the equity market is booming, allowing companies to buy back stock at high prices and boost their share prices even more. Others think these transactions happen more often during down markets when companies buy back stock at low prices that they believe undervalue their shares. Overall, there is no clear agreement on timing for stock buybacks.[37]
Flexibility and Signaling. As we mentioned above, it is commonly argued that corporate managers favor buybacks as a distribution mechanism simply because they prefer not to use dividends. Typically, once a company starts paying dividends, investors tend to expect the payout levels to remain constant or rise and therefore will react negatively to dividend cuts. On the other hand, buybacks can be executed without triggering ongoing shareholder expectations, so they are more flexible to implement with fewer financial market repercussions.[38]
Adjusting Capital Structure. Pettit argues that in addition to the signaling effects and flexibility of implementation, a company may use share buybacks to adjust its capital structure.[39] This essentially refers to changing the ratio between debt and equity, or how the company finances its operations and asset purchases. If managers want to reduce the relative importance of equity, they can issue bonds and then use the proceeds to implement stock buybacks that allow them to achieve a predetermined capital structure.
The Discipline of Debt and the Effect of the TCJA. Pettit also argues that debt imposes a higher level of discipline on managers, rationalizing that when a company needs to make interest payments to bondholders, managers are compelled to seek projects that earn returns higher than their costs of capital.[40] By comparison, equity does not exercise similar disciplinary effects.
A higher level of leverage certainly has its downsides. Pre-TCJA statistics show that roughly 30% of stock repurchases during booming stock markets were financed by corporate debt. However, share buybacks do not change a company’s production capabilities. This means there are no corresponding revenue-generating operations that allow the companies to pay off the debts. Increased debt levels do lead to a reduction in liquidity, and thus may increase the financial risks associated with market downturns.
For over two decades, the deductibility of interest payments and historically low interest rates have increased the preference for debt versus equity financing of new capital. Although the TCJA curtailed the tax benefit by reducing the deductibility of interest payments,[41] the after-tax cost of debt remained below shareholders’ required return on equity for many companies. Thus, debt continued to be used to finance corporate capital, as cash flow forecasts remained stable and debt servicing costs remained relatively low. However, the Federal Reserve’s efforts to reduce historically high inflation by raising the federal funds rate and reducing the size of its balance sheet have led to a substantial increase in the cost of financing new investments (or repurchases) with debt. More recent problems in the banking sector will likely further reduce the use of debt finance in the near term.
As we have already noted, the TCJA was the primary catalyst for the 2018 surge of share repurchases. This act cut the federal corporate income tax rate from 35% to 21% and enabled foreign profit repatriation, which provided multinational corporations with ample cash. Among S&P 500 companies, stock buybacks increased from $519 billion in 2017 to over $800 billion in 2018. Research has identified repatriated overseas profits were a more significant driver for increased buybacks than the tax rate reduction. Specifically, a study estimated that extra cash flow from overseas contributed to two-thirds of the buyback increase, whereas the lower tax rate was associated with the remaining one-third.[42]
The large amounts of stock buyback transactions continued until mid-2022, and some experts argue that they have been the largest source of demand for U.S. equity markets. For instance, in 2020 S&P 500 companies repurchased $520 billion in stock, followed by a record $880 billion in 2021. A small number of companies — including Apple, Google, Facebook, Microsoft, and Bank of America — accounted for a quarter of the total buyback value.[43]
In the second and third quarters of 2022, numerous media reports conjectured that companies would increase share buybacks to avoid the new buyback tax before it took effect in 2023. However, after the Federal Reserve aggressively increased interest rates and as concerns about a recession spread, corporations moved to conserve cash, and stock buybacks were much lower than expected toward the end of 2022.[44] This is consistent with the arguments above that many factors are important in determining the timing of stock buybacks, and thus, there is no single explanation for why or when firms decide to buy back shares.
An Overview of Interim Treasury Guidance
The Treasury’s preliminary guidance, known as Notice 2023-2 (referred to as “the notice”), clarifies many key aspects of the new buyback tax and provides helpful examples as to how the tax will be implemented. It also leaves several issues open for discussion and comments. This section broadly summarizes a selection of issues discussed in the notice.
Economically Similar Transactions, Explained
The law defines repurchases as in-scope when companies acquire any class of their own stock in exchange for cash or property[45] as well as through “economically similar” transactions. This has generated discussion as to what transactions are “economically similar.” The notice provides an exclusive list of transactions that are considered to be economically similar, including split-offs,[46] certain types of reorganizations, and certain liquidating transactions. It simultaneously offers a non-exclusive list of transactions that are not within scope, including complete liquidations and non-split off transactions. For split-offs, the notice clarifies that they are eligible for a qualifying property exception as long as the considerations are stock.[47] To the extent the split-off involves cash, this portion will be considered a repurchase, and the original distributing company’s tax base will include the cash portion of the transaction.[48]
Mandatorily Redeemable Preferred Stock, In Scope
Prior to the issue of guidance, practitioners were debating whether preferred stock would be subject to the buyback tax. On the one hand, some point out that the law does specify “any class of their own stock” is within the scope of the tax.[49] However, certain preferred stocks have mandatory redemption features, which mean these stocks must be redeemed over a specific period, at a specific price, or upon reaching a certain milestone (e.g., an employee’s termination or a company’s need to satisfy a liquidity provision).[50] These built-in call options make the stock resemble debt more than equity. In certain cases, these clauses obligate the company to buy back the stock. Some practitioners therefore argue that if the goal of the buyback tax is to encourage reinvestment in the company, the inclusion of mandatory redeemable preferred stocks under the new regulation is not necessarily consistent with its objective.[51]
The notice addresses this issue and indicates that if a company repurchases its mandatorily redeemable preferred stock, the transaction is subject to tax even when the preferred stock is not traded on an established securities market.[52] However, the notice does specifically ask for comments as to whether special rules should be considered for redeemable preferred stock.
Notable Exceptions, Applied
One notable exception of the tax is the netting rule, where a company can subtract the fair market value of any stock issued from the repurchased amount during the tax year. In other words, the tax base is reduced by stock issued in the same year, including stock issued to corporate employees and non-employees. However, the notice clarifies that if there are restrictions associated with the stock issued, the shares have to be fully vested before the netting rule becomes applicable.
In several examples, the notice illustrates the application of Section 83(b) election when it comes to the netting rule. This election, commonly used by start-ups and entrepreneurs, essentially provides an employee the option to pay taxes on the fair market value of the restricted stock at the time of grant. In other words, it allows the recipient of equity compensation to prepay his or her tax liability on a low valuation in anticipation of future appreciation, before the vesting period even starts.[53] The notice states that if the shareholder made an 83(b) election, it is included in the excise tax base during the year that the election is made. When the shares vest in a later date, there will be no tax consequences.[54]
Another notable exception states that if stock repurchase proceeds are contributed to an employer-sponsored retirement plan, that amount is not subject to the buyback tax. The notice clarifies key calculation and timing issues. For example, calendar year companies can treat the stock as having been contributed in the previous year if the contribution is made before April 30, when the required reporting form is due.[55] However, proceeds put into retirement plans are not treated as issued; as such, the netting rule will not apply.
SPACs Exempted, if Liquidated
When it comes to special purpose acquisition companies (SPACs), practitioners generally believe that they are not entirely subject to the buyback tax even though the notice does not name them specifically. SPACs are publicly listed blank-check entities that have no revenue or operations.[56] They actively seek operating businesses to merge with, and the targeted businesses become public companies as a result. This business combination is typically called a “de-SPAC process.” A SPAC has two years to find a target; otherwise the entity needs to dissolve and return funds to investors.[57]
After a record year of 613 SPAC initial public offering (IPO) issuances in 2021, there were only 86 in 2022 (less than 15% of the 2021 peak).[58] This also means a large number of SPACs will either need to find a target company to merge with or dissolve in 2023. The notice indicates that a complete liquidation is not subject to the repurchase tax, which applies to a SPAC that fails to find an operating partner. On the other hand, if a SPAC finds a merger target and the SPAC shareholders redeem their shares during the de-SPAC process, such non-liquidating redemptions will be subject to the buyback tax. However, as the newly-combined entity issues shares to complete the merger, the netting rule will apply and reduce the tax base.[59]
Conclusion
There are many reasons why firms may want to repurchase shares. While politicians and some researchers claim that stock buybacks are a tool that corporate executives manipulate to enrich themselves at the expense of shareholders, the preponderance of evidence does not support this view. Instead, buybacks are favored over dividend payments due to tax and financial advantages. The tax advantages stem largely from the deferral of tax payments on capital gains, with much of this advantage related to the avoidance of capital gains taxes at the time of death.
While it is easy to diagnose this advantage, it is difficult to implement an efficient solution as real and nominal changes in share values are hard to measure. Solutions that raise the cost of capital by taxing nominal gains will tend to lower investment and capital accumulation and may lead to a worse outcome than the current regime. Financial advantages are related to flexibility of share repurchases, investors’ views of changes in corporate dividend policy, and managing problems that arise from the separation of ownership and control.
The financial system should neither incentivize nor restrict the distribution of corporate profits to avoid problems related to trapped equity and misappropriated in failing companies. In addition, other tax policy issues are often interrelated with corporate financial policy. For example, major changes in the tax treatment of corporate profits held abroad have resulted in large flows of corporate cash back into the U.S. that have led to increases in corporate payouts in the last two decades.
It is important that we implement and maintain a well-coordinated tax system, including the taxation of individuals and corporations. We should abstain from using the tax system as a tool to solve regulatory issues related to other policy failures, such as potential linkages between stock buybacks and executive pay packages. Instead of imposing a stock buyback tax, we should look at broader tax reform that eliminates the taxation of dividends and gets rid of the double taxation of corporate income.
Endnotes
[1] The stock repurchase tax is included in Section 4501 of the Internal Revenue Code. See https://www.law.cornell.edu/uscode/text/26/4501.
[2] The Joint Committee on Taxation, “Estimated Budget Effects of the Revenue Provisions of Title I – Committee on Finance, of an Amendment in the Nature of a Substitute to H.R. 5376,” JCX-18-22, August 19, 2022, https://www.jct.gov/getattachment/efcca154-9fc1-4e72-83c0-d78b9e7372eb/x-18-22.pdf.
[3] Internal Revenue Service, Notice 2023-2: Initial Guidance Regarding the Application of the Excise Tax on Repurchases of Corporate Stock under Section 4501 of the Internal Revenue Code, December 27, 2022, https://www.irs.gov/pub/irs-drop/n-23-02.pdf.
[4] New York Times, “Full Transcript of Biden’s State of the Union Address,” February 8, 2023, https://www.nytimes.com/2023/02/08/us/politics/biden-state-of-the-union-transcript.html.
[5] Emphasis in the original. Warren Buffett, “Annual Letter to Berkshire Hathaway Shareholders,” February 25, 2023, https://www.berkshirehathaway.com/letters/2022ltr.pdf.
[6] The terms “stock buyback” and “share repurchase” (and similarly the variations “share buyback” and “stock repurchase”) are interchangeable.
[7] Liyu Zeng and Priscilla Luk, “Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market,” S&P Dow Jones Indices, March 2020, https://www.spglobal.com/spdji/en/documents/research/research-sp-examining-share-repurchases-and-the-sp-buyback-indices.pdf.
[8] Zeng and Luk in “Examining Share Repurchasing” describe the calculations as follows: “Only listed companies with fundamental data available in Compustat are calculated. Data as of fiscal year-end from 1980 to 2018. Dividend and buyback data may include the amount paid for preferred shares. Past performance is no guarantee of future results. Chart is provided for illustrative purposes.”
[9] Figure 2 also shows that share repurchases did not exceed dividends until 2004, as opposed to the late 1990s. The difference is related to the sample of firms used to produce the time series. For example, Figure 1 uses aggregate data and shows that buybacks exceeded dividends in 1997, while Figure 2 is based on S&P 500 companies only and shows that buybacks exceeded dividends in 2004.
[10] Zeng and Luk, “Examining Share Repurchasing.”
[11] Zeng and Luk, “Examining Share Repurchasing.”
[12] Jim Hsieh and Qinghai Wang, “Stock Repurchases: Theory and Evidence,” The Social Science Research Network, April 30, 2009, https://ssrn.com/abstract=1395943.
[13] William Lazonick, Mustafa Erdem Sakinç, and Matt Hopkins, “Why Stock Buybacks Are Dangerous for the Economy,” Harvard Business Review, January 7, 2020, https://hbr.org/2020/01/why-stock-buybacks-are-dangerous-for-the-economy.
[14] LBS News, “A New Major Study on Stock Buybacks,” London Business School, September 11, 2019, https://www.london.edu/news/share-buybacks-1680.
[15] PwC and Alex Edmans, “Share Repurchases, Executive Pay and Investment,” UK Department for Business, Energy & the Industrial Strategy, July 2019, bit.ly/3oixlvs.
[16] Jesse M. Fried and Charles C.Y. Wang, "Short-Termism and Capital Flows," Review of Corporate Finance Studies 8(1) (March 2019): 207–233, https://dash.harvard.edu/handle/1/30000680.
[17] Daniel J. Hemel and Gregg D. Polsky, “Taxing Buybacks,” Yale Journal on Regulation 38(1) (2021): 246–310, https://www.yalejreg.com/print/taxing-buybacks/.
[18] The term “shares outstanding” refers to a company’s stock currently held by all its shareholders. This includes share blocks held by institutional investors and restricted shares owned by company officers and insiders: https://www.investopedia.com/terms/o/outstandingshares.asp.
[19] Emphasis in the original. Buffett, “Annual Letter to Berkshire Hathaway Shareholders,” 2023.
[20] This is very similar to Table 1 in Hemel and Plosky, “Taxing Buybacks.”
[21] “Basis,” or “cost basis,” is the amount paid — the capital investment — for an asset: https://www.irs.gov/taxtopics/tc703.
[22] Step-up in basis refers to “the adjustment in the cost basis of an inherited asset to its fair market value on the date of the decedent’s death”: https://www.investopedia.com/terms/s/stepupinbasis.asp.
[23] John W. Diamond, “The Economic Effects of Proposed Changes to the Tax Treatment of Capital Gains,” Baker Institute Working Paper, October 27, 2021, https://www.bakerinstitute.org/research/economic-effects-proposed-changes-tax-treatment-capital-gains.
[24] Marvin Chirelstein, “Optional Redemptions and Optional Dividends: Taxing the Repurchase of Common Shares,” Yale Law Journal 78:(5) (1969): 739–756, https://www.jstor.org/stable/794989.
[25] Penn Wharton Budget Model, “The Excise Tax on Stock Repurchases: Effects on Shareholder Tax Burdens and Federal Revenues,” March 9, 2023, https://budgetmodel.wharton.upenn.edu/issues/2023/3/9/the-excise-tax-on-stock-repurchases-effects.
[26] Lazonick, Sakinç, and Hopkins, “Why Stock Buybacks Are Dangerous for the Economy.”
[27] William Lazonick, “Profits without Prosperity,” Harvard Business Review, September 2014, https://hbr.org/2014/09/profits-without-prosperity.
[28] Hemel and Polsky, “Taxing Buybacks.”
[29] Alex Edmans, “The Case for Stock Buybacks,” Harvard Business Review, September 15, 2017, https://hbr.org/2017/09/the-case-for-stock-buybacks.
[30] Burton G. Malkiel, “Biden’s Stock Buyback Tax Would Hit the Little Guy,” Wall Street Journal, February 12, 2023, https://www.wsj.com/articles/bidens-stock-buyback-tax-would-hit-the-little-guy-state-of-the-union-pension-savings-investment-retirement-mutual-fund-investor-e862a9a.
[31] Erica York, “Tax on Stock Buybacks a Misguided Way to Encourage Investment,” Tax Foundation, September 10, 2021, https://taxfoundation.org/tax-on-stock-buybacks/.
[32] Jesse M. Fried and Charles C.Y. Wang, “Are Buybacks Really Shortchanging Investment?” Harvard Business Review, March-April 2018, https://hbr.org/2018/03/are-buybacks-really-shortchanging-investment.
[33] Dhammika Dharmapala, C. Fritz Foley, and Kristin J. Forbes, “Watch What I Do, Not What I Say: The Unintended Consequences of the Homeland Investment Act,” The Journal of Finance 66(3) (May 2011):753–787, https://doi.org/10.1111/j.1540-6261.2011.01651.x.
[34] Thomas J. Brennan, “Where the Money Really Went: A New Understanding of the AJCA Tax Holiday,” Northwestern Law and Economics Research Paper No 13-35, April 21, 2014, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2312721.
[35] Tim Fernholz, “Why is Apple Borrowing Money to Pay Investors When It Has More Cash than Ever?” Yahoo! Finance, April 23, 2013, https://finance.yahoo.com/news/why-apple-borrowing-money-pay-000039137.html.
[36] Justin Pettit, “Is a Share Buyback Right for Your Company?” Harvard Business Review, April 2001, https://hbr.org/2001/04/is-a-share-buyback-right-for-your-company.
[37] Laura Davison, “Buyback Bonanza Could Fill Lag in Repurchase-Tax Effective Date,” Bloomberg Tax, August 6, 2022, https://www.bloomberg.com/news/articles/2022-08-06/buyback-bonanza-could-fill-lag-in-repurchase-tax-effective-date#xj4y7vzkg.
[38] Thornton Matheson and Thomas Brosy, “1% Buyback Tax Could Lead to Higher Dividend Payouts,” Tax Policy Center, December 20, 2021, https://www.taxpolicycenter.org/taxvox/1-buyback-tax-could-lead-higher-dividend-payouts.
[39] Pettit, “Is a Share Buyback Right for Your Company?”
[40] Pettit, “Is a Share Buyback Right for Your Company?”
[41] Specifically, the deductible business interest expense cannot exceed the sum of (a) taxpayer’s business interest income, (b) 30% of the adjusted taxable income, and (c) the taxpayer’s floor plan financing interest expense for the year. See IRS, “Basic Questions and Answers about the Limitation on the Deduction for Business Interest Expense,” June 17, 2022, https://www.irs.gov/newsroom/basic-questions-and-answers-about-the-limitation-on-the-deduction-for-business-interest-expense.
[42] Donald Marron, “Three Things You Should Know about the Buyback Furor,” Tax Policy Center, April 12, 2018, https://www.taxpolicycenter.org/taxvox/three-things-you-should-know-about-buyback-furor.
[43] Kate Dore, “There is a New 1% Tax on Stock Buybacks — Here’s What It Means for Your Portfolio,” CNBC, August 19, 2022, https://www.cnbc.com/2022/08/19/what-stock-buybacks-are-and-how-a-new-tax-affects-your-portfolio.html.
[44] Jeran Wittenstein, “Corporate America Buys Back Fewer Shares as Recession Fears Rise,” Bloomberg, December 14, 2022, https://www.bloomberg.com/news/articles/2022-12-14/corporate-america-buys-back-fewer-shares-as-recession-fears-rise.
[45] For redemption, see Section 317(b) of the Internal Revenue Code: http://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section317&num=0&edition=prelim.
[46] According to Notice 2023-2, split-off means “a distribution qualifying under §355 by a distributing corporation pursuant to which the shareholders of the distributing corporation exchange stock of the distributing corporation for stock of the controlled corporation and, if applicable, other property (including securities of the controlled corporation) or money.” §355 provides that if certain requirements are met, a corporation may distribute stock and securities in a controlled corporation to its shareholders and security holders without causing the distributees to recognize gain or loss. For Section 355, see https://www.irs.gov/pub/irs-drop/rr-03-79.pdf.
[47] For qualifying property exception, see Section 4501(e)(1) of the Internal Revenue Code: http://uscode.house.gov/view.xhtml?req=granuleid:USC-prelim-title26-section4501&num=0&edition=prelim.
[48] Example 11 of Notice 2023-2.
[49] Tax Notes Staff, “The New Excise Tax on Corporate Stock Buybacks,” Forbes, October 5, 2022, https://www.forbes.com/sites/taxnotes/2022/10/05/the-new-excise-tax-on-corporate-stock-buybacks/.
[50] PwC, “Classification of Preferred Stock,” Viewpoint, December 31, 2021, https://bit.ly/3q58njG.
[51] Naomi Jagoda and Michael Rapoport, “Tax Specialists Seek IRS Guidance on New Stock Buyback Tax,” Bloomberg Tax, August 18, 2022, https://news.bloombergtax.com/daily-tax-report/tax-specialists-seek-irs-guidance-on-new-stock-buyback-tax.
[52] Example 1 of Notice 2023-2: https://www.irs.gov/pub/irs-drop/n-23-02.pdf.
[53] Joyce Beebe, “Five Tax Considerations for Start-ups and Entrepreneurs,” Baker Institute Issue Brief, March 10, 2022, https://www.bakerinstitute.org/research/five-tax-considerations-for-start-up-companies-and-entrepreneurs.
[54] Examples 22 and 23 of Notice 2023-2: https://www.irs.gov/pub/irs-drop/n-23-02.pdf.
[55] This refers to Form 720. See https://www.irs.gov/pub/irs-pdf/f720.pdf.
[56] A blank check company is “a development stage company that has no specific business plan or purpose or has indicated its business plan is to engage in a merger or acquisition with an unidentified company or companies, other entity, or person:” https://www.investor.gov/introduction-investing/investing-basics/glossary/blank-check-company.
[57] Joyce Beebe, “SPACs and Select Tax Considerations,” Baker Institute Commentary, April 29, 2021, https://www.bakerinstitute.org/research/spacs-and-select-tax-considerations.
[58] SPAC Research, Active SPAC Summary, accessed January 15, 2023, https://www.spacresearch.com/.
[59] Michael Rapoport and Erin Slowey, “SPACs Win Small Respite under IRS Stock-Buyback Tax Guidance,” Bloomberg Tax, January 6, 2023.
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