Stock Market

The market shrugged at Biden’s tax on buybacks. Will it regret that?

U.S. President Joe Biden holds out his pen to U.S. Senator Joe Manchin (D-WV) as Senate Majority Leader Chuck Schumer (D-NY) and U.S. House Majority Whip James Clyburn (D-SC) look on after Biden signed “The Inflation Reduction Act of 2022” into law during a ceremony in the State Dining Room of the White House in Washington, August 16, 2022.

Leah Millis | Reuters

Former Securities and Exchange Commission chairman Jay Clayton isn’t a fan of the new 1% tax on stock buybacks.

“It is a tax on shareholders,” Clayton recently told CNBC.

If so, shareholders haven’t shown the same level of concern as the former SEC chairman. While stocks did post their first weekly loss in five weeks last week, the recent market rally had continued right through the announcement that the 1% tax on buybacks had made it into President Biden’s Inflation Reduction Act. The tax is half the 2% tax on buybacks that Congress had sought in the previous attempt to pass the legislation, and a far cry from legislation proposed by some Senate Democrats in recent years to ban the use of buybacks.

When the 2% tax was being considered, many chief financial officers on the CNBC CFO Council surveyed by CNBC indicated the tax would influence their decision making. Over half (55%) of U.S. CFOs said a 2% stock buyback tax would cause their company to buy back less of their own shares, while 40% of U.S. CFOs said that such a tax would have “no impact” on their buyback plans.

For Clayton, altering the mindset of CFOs on use of buybacks gets to the more fundamental issue of how the U.S. capital markets work. In his view, the tax goes against the idea of the “free flow of capital” which has always been one of the biggest advantages for the U.S. economic system. “Capital going to new things, new ideas, is what has kept America the leading place in the world to raise capital,” he said.

Setting the tax against this concept has Clayton worried. “I’m always worried about anything that puts grit in the flow of capital,” he said.

One thing is clear: the ease of using buybacks over the past decade has become core to the flow of capital for corporations. Any change, therefore, has the potential to be significant.

“Many features of the capital markets have arisen in the context of share repurchases being easy to do,” said Jesse Fried, an expert on buybacks at Harvard Law School. 

Buybacks, by taking shares out of the total share count, serve as a complement to equity compensation paid in stock, shares used for M&A, and shares issued to raise capital. All of those actions are dilutive to existing shareholders, and buybacks can offset that effect. That’s one of the reasons that the new legislation allows companies to reduce their buyback tax in relation to the number of shares bought back for specific business purposes.

Bruce Dravis, past chair of the American Bar Association’s corporate governance committee, studied $1.23 trillion of buybacks in 60 Fortune 100 companies over ten years post-financial crisis. His research shows that, on average:

  • Equity compensation — absent buybacks — would have increased share count to dilute shareholders by 7.6% from the base year.
  • The dollar value of buybacks used to offset equity compensation dilution (“compensation buybacks”) constituted 36.9% of all buybacks — just over one third.
  • “Pure play” buybacks (buybacks that reduced share count beyond offsetting equity compensation) represented 63.1% of all buyback spending.

The opposing camps are firm in their positions — either buybacks are bad all of the time, or taxes are always bad — but Dravis wrote in an email that he thinks Congress has done a reasonable job in recognizing the anti-dilutive offset that buybacks have come to serve in the market. A 1% excise tax on “pure play” buybacks during a company’s tax year — excluding compensation buybacks, as well as certain other share issuances – says to Dravis that “Congress seems to have navigated nicely between both camps with the IRA.” 

When taking all of the fees associated with buybacks into account, he isn’t even sure that a 1% excise tax would affect the willingness of companies to do pure-play buybacks. “Companies that authorize a pool of dollars for buybacks can’t pinpoint the exact number of shares they will repurchase — market volatility, financing fees or professional fees could eat up 1% or more of that cash even without a 1% excise tax — and the dollars devoted to buybacks nonetheless run to hundreds of billions annually,” he wrote.  

But Fried is worried about the future. He is not a defender of all buybacks — used for insider trading, and by managers to boost bonuses by gaming earnings metrics — there are significant flaws, he said, but those flaws can be addressed by regulations, from bodies like the SEC, rather than a tax. With the tax now in place, he suspects it will only increase in the future. 

That’s because Fried is troubled by a view among Senate Democrats that holds corporations are wasting cash on buybacks that could be spent on better investments. “There is eight-trillion dollars on the balance sheets of American corporations” he said, and he added that amount has increased by several trillions of dollars in recent years amid record buybacks. “They don’t have a lack of cash, they have too much cash,” Fried said.

Which leads him to see the risk of companies overinvesting as a result of efforts to reduce capital flows to buybacks as being as prominent as the risk from buybacks. Neither overinvestment or hoarding of cash is good for shareholders, he said.

“Leading Senate Dems have over the last five years introduced about ten bills to substantially restrict or even eliminate buybacks,” Fried said. “They seem to think buybacks are an important source of problems in the American economy. Given that mindset, when a Democratically controlled White House and Congress is ready to raise taxes again, and assuming Dems have power, they will likely use this buyback tax to incrementally raise revenue.”

The more the buyback tax grows, the more Fried thinks companies would end up becoming even more bloated with cash.

In the short-term, Fried says the immediate problem with the buyback tax is one of timing: while the new legislation includes an offset for buybacks with a specific business purposes, companies don’t always time their dilutive share offers and anti-dilutive buybacks in the same tax year. Equity compensation is one example. “Repurchases and issuances connected to the equity pay cycle don’t always take place in the same year,” Fried said. 

In fact, it can be hard to make sure these complementary measures line up because the compensation side of it depends on when employees decide to exercise their right to buy restricted units and options. If they aren’t doing so already, companies will need to stay on top of shares going out within a tax year to make sure they take can manage the new tax and achieve as much of the offset as they can. But there’s a catch: CFOs may not want to buy back shares when their stock price is high, and that’s when employees are most likely to want to exercise their right to acquire shares. 

Inability to manage this timing element could lead companies to reduce the use of equity pay, which would in turn potentially reduce the use of buybacks. Fried said companies might pursue additional financing options, such as issuing synthetic stock to employees. And there could even, at least theoretically, be tax benefits of the new Congressional approach, with a decision to issue shares for business purposes like equity compensation potentially serving as a tax subsidy of 1% against buybacks.

There’s also been speculation this will end up being a boom year for buybacks as companies rush to get ahead of the legislation becoming effective. And it is already a record period for buybacks. In the last 12 months ending in June, corporate buybacks have been strong, nearing a record $1 trillion, according to S&P Global. That is almost twice the $547 billion corporations returned to shareholders as dividends in the last 12 months.

For companies that have predominantly bought back stock purely to reduce share count and increase earnings per share without any business offset on the side of issuing capital, 2022 should be the year for more buybacks, Fried said.

But for the many companies that have used buybacks in the context of offsetting dilutive share issuances, he says we can’t know what the specific effects of 1% buyback tax will be. What we do know, though, is this: “It’s unlikely you can impose a tax and have no effect on behavior,” Fried said. 

“Many companies issue equity in the same year they repurchase tax, which will reduce or eliminate the tax. But many companies’ repurchases exceed issuance and there will be tax on that delta,” he said.

 Largest total buybacks, last 12 months:

  • Apple: $91.3 billion
  • Alphabet: $54.5 billion
  • Meta: $53.2 billion
  • Microsoft: $32.7 billion
  • Bank of America: $21 billion

Source: S&P Global

 

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