A last-minute modification to the Inflation Reduction Act of 2022 (H.R. 5376) resurrected a proposal to raise tax revenue from corporate stock repurchases. The provision is popular among Democratic lawmakers, but there is a lack of consensus among tax experts.
Background.
Companies can buy back their shares using surplus cash either from shareholders via a tender offer or on the open market. By doing so, the company reduces the total number of outstanding shares available for purchase and increases its per-stock value for shareholders, who are generally offered a buyback price preferable to the current market price.
This practice carries several advantages for a company. First, buybacks generally result in a quick boost to the stock’s value. Often, such a strategy indicates a company’s confidence that its stock is undervalued. Next, the company’s earnings per share increases because the number of outstanding shares is reduced, and the company’s price-to-earnings ratio improves.
Stock repurchases are often compared to dividend payouts, another common way companies conduct returns for shareholders. Ordinary dividends are taxed when the company distributes them to shareholders and are taxed as normal income. Qualified dividends, which meet the criteria to be taxed as capital gains, are taxed at rates of 20%, 15%, or 0% depending on income. Shareholders can choose whether to sell their stock back to the company in a repurchase, allowing a deferral of tax, unlike dividend payouts. If a shareholder does sell in a repurchase, they benefit from the lower capital gains rates, as the tax applies to profits from the sale.
Response to Trump-era tax cuts.
Buybacks exploded in popularity following the enactment of the Tax Cuts and Jobs Act of 2017, which enabled companies to have extra cash on hand as a result of a much lower corporate tax rate and other benefits. In 2018, $1 trillion was spent on corporate stock repurchases, much to the dismay of Democratic lawmakers, who were the minority party during the TCJA’s inception.
To answer, Democratic Sens. Ron Wyden of Oregon and Sherrod Brown of Ohio introduced the Stock Buyback Accountability Act in September 2021, which would have imposed a 2% excise on corporations when they buy back their stocks.
“Rather than investing in their workers, mega-corporations used the windfall from Republicans’ 2017 tax cuts to juice their stock prices and reward their wealthiest investors and their executives through massive stock buybacks,” Wyden said in announcing the bill. “Stock buybacks are currently heavily favored by the tax code, despite their skewed benefits for the very top and potential for insider game-playing.”
In the same statement, Brown echoed sentiments that stock buybacks only serve to further enrich the wealthy. “Instead of spending billions buying back stocks and handing out CEO bonuses, it’s past time Wall Street paid its fair share and reinvested more of that capital into the workers and communities who make those profits possible,” he said.
The proposal was initially included in President Joe Biden’s Build Back Better (BBB) framework, a once-$1.7 trillion legislative package featuring several revenue-generating tax provisions. The White House in a statement made similar arguments as Wyden and Brown, saying the surcharge on buybacks would apply to executives who “enrich themselves rather than investing workers and growing their businesses.” The stock repurchase excise tax rate was lowered to 1% and was present in the version of BBB that the House of Representatives passed in November 2021.
“Stock buybacks have long been a target of Democrats, who used them to attack the TCJA tax cuts for not creating more business investment,” the tax team at Grant Thornton stated. “Democrats also claim the policy intent behind the proposal is to equalize treatment of dividends and stock buybacks, both mechanisms for returning value to shareholders. Dividends are taxed, while stock buybacks increase share value but do not generally create tax until shares are sold.”
When Senate Democrats failed to secure the support of their colleague Sen. Joe Manchin of West Virginia, the BBB was stripped of many provisions in a monthslong rebrand to get centrists such as Manchin and Arizona Sen. Kyrsten Sinema on board. The buyback tax was among the casualties. Ahead of a vote earlier in August on what has been titled the Inflation Reduction Act of 2022—sporting the same bill number as the BBB—Democratic leaders faced a last-minute hitch. Sinema would vote in favor of the bill only if a proposal to rein in the so-called carried-interest loophole, whereby investment fund managers enjoy a hefty tax break, was removed.
With no choice but to capitulate, the carried-interest provision was replaced with the 1% corporate excise tax. Initially, the Joint Committee on Taxation estimated when the proposed tax was added to the BBB that it would generate $124 billion over 10 years. However, when the Inflation Reduction Act passed in the Senate, the JCT revised the projection downward to under $74 billion over the same period.
“This smaller gain may reflect the later effective date given large repurchases in 2022 and the possibility that companies will repurchase shares prior to the effective date,” the Congressional Research Service said. “A 1% tax is relatively small compared to the top tax rate on dividends and capital gains of 23.8% (20% plus the 3.8% net investment income tax).”
The Inflation Reduction Act version’s effective date is for repurchases of stock after December 31, 2022.
Legislative text.
The nondeductible stock repurchase excise tax language was lifted directly from the previous BBB version, sans the effective date. Specifically, it is imposed on U.S. “covered corporations” and is based on the value of the stock repurchased in a tax year. A covered corporation is a “domestic corporation the stock of which is traded on an established securities market.” A “repurchase” means a “redemption within the meaning” of Code Sec. 317(b) with regard to a covered corporation’s stock.
The Treasury Department can also apply this to any “economically similar” transaction.
Newly created Code Sec. 4501 also applies to a covered corporation’s specified affiliate, a subsidiary or partnership of which the covered corporation directly or indirectly owns 50% or more of the stock, capital interests, or profits interests held directly or indirectly. It also applies to certain U.S. subsidiaries of foreign-parented firms and surrogate foreign corporations under Code Sec. 7874(a)(2)(B).
There are several exclusions, such as when total stock repurchases are less than $1 million during the tax year, when repurchases are treated as dividends, when the repurchase is part of a Code Sec. 368(a) reorganization, and when repurchases are conducted by regulated investment companies or real estate investment trusts. See Checkpoint’s Executive Summary of the Inflation Reduction Act for more details on the proposal.
Treasury would be required to provide guidance on the tax’s calculation and to whom it applies. Martin Hamilton, partner at Proskauer Rose LLP, told Checkpoint that one area that should be addressed is “how to establish reasonable proxies for fair market value, similar to the guidance for determining the issue price of nontraded debt instruments issued for property.”
Hamilton said that although tracking fair market value of stock on the public market is straightforward, guidance is needed because “the statute clearly picks up classes of stock that may be thinly traded or that have been privately placed.”
More dividend payouts?
The Tax Policy Center estimated the tax would result in an uptick in dividend payouts of “roughly 1.5 percent” because “dividend distributions respond positively to increases in the relative taxation of capital gains.” The November 2021 blog post explained that share repurchases, which are subject to board approval and may lead to raises in executive compensation, follow short-term market trends.
“Since share buybacks help avoid investor-level taxation, the buyback tax is a reasonable way to reduce their tax advantage,” co-authors Thornton Matheson and Thomas Brosy concluded.
Steve Rosenthal, a senior fellow at the Tax Policy Center, told Checkpoint after the bill’s Senate passage that the think tank still expects the balance to “shift more toward dividends.”
“A separate question is whether corporations will retain more of their earnings, rather than distribute them (either as buybacks or dividends),” Rosenthal said. “Politicians argue that the buyback tax will encourage corporations to invest in their plants and equipment and their workers … but I believe if corporations have extra cash, they will distribute it.”
Martin agreed that “it seems very possible” corporations will begin to favor cash dividends and reduce buybacks. Such programs, he said, “now incur a tax cost that is effectively paid by the remaining shareholders and not by the participants in the buyback.” Conversely, corporations that decide to pay cash dividends pro rata will only be able to do so to the extent they have free cash” for that purpose.
Howard Wagner, a partner in tax services at Crowe LLP, is more reluctant, telling Checkpoint that “the decision to pay higher dividends or do share buybacks is driven by multiple market considerations.” Acknowledging that while one would think that there be a shift in corporate behavior, he said the “new excise tax will now become a component of that analysis for public companies as they make those decisions.”
Industry response.
Other tax experts from firms and policy groups have weighed in since last fall when the buyback tax was added to the BBB framework and to the Inflation Reduction Act. The Institute on Taxation and Economic Policy expressed their support and urged Congress to keep it. “Corporations have increasingly used stock buyback initiatives to benefit their shareholders while avoiding the income taxes that would apply to dividend distributions that are functionally equivalent,” the group wrote, adding that “at best, it will shift investor preferences enough to curb the runaway growth of stock buybacks.”
The proposal has its detractors. Upon the Stock Buyback Accountability Act’s rollout, Erica York, senior economist at the Tax Foundation, said an excise tax is “an inappropriate policy because stock buybacks do not create a negative externality that requires an excise tax to internalize, nor is there an argument for a user fee to apply to stock buybacks.” According to York, lawmakers concerned about “corporate short-termism” should look beyond just stock buybacks and focus on “root causes” such as executive pay and quarterly earnings reporting.
There are shared thoughts among practitioners at major firms that the definition of repurchase is far-reaching and could potentially extend to transactions unrelated to stock buybacks. The legislative language “economically similar” could prove complicated absent Treasury clarification. Martin said that, for example, this could affect “a variety of routine transactions involving preferred stock” and merger-and-acquisition activity.
“The definition as drafted in the statute is certainly quite broad,” he added.
Wagner said “it remains to be seen” how Treasury will use its authority to extend the repurchase definition to other corporate transactions.
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