Companies Shift Profits to High Net Worth Investors Tax-Free – A Share Buyback Tax Would Change That – ITEP

Last night, Senate Democrats announced a deal on the Inflation Reduction Act which, among other changes to a previous version of the bill, would apply a 1% tax on corporations buying back their own shares. This proposal was included in the Build Back Better Act passed by the House last year and was estimated at the time to be worth $124 billion over 10 years (see an earlier ITEP analysis of this proposal here). This measure would ensure that income transferred from corporations to wealthy shareholders does not continue to escape tax.

Share buybacks, like dividends, are a tool that companies use to give income to their shareholders because they have decided that the money has more value outside the company rather than being reinvested. in the business. Where dividends achieve this by giving money directly to their shareholders, share buybacks work indirectly. When a company reduces the number of its shares outstanding in the market through a stock buyback initiative, it increases the value per share for the remaining shareholders. (As explained in the previous ITEP analysis, the relationship between share buybacks and shareholder value is not always one-to-one, but it is almost always positive.)

However, share buybacks are not taxed like dividends, which creates a investor preference for share buyback initiatives rather than cash dividends. Dividends are taxed as they are distributed, and for most investors and stocks they are taxed at a rate of 15-20% (15-30% for foreign investors). However, share redemptions do not create an immediate taxable event, but rather increase the taxable capital gains investors will pay when they sell those shares.

The problem is that these capital gains are often never taxed at all. If the owner of the shares keeps his shares, he will not be taxed, because his gains are considered “unrealized”. Whether or not their earnings are realized, their ability to buy things – what economists and normal people would call Income-increased. And if they pass on their stock holdings to their heirs, the capital gains will never be taxed at all, benefiting from the base-increasing rule.

If an investor benefiting from a repurchase of shares of a company does not reside in the United States, they may not pay anything on their capital gains. Foreign investors (who own about 40 percent shares of U.S. corporations) are not subject to the federal personal income tax that would apply to their realized gains if they resided in the United States. The federal government, however, taxes dividends paid to foreign investors at rates ranging from 15 to 30%. If the capital gains rate in their home country is very low, there can be considerable tax savings for share buybacks compared to dividend distributions.

The Senate Democrats’ proposal would apply a 1% excise tax to corporations when they buy their own stock. While this would certainly mark progress in ensuring that wealthy investors pay something on the appreciation of their assets, it is not clear to what extent this would put the tax treatment (and therefore investor preferences) for dividends and share buybacks on an equal footing.

The 1% rate is obviously much lower than the rate for most dividends. As explained in the ITEP analysis of the proposal included in the Build Back Better Act, the stock redemption tax should be closer to 12% to achieve tax parity with the dividend tax in terms of revenue collection .

On the other hand, the stock redemption tax is mechanically quite different from the dividend tax, decreasing the after-tax income of the company rather than the after-tax income of its shareholders. About 35% of US corporate stock owners are non-taxable accounts, mostly retirement accounts. These shareholders are not affected by dividend taxes, but would pay some of the tax on share redemptions through the value of their shares. These shareholders would unambiguously prefer dividend distributions to buyback programs with this excise tax in place.

Congress should pass this provision now. Corporations are increasingly using stock buyback initiatives to benefit their shareholders while avoiding the income taxes that would apply to functionally equivalent dividend distributions. In the first year following the Republicans tax reform bill of 2017, companies bought up a $1 trillion record in their own actions. This provision by Senate Democrats would at the very least hamper the ability of companies to engage in completely tax-free stock buybacks. And at best, it will change investor preferences enough to curb the meteoric rise in share buybacks.

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