There has been a huge debate over share repurchases lately. The most recent tax proposals by the democrats includes a tax on share repurchases. Why all the repurchase hate?
In my opinion, most of the repurchase hate stems from a misunderstanding of repurchases, what they do to share price, earnings, the nature of the company, etc. Many people who don’t like repurchase s simply either do not understand repurchases, or, chose to ignore what buy backs are.
What is the alternative to a buyback? If a company wants to get rid of the cash and hand it back to shareholders, the alternative is to pay more in dividends. Increasing a regular dividend is a pretty large commitment, so, I think it is most appropriate to think about the alternative to a repurchase as a special dividend. And, there are big tax differences between a special dividend and a share repurchase.
First, a share repurchase only imposes taxes on those that actually sell their shares. In an open market share repurchase, the firm buys shares from the open market, which means the person selling to the firm does not actually know they are selling to the firm. But, they do know they are selling, and, are affirmatively choosing to sell, and, pay taxes (if, indeed, they sell at a gain). Only people who want to pay taxes, and sell, pay taxes. The rest are allowed to just keep on holding their shares, and, not paying taxes (because you only pay taxes when you sell, for now).
Second, with a special dividend, public firm shareholders will generally pay taxes on the entire amount of the dividend. With a share repurchase, the person selling will generally pay taxes on the difference between the sale price, and their purchase price (their basis), if they had a gain. If they had no gain, they pay no taxes.
Let’s make this a little more real. Microsoft recently announced a $60 billion share repurchase plan. Bill Gates still holds some Microsoft stock. Let’s say about 1.3% of all Microsoft stock. Gates has generally not sold his shares, but, has given them away (a LOT of them). So, with a $60 billion share repurchase, Bill Gates will likely pay nothing in taxes. He is able to sit on the large amount of money he has, not realize any gains, and, those other shareholders who were likely going to sell their shares anyways will pay their taxes. And, they will only pay taxes on the extent that the market price when they sell exceeds their purchase price. So, much less than 100% of that $60 billion will get taxed. And, it is not clear what taxes are paid would not have been paid anyways by people who would have sold anyways.
Let’s say, instead, that Microsoft were to pay that $60 billion out as a special dividend. There is some precedent for this—in 2004, they paid out a $32 billion special dividend. A $60 billion special dividend would produce $60 billion in taxable dividends, for Bill Gates, taxed at the 20% dividend tax rate (let’s assume away the ACA Medicare tax). If 1.3% of that $60 billion divided were Bill’s, he would owe 1.3%*$60,000,000,000*20%, or, $156 million in tax. That’s a lot of money. Similar savings would also accrue to all the other Microsoft shareholders, the other 98.3%, to the extent they are taxable U.S. shareholders.
Now, these savings are not permanent, necessarily. Paying a dividend decreases stock price mechanically, so, if you sold, you would recoup some of that money, but, you lose the time value of money on those taxes paid. It gets complicated. There are other technical implications (effects on E&P, etc.). But, we generally think about a dividend versus a share repurchase in these terms: The repurchase does not force anyone to pay taxes, and, a dividend does. That is especially costly for those who were never really planning on selling their shares. Like Bill. And, while Bill is no longer calling the shots at Microsoft, Satya Nadella, the current CEO, would stand to lose something like .02%*$60,000,000,000*20%, which is still $2.4 million, just from the choice of a share repurchase versus a special dividend. Not nothing.
One large focus of tax policy these days, at least as practiced by some, is trying to solve the problem of wealthy shareholders being able to sit on appreciated shares and never having to pay taxes on them. Repurchases allow that phenomena to occur, while paying dividends does not. As a result, it should not be a surprise that share repurchases are getting more and more popular.
