How the New 1% Tax on Stock Buybacks Will Affect Businesses
Stock Buybacks: The What and the Why
When a company purchases shares of its own stock from the open market, it is referred to as a stock buyback or repurchase (often used interchangeably). The goal of a stock buyback is generally to raise the company’s stock price by taking shares out of circulation. Corporations can use this tactic to return value to their shareholders, as an alternative to paying dividends or otherwise distributing income to their shareholders. The Inflation Reduction Act (IRA) of 2022 introduced a new 1% excise tax on corporate stock buybacks, imposed on the aggregate fair market value (FMV) of stock repurchased by certain corporations during the taxable year (subject to adjustments). In this article, we'll go into the advantages and disadvantages of utilizing stock buybacks/repurchases generally, before discussing the new 1% stock buyback tax and its effect on businesses.
What are the Potential Advantages of Buybacks?
Favorable tax treatment: Individual shareholders might face a lower tax rate (i.e. 0%-20%) on both dividends and capital gains than ordinary income, which can be taxed at rates of up to 37%. However, the income tax on dividends is imposed on the entire dividend amount, whereas the capital gains tax is only on the sales price minus the original stock purchase price. This tax advantage means that the capital gains taxes can be lower for shareholders when a stock buyback occurs than when they receive dividends. In addition, unlike dividend payments, stock buybacks do not create an immediate taxable event for shareholders (except for the shareholders who sell their stock to corporations in the stock buybacks), but rather may increase their taxable capital gains that arise when they ultimately sell those shares. Foreign shareholders enjoy that tax advantage of having no US tax on capital gains, however dividends are subject to US tax at the rate of 30% (which may, or may not, be reduced or eliminated under relevant tax treaties). Foreign shareholders may be subject to foreign income taxes on the same income. On the other hand, if stock is held by tax-exempt entities and tax-favored accounts, such as pension funds, there will be no tax on either dividends or capital gains
Efficient allocation of excess cash: Companies with significant excess cash might find stock buybacks a way to efficiently allocate resources when there aren't enough profitable investment opportunities.
Earnings and control: Stock repurchases can boost earnings per share (EPS) and help companies defend against hostile takeovers. They can also offset dilution from stock-based compensation.
Financial flexibility: Unlike dividends, which are routinely paid out, stock buybacks provide more flexibility. Companies can decide when and how much stock to repurchase, offering an edge especially when stock prices are deemed undervalued.
What are the Potential Disadvantages of Buybacks?
Potential underinvestment: Excessive buybacks might mean companies forego investing in capital and research and development (R&D), or other growth opportunities, that might impact a corporation’s long-term health.
Debt financing: Some companies buy back stock using borrowed money, increasing their debt.
Executive enrichment: Executives might use buybacks to increase their bonuses that are based on increases in EPS (resulting from the reduced number of outstanding shares) or the value of their stock holdings.
The New 1% Excise Tax
The Inflation Reduction Act of 2022 introduced a 1% buyback excise tax that applies to the FMV of stock repurchased by publicly traded corporations, effective for repurchases after 31 December 2022. If the corporation issues stock to the public or to employees during the taxable year, the FMV of the issued stock reduces the taxable base. The new excise tax does not apply to:
- repurchases that are part of a tax-free reorganization;
- repurchases contributed to an employee pension plan, an employee stock ownership plan or other similar plans;
- repurchases of USD 1 million or less during the taxable year;
- purchases by a securities dealer in the ordinary course of business;
- repurchases by real estate investment trusts (REITs) or regulated investment companies (RICs); and
- repurchases that are treated as dividends for US federal income tax purposes.
Would the Excise Tax Efficiently Slow Buyback Activity?
The effect of the excise tax on corporate dividend pay-outs is expected to be minimal, given its 1% rate is relatively small compared to the top tax rate on dividends and capital gains, which stands at 23.8% (20% plus the 3.8% net investment income tax). A 2021 study by the Tax Policy Center estimated that the 1% excise tax - under our current tax system - would increase dividends paid by roughly 1.5%.
President Biden and Senators Brown and Wyden have proposed to increase the excise tax rate to 4% on publicly traded companies, which might have a more significant impact on the stock buyback trend. However, since the legislation is still in its early stages, it remains to be seen how this change might affect businesses.
Additional types of taxes
Excise taxes are indirect taxes on specific goods, services and activities. They are usually included in the price paid by the consumer and are often levied on items such as alcohol, tobacco and gasoline. In the context of foreign investors doing business in the United States, the 1% tax on buybacks is just one example of several excise taxes that could apply. Here are examples of additional taxes that could apply - depending on the specifics of the foreign investor's business activities in the United States.
Federal unemployment taxes:
A federal law that requires employers to pay unemployment taxes. Employees do not pay this tax or have it withheld from their pay;
Customs duties and import tariffs:
These are taxes imposed on goods imported into the United States. The rate of customs duty varies depending on the type of goods and where they are being imported from;
Excise taxes on insurance policies issued by foreign insurers:
Under US federal law, any policy of insurance or reinsurance issued by a foreign insurer is subject to an excise tax. The rate varies depending on the type of policy; and
Branch profits tax:
This is a tax imposed on foreign corporations engaged in a US trade or business, imposed in addition to any tax on income that is effectively connected to the conduct of the business. The branch profits tax is imposed at the time profits are remitted or deemed remitted outside the United States.