Hours before President Joe Biden’s April 28 primetime pitch for $4.5 trillion in infrastructure and social spending, Apple (AAPL) wowed Wall Street with its own big-spending plan — $90 billion in Apple stock buybacks.
But Apple was hardly the first big company to use fat recent profits to repurchase shares from investors. Just a day before Apple’s news, Google parent Alphabet (GOOGL) teed up a $50 billion buyback. Among others, JPMorgan Chase (JPM) set plans to buy back $30 billion in shares.
“We’re buying back stock because our cup runneth over,” JPMorgan CEO Jamie Dimon told analysts April 14. “We’re earning a tremendous sum of money, and we really have no option right now.”
Yet a possible pitfall lies ahead. An under-the-radar proposal to tax stock buybacks as if they were dividends could reel in huge sums from investors, providing needed cash for Biden’s government expansion. That might quiet the stock buyback boom and weigh on foreign demand for U.S. equities. The approach to taxation also may stir controversy. It’s already taking flack for taxing “phantom income” and micromanaging corporate finances.
Biden Tax Hikes Aim At Elusive Target
Surging corporate cash flow offers a ripe target for Democrats. Biden’s American Jobs Plan and American Families Plan target corporate America and investment gains of the wealthy to raise nearly 75% of $3.4 trillion in proposed tax hikes over a decade, according to analyses by the Penn Wharton Budget Model.
Yet taxing corporate profits, either directly or through levies on stockholders, is proving more elusive than the White House may have expected.
- Democrats have no votes to spare in the Senate, and West Virginia Sen. Joe Manchin, a Democrat, has signaled he won’t back a corporate tax rate above 25% out of concern for U.S. competitiveness.
- Biden proposes to nearly double the tax rate on long-term capital gains and dividend income. But those increases would only fall on the one-fourth of U.S. corporate equity held by taxable U.S. investors. The higher rates wouldn’t apply to tax-advantaged retirement accounts, foreign investors, nonprofits and more.
- If dividends are hit with higher taxes, firms may direct more of their excess cash to stock buybacks and hold the line on dividend increases.
- Capital gains tax hikes will give investors an incentive not to sell shares, curtailing any near-term boost in tax revenue.
$5 In Apple Stock Buybacks Per $1 In Dividends
Corporate cash spent on buybacks buoys earnings per share by reducing share counts, contributing to higher stock prices. Stockholders who sell their shares back to the company may pay capital gains on the proceeds. For those who don’t redeem their shares, buybacks will result in a bigger capital-gains tax bill, but only when they sell their stock — if they sell.
That ability to defer taxes is likely the biggest reason that buybacks have become the preferred way of distributing capital to shareholders for many of America’s biggest and most successful companies.
Apple spent more than five times as much on Apple stock buybacks ($72.5 billion) in fiscal 2020 as it paid out in dividends ($14.1 billion).
Facebook‘s (FB) latest 10-K indicated that its board had authorized $33.6 billion in future FB stock buybacks. Yet Facebook executives said they “do not expect to declare or pay any cash dividends in the foreseeable future.”
Google has never paid a cash dividend. Warren Buffett’s Berkshire Hathaway (BRKB) hasn’t declared a dividend since 1967 but spent nearly $25 billion on buybacks last year. Meanwhile, Buffett has cheered on Apple stock buybacks as one of the iPhone maker’s top shareholders via Berkshire.
Stock-option compensation may factor into companies’ decisions. Grants of Apple stock options, for example, become more valuable as buybacks help push up the Apple stock price. Yet dividend payouts exclude option holders.
Buying back shares also sends a signal to investors. “We continue to believe there is great value in our stock,” CFO Luca Maestri said of the expanded Apple stock buyback program.
Up until the late 1990s, S&P 500 companies spent more on dividends than on buybacks. But in 2019, buybacks totaled $729 billion, 50% more than the $485 billion distributed as dividends.
Taxing Stock Buybacks Like Dividends
Now all that buyback cash is getting attention as a potential avenue to fund Biden’s spending plans.
The liberal Center on Budget and Policy Priorities last month highlighted a proposal to tax stock buybacks like dividends.
Chuck Marr, director of federal tax policy for the influential group, told IBD that the current “tax bias in favor of buybacks” could grow wider if Biden hikes the dividend tax rate. “It seems you should correct that flaw.”
The proposal, advanced this year by law professors Daniel Hemel of the University of Chicago and Gregg Polsky of the University of Georgia, could raise more than $500 billion over a decade, they “conservatively” estimate.
The estimated boost to tax revenue would rise to $700 billion if buybacks sustain their 2016-2020 pace. Including the Covid-depressed 2020 figure, the sum spent on buybacks has averaged about 2.65% of S&P 500 market value.
Their estimate assumes current-law dividend tax rates. If the rate rises, then taxing buybacks like dividends would raise even more.
Taxing Foreign Investors
The bulk of the extra revenue from taxing buybacks like dividends would come from foreign investors, including those who hold U.S. equities in low-tax havens, Hemel and Polsky say.
The share of publicly traded U.S. stocks held by foreigners has tripled to 30% since the late 1990s, according to Steve Rosenthal, senior fellow at the Urban-Brookings Tax Policy Center.
In Rosenthal’s view, “treating buybacks as dividends is more important than ever.”
Foreign investors don’t face U.S. taxes on capital gains, so the growth in buybacks can’t yield more tax revenue from this block of stock owners.
Yet they do face U.S. taxes on dividends, paying an average 17% rate that can vary based on tax treaty, or lack thereof. Those rates aren’t expected to change under Biden’s plan.
If foreigners are hit with dividend tax rates on buybacks, they may gradually shift some funds from U.S. equities, Hemel and Polsky suggest. That shift “would be potentially mitigated” by the ability of some investors to claim tax credits in their home countries for dividend taxes paid here, they write.
Part of the revenue raised, therefore, would come from shifting tax revenue to the U.S. from foreign countries. The U.S. might be seen as “siphoning off revenue from its overseas trading partners,” Hemel and Polsky write.
Taxing Stock Buybacks Gets At ‘Unrealized Stock Gains’
Taxing continuing shareholders upfront for buybacks rather than in the future as capital gains, also offers “a way of getting at unrealized stock gains” of America’s richest billionaires that may otherwise elude taxes until death, Marr said.
Biden has proposed ending the stepped-up basis rule that cancels capital-gains tax liability for shares passed to heirs at death. Without that change, Penn Wharton estimates that Biden’s big hike in the capital-gains tax rate would actually cost $33 billion in tax revenue over 10 years, as more investors hold for the long term to defer taxation.
Ending the step-up in basis would turn Biden’s capital-gains tax hike into a $113 billion revenue raiser over a decade. That’s still just a sliver of his $4.5 trillion spending plans.
Yet taxing buybacks like dividends would narrow the opportunity to defer taxes, because all capital distributions would be taxed immediately. That would produce a flood of revenue, partly by bringing forward some capital gains taxes that U.S. investors would otherwise pay in future decades.
Stock Buyback Politics
“From a substantive point of view and from a political perspective, it fits very well” with Democrats’ aims, said Marr, who used to analyze the impact of U.S. tax policy on financial markets for Lehman Brothers and Barclays.
So why have Wall Street policy handicappers overlooked the possibility of a buyback tax? As Hemel and Polsky explain, the “emerging anti-buyback movement” has focused on legal restrictions, not taxes.
Liberals’ criticism of stock buybacks reached new heights after the Trump tax cuts. Wisconsin Sen. Tammy Baldwin proposed an effective ban on open-market buybacks via repeal of a 1982 Securities and Exchange Commission rule that shields companies from charges of manipulating their share price.
Bernie Sanders, with Walmart (WMT) in mind, teamed with Senate Majority Leader Chuck Schumer on a 2019 proposal to make companies provide a $15 wage and week of paid sick leave before they could buy back shares.
Rubio Targeted Stock Buybacks In 2019
Still, the idea of taxing buybacks like dividends isn’t new. Yale Law School professor Marvin Chirelstein proposed it in 1969. In 2019, Sen. Marco Rubio unearthed the idea, sounding a similar note as Democrats.
The tax preference for buybacks “engineers (the) economy in favor of inflating prices of shares at the expense of future productivity & job creation,” the Florida Republican tweeted. Rubio previewed legislation that would tax buybacks like dividends, while boosting tax incentives for capital investment.
However, a review of 2018’s record $806 billion in buybacks by Goldman Sachs strategists David Kostin and Cole Hunter undercut Rubio’s contention. They found that the bulk of the nearly $300 billion increase in S&P 500 buybacks compared to the prior year came from just 10 firms. Apple stock buybacks led the way. Yet those same 10 firms invested 13% of sales in R&D and capex vs. 9% for the full S&P 500.
Hemel and Polsky likewise conclude that evidence “buybacks are cannibalizing productive investment is quite weak.”
Some scholars go further, saying buybacks aid U.S. economic dynamism. New York University finance professor Aswath Damodaran sees buybacks as “flexible dividends” that let relatively mature companies return excess cash to shareholders when they’re riding high. That frees up funds for investment in newer companies with better investment opportunities.
Option A: Taxing Stock Buybacks As ‘Phantom Income’
Rubio’s bill never materialized, perhaps because taxing stock buybacks like dividends presents serious challenges.
In Chirelstein’s proposal, “nonredeeming shareholders are deemed to have received cash dividends and then to have reinvested those dividends in the corporation,” Hemel and Polsky explain.
Shareholders who owe tax on the “deemed” dividend also would have their investment cost basis adjusted higher. Take a company with 1 billion shares conducting a $2-billion buyback.
Some shareholders would pay a dividend tax on that $2 per share and have their cost basis increased by that same $2 per share. That ensures the buyback won’t be taxed as both a dividend and later as a capital gain.
Still, aspects of the proposal may prove controversial.
As a shareholder, “I’m going to get a tax bill for a decision I did not make and income I didn’t receive,” Scott Clemons, chief investment strategist at Brown Brothers Harriman, told IBD. “You’ve now committed to tax phantom income. To me, that’s a real obstacle.”
Some investors might not have cash readily accessible to cover this tax on phantom income. U.S. corporations withhold taxes on dividends for foreign investors. Yet if a dividend is merely imputed, there would be no funds to withhold.
The Tax Policy Center’s Rosenthal thinks those complications are manageable. He notes that imputed interest on zero-coupon bonds is taxable, even for foreign investors. Yet investors looking to buy those discounted bonds know their interest liability in advance and can plan accordingly.
Option B: $3 In Dividends Per $7 In Stock Buybacks
In case those issues stand in the way of adoption, Hemel and Polsky devised a workaround. Yet their solution could have even bigger implications for future Google, Facebook and Apple stock buybacks.
In their proposal, companies would have to issue $3 in dividends for every $7 in stock buybacks. This would create real income out of phantom income.
Requiring at least 30% of capital distributions to be issued as cash dividends also would dispense with most investor liquidity issues. Foreign investors whose home countries don’t have a tax treaty with the U.S. pay a 30% rate.
Say a company pays out a $3 dividend per share while spending $7 per share to buy back stock. The company could then withhold the full $3 as a tax payment for the foreigner facing a 30% dividend rate.
That should “fully neutralize the phantom income objection,” Hemel and Polsky write.
Yet foreigners could face a 100% tax rate on the actual dividend they receive. For U.S. investors, the tax rate might exceed 100% — if they face the top 23.8% federal dividend tax rate, plus state rate that can approach double-digits or higher.
In the view of Doug Holtz-Eakin, president of the free-market-oriented American Action Forum, the proposal’s “heavy-handed” dividend mandate is even more troubling than taxing phantom income.
He sees the mandate to issue dividends as “micromanaging the financial policy of U.S. firms.”
From an S&P 500-wide perspective, requiring $3 in dividends for $7 in buybacks doesn’t look too onerous. In 2019, the split was about $4.70 in dividends per $7 in buybacks. But a closer look reveals a big potential impact.
What might it mean for Apple, based on last year’s $86.6 billion capital distribution? Nearly doubling its dividend to $26 billion and shrinking the Apple stock buyback by $12 billion, to $60.6 billion.
Instead of a $50 billion buyback, Google might only repurchase $35 billion of its stock and declare a $15 billion cash dividend.
After spurning dividends for a half-century, Warren Buffet’s Berkshire Hathaway might have to change course. Buffett’s $24.7 billion buyback in 2020 might need to be restructured in the future as a $7.4 billion dividend and $17.3 billion repurchase.
Option C: Excise Tax On Buybacks
Hemel and Polsky also note one more option: an excise tax, paid by the company. This idea, proposed by Harvard professor William Andrews in 1982, steers clear of imputing or mandating dividends.
Labor unions last year led a push for a 0.5% buyback tax in New York’s state legislature. That effort stalled amid concern about driving such transactions out of state.
Though worth considering for its simplicity, Polsky told IBD he sees an excise tax as “rough justice.”
An excise tax on buybacks would hit all investors proportionally, even those who only own stocks in their 401(k). The cost would come via lower share prices, Polsky said.
By contrast, taxing buybacks like dividends would primarily affect foreign investors and U.S. investors holding shares in taxable accounts.
How Would Excise Tax Impact Apple Stock?
A look at what an excise tax might mean for Google and Apple stock reveals the limits of this approach.
IBD finds that a 4% tax would negate any buyback-related rise in earnings per share for stocks with a forward price-earnings ratio of 25.
For Apple stock, with a slightly lower valuation, EPS would rise just 0.1% after a $90 billion buyback and $3.6 billion tax. That compares to a 4.5% EPS lift from a buyback with no excise tax. Spending all that cash for a negligible return might lower the price of Apple stock.
For Google, with a somewhat higher valuation, a $50 billion buyback and $2 billion tax would reduce EPS by 0.4%.
This suggests that even a 4% excise tax would be untenable — unless the goal is to stop most buybacks. Yet taxing buybacks like dividends should boost federal revenue by 7% of total spending on buybacks, Hemel and Polsky estimate.
An excise tax rate “low enough that companies suck it up and just pay it” would likely raise far less, Polsky said.
Taxing Buybacks Like Dividends: Impact On Apple Stock, Etc.
How would taxing buybacks like dividends impact Apple stock, Google, Berkshire Hathaway, and the overall stock market? That’s uncertain, and numerous Wall Street strategists contacted by IBD declined to weigh in on this hypothetical.
Yet there’s reason to think that the negative effect would be modest, if the dividend is imputed, and likely smaller than if the dividend is mandated.
Under either approach, investors who hold onto their shares would, as a group, face the same average effective tax rate as if they had simply received a dividend, diluting the buyback’s punch. IBD estimates that rate is close to 12.5%. That reflects an average 30% rate for taxable U.S. investors, including state taxes; a 16.8% rate for foreigners; a 10.5% rate for corporate holders of stock; and a 0% rate for everyone else.
That would reduce the amount of freed-up cash that the buyback injects into the stock market. Some of that liquidity would return over time, because the cost-basis adjustment would lower capital gains taxes.
On top of that, the mandated dividend approach would likely reduce buybacks for some companies, trimming their positive effect on earnings per share. From a broad stock market perspective, fewer buybacks might erode one reliable support for higher share prices. Year after year, with a few fleeting exceptions, net stock issuance has been negative, as buybacks exceed the value of new share offerings.
Warren Buffett’s Bigger Bite Of Apple Stock
In a February letter, Buffett explained that Berkshire stopped buying Apple stock in 2018, then sold $11 billion in Apple shares last year.
Yet, because of both Berkshire and Apple stock buybacks, he told shareholders, “you now indirectly own a full 10% more of Apple’s assets and future earnings than you did.”
“The math of repurchases grinds away slowly, but can be powerful over time.”
Buffett was no doubt preaching to the choir. Responding to a new ProPublica report showing how he and other billionaires limit their tax bills, Buffett, famed for his philanthropy as well as his stock-picking, wrote that Berkshire investors held a “50-to-1 vote against dividends.”
Please follow Jed Graham on Twitter @IBD_JGraham for coverage of economic policy and financial markets.
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