Four Things To Know About The New Excise Tax On Stock Buybacks

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tax notes Contributing editor Robert Golder breaks down the new excise tax on corporate stock buybacks in five minutes to the Inflation Reduction Act.

This transcript has been edited for length and clarity.

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President Joe Biden recently signed the Inflation Reduction Act (PL 117-169This includes various health care and clean energy provisions, but this video looks at one of the major tax provisions.

I’m Bob Golder, Together With Contributing Editor tax notes, In the next five minutes, we will explore the new excise duty on corporate stock buybacks.

What is stock buyback?

A buyback basically occurs when a corporation digs into its cash reserves and reclaims its own common stock. It does this by acquiring them in bulk from existing shareholders. The economic effect of these transactions is to increase the value of all shares of stock that he did not reclaim. They are more valuable because there are fewer of them.

Now, you may recognize this as what we call the “dividend equivalent.” The problem is that our income tax rules do not recognize this as an actual dividend because there is no direct cash payment to shareholders. What we get is a tax-induced bias in favor of buybacks and against dividends.

To really understand buybacks, you want to think about the concept of earnings per share. What buybacks do is they artificially increase that ratio. Those numerators shrink the denominator, the number of shares outstanding, without doing anything to the firm’s reported earnings.

The company’s position is not better after the buyback, but it looks prosperous just because they have increased that ratio.

Who Uses Buyback?

Well, buybacks used to be illegal. There was a time when virtually no one was using them. This changed in the early 80s when they were legalized.

Since then they have been caught. They have become very popular. Today, many large multinational corporations use them. firm like apple
Facebook, Google
The country’s largest users of share buybacks.

For the economy as a whole – the total amount of buybacks, it’s actually higher than the total amount of dividends, so it’s not too much to say that buybacks are slowly but surely replacing dividends.

Why should we pay tax on buybacks?

Some people think buybacks are a bad idea because they leave the company poor. They don’t have that much cash to do important things like making strategic investments. A real concern is that the company may miss the next big innovation because it squandered its cash in the form of share buybacks.

Accordingly, there are two different justifications for this type of excise duty. First, it basically penalizes the company for not spending its money more prudently. That’s why some Republicans like the idea, including Senator Marco Rubio of Florida. Senator Rubio did not vote for the Inflation Reduction Act, but he has supported the concept before.

The second premise of the tax is that it helps to address this distortion I mentioned earlier, where the income tax code favors buybacks relative to dividends. Arguably, this is not enough because the rate is so low. The rate is just 1 percent, and it probably needs to be higher to prevent corporations from doing buybacks and going back to making dividends.

How does the buyback tax work?

Well, the first thing you should know is that it is not an income tax; It is an excise tax. Its calculation is completely unrelated to the profitability of the firm.

What you do is that you look at the previous calendar year and you figure out how much money the company spent on its buybacks. You then subtract how many new shares of stock issued to the public or employees. This gives you a concept called its “pure repurchase”. Then you multiply that by the excise tax rate, which I said is just 1 percent, and that gives you your tax liability.

The tax only applies to publicly traded firms, so privately held organizations are off the hook. It also does not apply to real estate investment trusts or regulated investment companies. And this is going to be applicable on buybacks that happen after December 31 this year.

There you have it – everything you ever wanted to know about corporate stock buybacks in less than five minutes. thanks for watching.

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