Biden’s tax on share buybacks shrank the stock market. Will it regret it?

US President Joe Biden holds his pen as Senate Majority Leader Chuck Schumer (D-NY) and US House Majority Whip James Clyburn (D-SC) face US Senator Joe Manchin (D-WV). The Act of 2022 in Law during a ceremony at the State Dining Room of the White House on August 16, 2022 in Washington.

Leah Millis | Reuters

Former Securities and Exchange Commission chairman Jay Clayton isn’t a fan of the new 1% tax on stock buybacks.

“It’s a tax on shareholders,” Clayton recently told CNBC.

If so, shareholders have not shown the same level of concern as the former chairman of the SEC. While stocks posted their first weekly loss in five weeks last week, the recent market rally was continued through the announcement that a 1% tax on buybacks had replaced it in President Biden’s Inflation Reduction Act. This tax is half of the 2% tax on buybacks that Congress sought in a previous attempt to pass legislation, and a far cry from legislation proposed in recent years by some Senate Democrats to ban the use of buybacks.

When the 2% tax was being considered, many chief financial officers CNBC CFO Council The survey conducted by CNBC indicated that the tax would affect their decision making. More than half (55%) of US CFOs said that a 2% stock buyback tax would cause their company to buy back their own shares, while 40% of US CFOs said that such a tax would be imposed on their buyback plans. will have no effect”. ,

For Clayton, changing the CFO’s mindset on the use of buybacks becomes a more fundamental issue of how US capital markets work. In his view, the tax goes against the idea of ​​a “free flow of capital” which has always been one of the greatest benefits to the American economic system. “The capital that goes to new things, the new ideas, has given America the world leader in raising capital,” he said.

Clayton is concerned about taxing against this concept. “I’m always worried about anything that puts patience in the flow of capital,” he said.

One thing is clear: Ease of access to buybacks has become the core of the flow of capital for corporations over the past decade. Therefore, any change has the potential to be significant.

“Many features of the capital market have arisen in terms of making it easier to repurchase shares,” said Jesse Fried, a buyback specialist at Harvard Law School.

The buyback serves as a supplement to the equity compensation paid in stock, by removing the shares from the total number of shares, the shares used for M&A and the shares issued to raise capital. are vulnerable to all those verbs existing shareholders, and buybacks can offset that impact. This is one reason why the new law allows companies to reduce their buyback tax in relation to the number of shares bought back for specific business purposes.

Bruce Dravis, former chairman of the American Bar Association’s Corporate Governance Committee, studied $1.23 trillion buybacks in 60 Fortune 100 companies in the ten years following the financial crisis. Their research shows that on average:

  • Equity compensation — absent buyback — will increase the number of shares to be diluted to 7.6% to shareholders from the base year.
  • The dollar value of buybacks used to offset equity compensation dilution (“compensation buybacks”) was 36.9% of all buybacks — just over a third.
  • “Pure play” buybacks (buybacks that reduce the number of shares beyond offsetting equity compensation) represent 63.1% of all buyback expenses.

The opposing camp is firm on its position – either buybacks are bad all the time, or taxes are always bad – but Dravid wrote in an email that he thinks Congress did a fair job in recognizing the anti-dilutive offset The buyback has come. To serve the market. A 1% excise tax on “pure play” buybacks during a company’s tax year – excluding compensation buybacks, as well as some other stock issuances – calls Dravid a statement that “the Congress has done a good trade-off between the two camps with the IRA.” navigated the way.”

Considering all the charges associated with buybacks, he’s also not sure that a 1% excise duty will affect companies’ willingness to do pure-play buybacks. “Companies that authorize a pool of dollars to repurchase cannot pinpoint the exact number of shares they will repurchase – even without market volatility, financing fees or professional fees 1% excise tax on that cash. 1% or more – and the dollars devoted to buybacks still run into hundreds of billions a year,” he wrote.

But Fried is worried about the future. He is not the keeper of all buybacks — used for insider trading, and by managers to boost bonuses by gaming income metrics — with significant flaws, he said, but those flaws can be addressed by regulations, from bodies like the SEC, rather than a tax. With the tax now, he suspects it will only increase in the future.

That’s because Fried is upset with an idea from Senate Democrats who believe corporations are wasting cash on buybacks that could be spent on better investments. “American corporations have eight trillion dollars on their balance sheets,” he said, adding that the amount has increased by several trillion dollars in recent years amid record buybacks. “They don’t have a shortage of cash, they have a lot of cash,” Fried said.

Which leads them to see the risk of companies overinvesting as a result of efforts to reduce capital flows to buybacks as dominant as the risk from buybacks. He said neither over-investment nor hoarding of cash is good for the shareholders.

“Leading Senate Dems have introduced about ten bills over the past five years to substantially restrict or even eliminate buybacks,” Fried said. “They think buybacks are a significant source of problems in the American economy. Given that mindset, when a democratically controlled White House and Congress are ready to raise taxes again, and recognizing that Dems have power So, they will probably use this buyback tax to gradually increase revenue.”

The more buyback tax increases, the more Fried thinks companies will be even more bloated with cash.

In the short-term, Fried says the immediate problem with the buyback tax is one of timing: While the new law includes an offset for buybacks with specific business objectives, companies will always use their weak share offers and anti-dilutive buybacks. does not give time. in the same tax year. Equity compensation is an example. “The buybacks and issuances associated with the equity pay cycle do not always occur in the same year,” Fried said.

In fact, these complementary measures can be difficult to ensure because the compensation side of it depends on when employees decide to exercise their right to purchase restricted units and options. If they aren’t already doing so, companies will need to be on top of outgoing shares within one tax year to ensure they can manage the new tax and get as much offset as possible. . But there’s a catch: CFOs don’t want to buy back shares when their share price is high, and that’s when employees want to exercise their right to acquire shares.

An inability to manage this time element could prompt companies to reduce the use of equity pay, which in turn would potentially reduce the use of buybacks. Fried said companies may pursue additional financing options, such as issuing synthetic stock to employees. And at least theoretically, the new Congressional approach could also have tax benefits, with the decision to issue shares for business purposes such as equity compensation potentially acting as a tax subsidy of 1% against buybacks. Is.

There is also speculation that this will be a booming year for buybacks as companies rush to move ahead before the law takes effect. And that’s already a record period for buybacks. Corporate buybacks have been strong in the last 12 months ending June, Record close to $1 trillionAccording to S&P Global. That’s almost double the $547 billion corporations returned to shareholders in the form of dividends over the past 12 months.

Fried said that for companies that have bought back stock primarily to reduce share count and increase earnings per share without any business offset in favor of issuing capital, 2022 will be the year for more buybacks. should, Fried said.

But for many companies that have used buybacks in the context of issuance of weak shares, they say we can’t know what the specific effects of a 1% buyback tax would be. What we do know, however, is this: “It’s unlikely you can be taxed and have no effect on behavior,” Fried said.

“Many companies that issue equity in the same year do repurchase tax, which will reduce or eliminate the tax. But many companies issue repurchases more than issuance and that delta will be taxed,” he said.

Biggest total buybacks in the last 12 months:

  • Apple: $91.3 billion
  • Alphabet: $54.5 billion
  • Meta: $53.2 billion
  • Microsoft: $32.7 billion
  • Bank of America: $21 billion

Source: S&P Global