The market shrugged off Biden’s tax on buyouts. Will he regret it?

US President Joe Biden hands his pen to US Senator Joe Manchin (D-WV) as Senate Majority Leader Chuck Schumer (D-NY) and US House Majority Whip James Clyburn ( D-SC) look on after Biden signed “The Reducing Inflation Act of 2022” during a ceremony in the State Dining Room of the White House in Washington, August 16, 2022.

Leah Millis | Reuters

Former Securities and Exchange Commission Chairman Jay Clayton is not a fan of the new 1% tax on share 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 SEC chairman. As stocks posted their first weekly loss in five weeks last week, the market’s recent rally continued until the announcement that the 1% tax on redemptions had been incorporated into the reduction law. of President Biden’s inflation. The tax is half the 2% tax on buyouts that Congress had asked for when the legislation was previously attempted, and a far cry from legislation some Senate Democrats have proposed in recent years to ban the use to redemptions.

When the 2% tax was being considered, many CNBC CFO Council CFOs interviewed by CNBC indicated that the tax would influence their decision-making. More than half (55%) of US CFOs said a 2% stock buyback tax would cause their company to buy back fewer of their own shares, while 40% of US CFOs said a such a tax would have “no impact” on their buyout plans. .

For Clayton, changing the mindset of CFOs about the use of buybacks goes back to the more fundamental question of how US financial markets work. According to him, the tax goes against the idea of ​​the “free movement of capital” which has always been one of the greatest advantages of the American economic system. “Capital invested in new things, new ideas, is what has kept America number one in the world for raising capital,” he said.

The implementation of the tax against this concept worries Clayton. “I’m always worried about anything that puts a grain on the flow of capital,” he said.

One thing is clear: the ease of use of buyouts over the past decade has become critical to the flow of capital for businesses. Any change can therefore be significant.

“Many features of capital markets emerged in the context of stock buybacks being easy to do,” said Harvard Law School buyout expert Jesse Fried.

Buybacks, by removing shares from the total number of shares, serve to supplement equity compensation paid in shares, shares used for mergers and acquisitions, and shares issued to raise capital. All of these actions are dilutive for existing shareholders, and buybacks can offset this effect. This is one of the reasons why the new legislation allows companies to reduce their redemption tax based on the number of shares redeemed for specific business purposes.

Bruce Dravis, former chairman of the American Bar Association’s corporate governance committee, studied $1.23 trillion in buyouts at 60 Fortune 100 companies over ten years after the financial crisis. His research shows that on average:

  • Equity compensation – absent buyouts – would have increased the number of shares to dilute shareholders by 7.6% over the base year.
  • The dollar value of buyouts used to offset stock-based compensation dilution (“compensation buyouts”) constituted 36.9% of all buyouts, or just over one-third.
  • “Pure” buybacks (buybacks that reduced the number of shares beyond stock offset) accounted for 63.1% of all buyback expenses.

The opposing camps are firm in their positions — either buyouts are bad all the time, or taxes are always bad — but Dravis wrote in an email that he thinks Congress has done a reasonable job in acknowledging compensation. anti-dilutive that redemptions came to serve on the market. A 1% excise tax on “pure” redemptions in a company’s tax year – excluding offsetting redemptions, as well as certain other stock issues – tells Dravis that “Congress seems to have navigated well between the two camps with the IRA”.

Considering all the fees associated with buyouts, it’s not even certain that a 1% excise tax would affect companies’ willingness to do pure buyouts. “Companies that allow a pool of dollars for buybacks cannot determine the exact number of shares they will buy back – market volatility, financing costs or professional fees could eat up 1% or more of that money even without a 1% excise tax – and the dollars spent on buyouts still run into the hundreds of billions a year,” he wrote.

But Fried is worried about the future. He’s not an advocate of all buyouts — used for insider trading and by managers to boost bonuses through gambling revenue metrics — there are significant flaws, he said, but these defects can be corrected by regulations, from organizations like the SEC, rather than a tax. With the tax now in place, he suspects it will only increase in the future.

That’s because Fried is troubled by Senate Democrats’ view that companies are wasting money on buyouts that could be spent on better investments. “There are eight trillion dollars on the balance sheets of American companies,” he said, and he added that this amount had increased by several trillions of dollars in recent years amid record takeovers. “They don’t run out of money, they have too much,” Fried said.

Which leads him to view the risk of corporate overinvestment due to efforts to reduce capital flows to takeovers as being as important as takeover risk. Neither overinvesting nor hoarding cash is good for shareholders, he said.

“Over the past five years, leading Senate Democrats have introduced about a dozen bills to dramatically restrict or even eliminate buyouts,” Fried said. “They seem to think buyouts are a big source of trouble in the US economy. Given that mindset, when a Democratic-controlled White House and Congress are willing to raise taxes again, and assuming the Democrats have the power, they will likely use this buyout tax to gradually increase revenue.”

The more the buy-in tax increases, the more Fried thinks companies would end up getting even more bloated with money.

In the short term, according to Fried, the immediate problem with the buyout tax is one of timing: while new legislation provides compensation for buyouts for specific business purposes, companies don’t always time their dilutive stock offerings. and their anti-dilutive buybacks. in the same tax year. Equity compensation is one example. “Buybacks and issuances tied to the equity compensation cycle don’t always happen in the same year,” Fried said.

In fact, it can be difficult to ensure that these complementary measures align, as the compensation aspect depends on when employees decide to exercise their right to purchase restricted units and options. If they’re not already doing so, businesses will need to stay on top of outgoing actions in a tax year to ensure they can manage the new tax and get as much compensation as possible. But there’s a catch: CFOs may not want to buy back shares when their stock price is high, and that’s when employees are most likely to want to exercise their right to vest. actions.

Failure to manage this timing element could cause companies to reduce reliance on equity compensation, which in turn would potentially reduce reliance on buyouts. Fried said companies could look at additional financing options, such as issuing synthetic stock to employees. And there could even be, at least in theory, tax benefits from Congress’ new approach, with a decision to issue stock for business purposes as stock-based compensation that can serve as a 1% tax subsidy against redemptions. .

There has also been speculation it will end up being a banner year for takeovers as companies race to get ahead of when the legislation takes effect. And it’s already a record period for takeovers. In the past 12 months ending in June, corporate takeovers have been strong, approaching a record $1 trillion, according to S&P Global. That’s nearly double the $547 billion that companies have returned to shareholders in the form of dividends over the past 12 months.

For companies that have primarily repurchased shares just to reduce the number of shares and increase earnings per share without any trade compensation on the capital issuance side, 2022 should be the year of more repurchases, Fried said. .

But for the many companies that have used buybacks as part of offsetting dilutive stock issuances, he says we can’t know what the specific effects of the 1% buyback tax will be. What we do know, however, is this: “It’s unlikely that you can impose a tax and have no effect on behavior,” Fried said.

“Many companies issue shares in the same year they redeem the tax, which will reduce or eliminate the tax. But many companies’ redemptions exceed the issue and there will be a tax on that delta,” a- he declared.

Largest Total Redemptions, 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