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A Different Way to Tax Stock Buybacks

Posted on Nov. 22, 2021
Reuven S. Avi-Yonah
Reuven S. Avi-Yonah

Reuven S. Avi-Yonah is the Irwin I. Cohn Professor of Law at the University of Michigan. He thanks Gregg Polsky for his helpful comments.

In this article, Avi-Yonah reviews the Build Back Better Act, which would impose a 1 percent excise tax on corporate stock buybacks. He argues that while the measure is an effective way to raise revenue from high-income taxpayers, it will not address the main tax problem with buybacks: the tax exemption for foreign shareholders, which Congress should reconsider.

Copyright 2021 Reuven S. Avi-Yonah.
All rights reserved.

The Build Back Better Act (H.R. 5376) pending in the House contains a provision championed by Democratic senators Sherrod Brown of Ohio and Ron Wyden of Oregon that would impose a 1 percent excise tax on corporate stock buybacks. As explained in the House Rules Committee summary:

The provision imposes a 1 percent excise tax on [a] publicly traded U.S. corporation for the value of any of its stock that is repurchased by the corporation during the taxable year. The term repurchase means a redemption within the meaning of section 317(b) with regard to the stock of such corporation, and any other economically similar transaction as determined by the Secretary of Treasury.

The amount of repurchases subject to the tax is reduced by the value of any new issuance to the public and stock issued to the employees of the corporation.

A subsidiary of a publicly traded U.S. corporation that performs the buyback for its parent or a U.S. subsidiary of a foreign corporation that buys back its parent’s stock is subject to the excise tax.

The provision excludes certain repurchases from the excise tax to the extent: 1) the repurchase is part of a tax-free reorganization; 2) the repurchased stock or its value is contributed to an employee pension plan, [employee stock ownership plan], or similar plan; 3) the total amount of stock repurchases within the year is less than $1 million; 4) the purchase is by a dealer in securities in the ordinary course of business; 5) the repurchase is treated as a dividend; and 6) the repurchase is by a [regulated investment company] or [real estate investment trust].

The provision provides authority for Treasury to issue guidance necessary or appropriate to administer and to prevent the avoidance of the purposes of this section.

The provision applies to repurchases of stock after December 31, 2021.

The rationale for that provision is not so much the tax consequences of stock buybacks but rather the corporate governance and fairness implications. As Brown and Wyden explained in a September release unveiling their legislation:

“A few decades ago, a majority of Wall Street capital funded the real economy — wages, machinery, research, new construction. Today, much of that capital is funneled back to wealthy executives in the form of stock buybacks — which used to be illegal market manipulation — and only about 15 percent goes to the real economy. Instead of spending billions buying back stocks and handing out CEO bonuses, it’s past time Wall Street paid its fair share and reinvested more of that capital into the workers and communities who make those profits possible,” said Brown.

“Rather than investing in their workers, mega-corporations used the windfall from Republicans’ 2017 tax cuts to juice their stock prices and reward their wealthiest investors and their executives through massive stock buybacks,” said Wyden. “Even as millions of families struggled through the pandemic, corporate stock buybacks are once-again nearing all-time highs. Stock buybacks are currently heavily favored by the tax code, despite their skewed benefits for the very top and potential for insider game-playing. Our bill simply ends this preferential treatment and encourages mega-corporations to invest in their workers.”

For many years stock buybacks were nearly banned due to the market-manipulation risk they presented. Today, serious concerns remain about corporations using stock buybacks to inflate their stock prices, particularly when corporate insiders have significant amounts of stock-based compensation themselves.

After the 2017 Republican tax law, instead of higher job growth or a GDP surge, we saw corporations spending hundreds of billions of dollars buying back their own stock. The big winners were rich shareholders, CEOs, and foreign entities, not American workers.

It seems unlikely that the excise tax will deter buybacks, although it will, precisely for that reason, raise revenue. This article does not discuss the nontax implications of buybacks,1 focusing instead on their major tax problem, which is the effect not on taxable U.S. shareholders but on foreign shareholders. The proposed excise tax is not likely to resolve that problem, but there is a better solution: Treat stock buybacks as dividends for foreign shareholders.

The Problem With Buybacks

For a publicly traded corporation, buybacks always permit shareholders who sell their shares to the corporation to achieve capital gains treatment because other shareholders will not participate, so the redemption test of section 302(b)(2) will be met.

That result has two main consequences in the post-2003 era when the tax rates on dividends and capital gains were equalized: For taxable U.S. individuals, it permits basis recovery sooner rather than later, and for foreign shareholders, it avoids tax altogether.2

The basis recovery issue has been the focus of important work since Marvin A. Chirelstein’s classic 1969 article.3 In 2009 Ethan Yale proposed an elegant solution of allowing basis recovery for dividends as well, while not taxing nonparticipating shareholders.4 Daniel J. Hemel and Gregg D. Polsky have focused on non-redeeming shareholders (such as corporate founders), arguing they should be taxed.5

In my view, the problem is not significant enough to warrant major reform. Among U.S. shareholders, tax-exempt entities, which account for a large portion of U.S. shareholders, are indifferent between dividends and capital gains treatment, while corporations usually prefer dividends because of the dividends received deduction. For taxable U.S. individual shareholders (a dwindling segment of all shareholders), since the rate equalization, the issue is only basis recovery, which is a question of timing.6

Hemel and Polsky argue that a major problem with buybacks is the ability of founders like Mark Zuckerberg to avoid selling, thereby enhancing their ownership with no tax cost. They endorse Chirelstein’s approach (discussed below) because it involves a tax on all shareholders, not just participating ones.

But the issue involves much more than stock buybacks and should be addressed with broader solutions, such as the proposed billionaire’s mark-to-market tax (if that cannot pass for political reasons, neither can the approach preferred by Hemel and Polsky, which also involves deemed realizations). The focus should be on the more serious problem of foreign shareholders (including Americans pretending to be foreigners), because it involves the ability to escape taxation altogether. Foreign shareholders are generally not subject to tax on capital gains, but they are subject to withholding tax on dividends. That has been suggested as the explanation for the recent sharp rise in buybacks, because hedge funds based in tax havens and other foreign investors own a large percentage of U.S. equities.7 Most of that activity is likely not reported to tax authorities in residence countries and therefore represents illegal tax evasion along the lines unveiled in the Panama, Paradise, and Pandora Papers. Some of it also involves illegal tax evasion by U.S. citizens and residents.8

Buybacks as Dividends for Foreign Shareholders

The disparate treatment of dividends and buybacks has received much academic attention since 1969, when Chirelstein pointed out that economically, those items (as well as other capital gains) are identical because they rely on the same underlying corporate income (a capital gain represents an increase in the present value of future corporate income). He therefore proposed treating buybacks and dividends the same by treating each buyback as a hypothetical pro rata dividend to all shareholders followed by a sale of stock from participating to nonparticipating shareholders. Hemel and Polsky have endorsed that approach, with modifications.9

Yale’s proposal treats dividends as buybacks by allowing basis recovery on dividends, instead of treating buybacks as dividends (the Chirelstein approach).10

Finally, George K. Yin has proposed equalizing dividends and buybacks by imposing a corporate-level tax on all distributions.11

However, none of those proposals effectively addresses the main problem of foreign shareholders but they all involve highly complicated ways to solve the lesser problem of domestic shareholders (of course, before 2003 the domestic problem was much more acute, which justified Chirelstein and Yin’s concern).

Chirelstein does not address foreign shareholders (they barely existed in 1969), but the problem with his proposal is that you cannot withhold on the hypothetical dividend to nonparticipating shareholders. Hemel and Polsky address that, but their proposed solution involves forcing corporations to pay cash dividends every time they execute a buyback, which seems a large interference with board discretion.12

Yale acknowledges that with foreign shareholders, withholding agents would have no idea what the basis was but would need to know it to assign part of it to a dividend.13

Yin solves the problem by applying his tax to all distributions to both foreign and domestic shareholders, but that would require overriding all U.S. tax treaties because the tax will not distinguish between shareholders resident in treaty partner countries and those in tax havens.

Each proposal is complex and involves rewriting a substantial part of subchapter C of the code.14

I propose instead focusing on the foreign part of the problem by stating in sections 871 and 881 that the term “dividend” includes the amount paid by a corporation to redeem its own stock and would therefore be subject to withholding tax of 30 percent (or lower as prescribed by a treaty). That definition should carry over into existing treaties under U.S. model article 3(2) (incorporating definitions under domestic law) without the need for amendment or override. It is also consistent with the position of several U.S. treaty partners that treat all corporate distributions as dividends for treaty purposes (such as the United Kingdom and China).

To understand the logic of my proposal, it is useful to ask why the United States does not tax the capital gains of foreigners. Formally, the answer is that those gains are foreign-source income, but that is clearly dissatisfactory because the gains are economically equivalent to U.S.-source dividends.

The real answer — as usual when fixed, determinable, annual, and periodic income is concerned — is administrative necessity: The United States cannot impose a withholding tax on sales of U.S. corporate shares between foreign shareholders, but it can tax dividends. If that is the reason, however, the no-tax rule should not apply to buybacks because withholding is as easy for them as it is for dividends.15 Nor should basis recovery be allowed (except for complete terminations) because it makes the withholding agent’s life too complicated.16

Even though my proposal applies only to foreign shareholders, it is nondiscriminatory because the underlying problem of not taxing capital gains applies only to foreign shareholders, so they are not in a comparable situation to U.S. shareholders.

Conclusion

The Build Back Better Act is a good way to raise revenue from high-wealth individuals, so it should be applauded. But its proposed rate is too low to deter buybacks, which raise tax evasion concerns for foreigners and for Americans pretending to be foreigners. Therefore, the IRC should be amended to treat buybacks from foreign shareholders as dividends subject to withholding tax.

FOOTNOTES

1 For discussion, see Daniel J. Hemel and Gregg D. Polsky, “Equalizing the Tax Treatment of Stock Buybacks and Dividends,” University of Chicago P.L. Working Paper No. 771 (Apr. 15, 2021); Hemel and Polsky, “There’s a Problem With Buybacks, but It’s Not What Senators Think,” Tax Notes, Feb. 18, 2019, p. 765; and Hemel and Polsky, “Taxing Buybacks,” 38 Yale J. Reg. 246 (2021).

2 For U.S. corporations, the preference is less clear, and tax-exempt organizations are indifferent. See Hemel and Polsky, “Taxing Buybacks,” supra note 1.

3 Chirelstein, “Optional Redemptions and Optional Dividends: Taxing the Repurchase of Common Shares,” 78 Yale L.J. 739 (1969).

4 Yale, “Corporate Distributions Tax Reform: Exploring the Alternatives,” 29 Va. Tax Rev. 329, 353 (2009).

5 Hemel and Polsky, “Taxing Buybacks,” supra note 1.

6 There are issues other than basis recovery in allowing some shareholders to participate but others not to. Buybacks allow discrimination because corporations can await dividends and recent heirs can sell to maximize their tax positions. High-basis malcontents sell out, and happy shareholders with low basis do not. That discrimination is the tax advantage on top of the use of basis. See section 305(b)(2) (dividend treatment when stock dividend results in the receipt of property by some shareholders and an increase in the proportionate interest of other shareholders). Those issues require a broader rewrite than what is proposed here. Thanks to Calvin H. Johnson for his insight on this topic.

7 Reuven S. Avi-Yonah, “The Redemption Puzzle,” University of Michigan P.L. Working Paper No. 213 (June 30, 2010).

8 See Avi-Yonah, “What Goes Around Comes Around: Why the U.S. Is Responsible for Capital Flight (and What It Can Do About It),” Michigan P.L. Research Paper No. 307 (Jan. 23, 2013).

9 Hemel and Polsky, “Taxing Buybacks,” supra note 1.

10 Yale, supra note 4.

11 Yin, “A Different Approach to the Taxation of Corporate Distributions: Theory and Implementation of a Uniform Corporate-Level Distributions Tax,” 78 Geo. L.J. 1837, 1849-1852 (1990).

12 Hemel and Polsky, “Taxing Buybacks,” supra note 1:

Our own view is that a legal requirement that corporations pay $0.43 in cash dividends for every $1 of share buybacks would fully neutralize the phantom income objection to Chirelstein’s proposal. More precisely, the requirement would be that the ratio of cash dividends to buybacks be equal to t/(1 - t), where t represents the highest applicable tax rate on dividends. While such a requirement would constrain corporations in their choice of form for cash distributions, the constraint seems minor given that every economic outcome that can be achieved through buybacks also can be attained through a mix of buybacks and cash dividends.

13 Yale, supra note 4.

14 For an excellent proposal for that rewrite, see Bret Wells, “Reform of Corporate Distributions in Subchapter C,” 37 Va. Tax Rev. 365 (2018).

15 Tax should also apply to the sale of controlling interests, as it does in many countries, because the buyer will want the shares registered in its name and therefore will withhold. See Avi-Yonah, “Money on the Table: Why the U.S. Should Tax Inbound Capital Gains,” Michigan P.L. Working Paper No. 239 (June 3, 2011).

16 In complete terminations, shareholders should be allowed to apply for refunds by showing their bases, but it seems unlikely many will do so, given that they are probably guilty of tax evasion — applying for the refund will give the IRS information it can share with their residence countries.

END FOOTNOTES

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