Yale scholars on tax treatment of stock buybacks

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dodecahedron
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Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 11:50 am

Two Yale researchers, Wanling Su from the law school and Rahul Goravara from the business school, have posted an article on SSRN stating that tax law (as passed by Congress and interpreted in the federal courts) actually calls for stock buybacks to be treated as the substantial equivalent of dividends in most cases. The only exception, according to Congress, would be cases where the stock buyback changes the interest of a noncontrolling shareholder by more than 20% (which, of course, would be rare.) Otherwise, stock buybacks legally are supposed to get the same tax treatment as dividends. Courts have agreed with this interpretation, but the IRS has apparently not been enforcing this rule.

SSRN: What is a dividend

Taxprof: Most stock buybacks should be treated as dividends
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TOJ
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Re: Yale scholars on tax treatment of stock buybacks

Post by TOJ » Wed Jun 08, 2016 11:53 am

Interesting. I wonder if we also should pay the IRS money whenever the county says our house went up in value.

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dodecahedron
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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 12:08 pm

TOJ wrote:Interesting. I wonder if we also should pay the IRS money whenever the county says our house went up in value.
I fail to see the parallel with your analogy. Congress did not enact a law stating that unrealized capital gains on stock are taxable. Rather, Congress simply enacted a law stating that companies that do stock buybacks are generally making taxable distributions to their shareholders in the amount of the buyback (except in the rare case where such a buyback changes the interest of a noncontrolling shareholder by more than 20%).

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Re: Yale scholars on tax treatment of stock buybacks

Post by Chip » Wed Jun 08, 2016 12:22 pm

Would this also mean that if a company issues new equity it is a "negative dividend"?

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Re: Yale scholars on tax treatment of stock buybacks

Post by avalpert » Wed Jun 08, 2016 12:32 pm

I don't see how this is actionable so I assume this thread will be locked.

The most interesting implication here is the power the executive branch has through the IRS to thwart Congressional actions, but only to the benefit of taxpayers.

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Re: Yale scholars on tax treatment of stock buybacks

Post by qwertyjazz » Wed Jun 08, 2016 12:38 pm

From a non-lawyer and someone who realizes to learn personal finance needs to know more law
I think the issue is one of precedence - maybe wrong term - laws beat IRS decisions
If IRS changes their minds, would they go back or only make the change going forward?

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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 12:40 pm

Chip wrote:Would this also mean that if a company issues new equity it is a "negative dividend"?
When a company issues new equity, it seems generally likely to change the ownership interest of at least one noncontrolling shareholder by more than 20%, e.g., when a brand new shareholder enters the scene or at least a few existing shareholders substantially increase their holdings, while others remain the same, so I think this law would rarely come into play when companies issue new equity.

It seems clear that the original intent of Congress in passing the law in the first place was to prevent corporations from doing an end-run around the taxation of dividends by doing stock buybacks. Why the IRS has chosen not to enforce this provision of tax law in the past is unclear, but it does seem that if the IRS chooses to enforce the provision in the future, the courts will uphold it.

As far as actionable, this is relevant to those making decisions about tax efficient investments. Companies that make heavy use of stock buybacks could be less tax efficient than previously assumed if the IRS chooses to enforce existing provisions of tax law in the future.

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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 12:44 pm

qwertyjazz wrote:From a non-lawyer and someone who realizes to learn personal finance needs to know more law
I think the issue is one of precedence - maybe wrong term - laws beat IRS decisions
If IRS changes their minds, would they go back or only make the change going forward?
As a practical matter, I would guess they would not go backwards. In any case, the statute of limitations would restrict their ability to go back more than three years.

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Re: Yale scholars on tax treatment of stock buybacks

Post by synpacket » Wed Jun 08, 2016 12:59 pm

I don't really get it. It seems like you'd be paying taxes on an unrealized increase in value. Similar to TOJ's analogy, they may as well tax unrealized capital gains.

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Re: Yale scholars on tax treatment of stock buybacks

Post by inbox788 » Wed Jun 08, 2016 1:04 pm

The issue isn't so clear cut.
The Tax Code defines a dividend as “any distribution of property made by a corporation to its shareholders.” Corporations found a way around this definition and thus the dividend tax. It involves buying back their own stock. A buyback can act like a dividend in substance, distributing cash to shareholders without changing anyone’s stake in the corporation.
An outright dividend is a cash distribution, but a buyback isn't. There is the hysteresis effect, which alters when the distribution is truly recognized and who receives the distribution. A dividend of 1% is every shareholder receiving 1% or a penny for every dollar in cash as dividend. A buyback is 1% of shareholders receiving 100% cash. If you tax both sales of buyback (which is already done) as well as all the remaining shareholders who receive the benefit of the buyback (which you will when they sell and not now), isn't this somehow double taxation? And even if it were not, how would the accounting be handled by the shareholders and IRS? Tracking and reporting would be a nightmare worse than tracking dividends.
Chip wrote:Would this also mean that if a company issues new equity it is a "negative dividend"?
Good question. Since a company may issue stock for employees incentives, would paying for employees stock instead of buy back be treated any differently? Or should it?

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Re: Yale scholars on tax treatment of stock buybacks

Post by ralph124cf » Wed Jun 08, 2016 1:05 pm

As a practical matter it would seem very hard if not impossible to identify who sold stock to the company versus sold it to somebody else if this was a normal transaction using a broker. My understanding is that in general most stock buybacks do not exceed 1% of the trading in a given stock on any trading day to avoid moving the market excessively.

I agree that this is non-actionable, and the thread will probably be locked shortly.

Ralph

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Re: Yale scholars on tax treatment of stock buybacks

Post by qwertyjazz » Wed Jun 08, 2016 1:14 pm

Why couldn't the IRS take the cost of the buyback divide it by the number of shares prior to the buyback and say every owner prior owes that amount?

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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 1:18 pm

ralph124cf wrote:As a practical matter it would seem very hard if not impossible to identify who sold stock to the company versus sold it to somebody else if this was a normal transaction using a broker. My understanding is that in general most stock buybacks do not exceed 1% of the trading in a given stock on any trading day to avoid moving the market excessively.

I agree that this is non-actionable, and the thread will probably be locked shortly.

Ralph
I agree there are some practical enforcement issues (especially if enforced retroactively) but there are ways the IRS could implement this if they choose to enforce the law. If and when the IRS does begin enforcing the law, the article implies that buybacks will essentially dry up and be pointless. Again, as far as actionable, anyone who is choosing to invest in stocks or sectors where buybacks have historically provided tax efficiency advantages due to regular buyback policies can't count on those continuing in the future.

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Re: Yale scholars on tax treatment of stock buybacks

Post by dkturner » Wed Jun 08, 2016 1:24 pm

In practice how would this taxation work? I can understand the system if a shareholder tenders shares directly to the issuer, but how would it work if a company simply buys back its stock at random on the open market?

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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 1:25 pm

synpacket wrote:I don't really get it. It seems like you'd be paying taxes on an unrealized increase in value. Similar to TOJ's analogy, they may as well tax unrealized capital gains.
No, you would not be paying taxes on unrealized capital gains, rather you would be paying taxes based on the company's explicit decision to distribute some of its cash back to its shareholders in an indirect way designed to reduce taxes. So the amount of tax you would pay would have nothing to do with the unrealized capital gain, it would have to do with the amount of cash the company spent on the buyback. (They might or might not be equal in value, depending on what else is going on.)

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Re: Yale scholars on tax treatment of stock buybacks

Post by BolderBoy » Wed Jun 08, 2016 1:33 pm

ralph124cf wrote:I agree that this is non-actionable, and the thread will probably be locked shortly.
Then let me make it actionable by saying that I need some education.

"The Company" has $100k in cash sitting around (they may have already paid taxes on this net profit). The Company decides to try to buy back some of its stock. They find willing sellers of the stock who are desirous of selling their shares for a capital gain, a capital loss or to break even. The buying & selling is done. The company is now showing $100k less on its books (in cash) and $100k more on its books (in stock value). That seems like a net change of zero.

What would there be to tax, since the net gain is -0-?

Sure, the company could have distributed the $100k to its shareholders as dividends, but there is generally no requirement to do so. So isn't the declaration that a stock buyback = dividend distribution akin to punishing a company for being profitable, self-sustaining, job producing and the like?

Put another way, isn't the company simply another player in the stock trading arena?

Inquiring minds want to know...
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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 1:36 pm

Also, the SSRN article has some interesting discussion on the always interesting topic of "Why do companies issue dividends, anyway?" question. One fascinating fact cited that I did not know is that only 10% of regular dividends are reinvested in the company that issued them.

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Re: Yale scholars on tax treatment of stock buybacks

Post by Da5id » Wed Jun 08, 2016 1:38 pm

BolderBoy wrote:
ralph124cf wrote:I agree that this is non-actionable, and the thread will probably be locked shortly.
Then let me make it actionable by saying that I need some education.

"The Company" has $100k in cash sitting around (they may have already paid taxes on this net profit). The Company decides to try to buy back some of its stock. They find willing sellers of the stock who are desirous of selling their shares for a capital gain, a capital loss or to break even. The buying & selling is done. The company is now showing $100k less on its books (in cash) and $100k more on its books (in stock value). That seems like a net change of zero.

What would there be to tax, since the net gain is -0-?

Sure, the company could have distributed the $100k to its shareholders as dividends, but there is generally no requirement to do so. So isn't the declaration that a stock buyback = dividend distribution akin to punishing a company for being profitable, self-sustaining, job producing and the like?

Put another way, isn't the company simply another player in the stock trading arena?

Inquiring minds want to know...
Good question. But why stop with buybacks? If BRK buys some shares of Amex or Coca Cola, as it is wont to do rather than pay dividends, why is that fundamentally different than buying back its own stock?

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Re: Yale scholars on tax treatment of stock buybacks

Post by avalpert » Wed Jun 08, 2016 1:59 pm

dodecahedron wrote:
ralph124cf wrote:As a practical matter it would seem very hard if not impossible to identify who sold stock to the company versus sold it to somebody else if this was a normal transaction using a broker. My understanding is that in general most stock buybacks do not exceed 1% of the trading in a given stock on any trading day to avoid moving the market excessively.

I agree that this is non-actionable, and the thread will probably be locked shortly.

Ralph
I agree there are some practical enforcement issues (especially if enforced retroactively) but there are ways the IRS could implement this if they choose to enforce the law. If and when the IRS does begin enforcing the law, the article implies that buybacks will essentially dry up and be pointless. Again, as far as actionable, anyone who is choosing to invest in stocks or sectors where buybacks have historically provided tax efficiency advantages due to regular buyback policies can't count on those continuing in the future.
Well sure they can't count on it continuing - they also can't count on capital gains rates not going to 45% and there 401ks not being taken by the government to pay chinese investors in a mexican wall building scheme.

But in general around here the rule is we don't discuss theoretical policy changes - particularly ones that no one is actually suggesting be made.

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Re: Yale scholars on tax treatment of stock buybacks

Post by qwertyjazz » Wed Jun 08, 2016 2:04 pm

Back to not being a lawyer
But the difference between this and theory is per the blog this is the law of the land
Congress wrote it - President signed it etc.

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Re: Yale scholars on tax treatment of stock buybacks

Post by avalpert » Wed Jun 08, 2016 2:11 pm

qwertyjazz wrote:Back to not being a lawyer
But the difference between this and theory is per the blog this is the law of the land
Congress wrote it - President signed it etc.
And the IRS implements it. Whether the way the IRS implements it is correct, when it isn't challengable in court, is a theoretical discussion.

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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 2:21 pm

qwertyjazz wrote:Back to not being a lawyer
But the difference between this and theory is per the blog this is the law of the land
Congress wrote it - President signed it etc.
Indeed it is the law of the land and has been in place since 1976 and the federal courts have confirmed it in all cases that have brought the matter to their attention, but many past discussion threads in this forum on the dividend puzzle have ignored the law and suggested that companies wanting to be more tax efficient should simply do stock buybacks rather than pay dividends, not realizing that the only reason this avoids taxes is that the IRS has chosen not to enforce this existing law.
avalpert wrote: And the IRS implements it. Whether the way the IRS implements it is correct, when it isn't challengable in court, is a theoretical discussion.
If people were advising others on this forum to invest in businesses that do a lot of small cash transactions that go untaxed because the IRS has chosen not to track those and enforce the law, would that be a theoretical discussion?
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Re: Yale scholars on tax treatment of stock buybacks

Post by qwertyjazz » Wed Jun 08, 2016 2:22 pm

So one way this is actionable is as a teaching lesson - how often does the IRS follow a higher level? What are the risks you take when they disagree? How should you look at the difference? (avoiding the political of what should happen) so in effect a civic lesson as these kind of situations of difference at the different levels will continue to occur

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Re: Yale scholars on tax treatment of stock buybacks

Post by avalpert » Wed Jun 08, 2016 2:38 pm

dodecahedron wrote:
avalpert wrote: And the IRS implements it. Whether the way the IRS implements it is correct, when it isn't challengable in court, is a theoretical discussion.
If people were advising others on this forum to invest in businesses that do a lot of small cash transactions that go untaxed because the IRS has chosen not to track those and enforce the law, would that be a theoretical discussion?
No, that would be promoting tax fraud which is also frowned upon in this forum.

The IRS hasn't merely chosen to look the other way, they have provided explicit guidance. When they choose to revoke that guidance that would be the time to talk about the impact for investment choices - ahead of that it is equal to speculating on whether congress will confiscate your IRA.

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Re: Yale scholars on tax treatment of stock buybacks

Post by dodecahedron » Wed Jun 08, 2016 2:54 pm

avalpert wrote: The IRS hasn't merely chosen to look the other way, they have provided explicit guidance.
I agree that's a relevant distinction, though I think the many threads on this forum where people are treating buybacks and dividends as substantially different from a tax point of view would do well to acknowledge the relative fragility of the authority for their position.

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Re: Yale scholars on tax treatment of stock buybacks

Post by Da5id » Wed Jun 08, 2016 3:00 pm

dodecahedron wrote: I agree that's a relevant distinction, though I think the many threads on this forum where people are treating buybacks and dividends as substantially different from a tax point of view would do well to acknowledge the relative fragility of the authority for their position.
Hmm. Existing practice has gone on a while, doesn't seem that fragile. And it also is changeable instantaneously. e.g. company A does dividends. Rules change to make taxation worse on dividends (say qualified becomes same as ordinary income). Company A board votes to switch to buybacks. Company B does buybacks, rules being discussed here change to make buybacks taxable as qualified divs or ordinary income, Company B board votes to switch to dividends. Or to offshoring profits. Or to buying shares of a different company (which doesn't seem taxable if I understand the issue, which points out the perhaps unintuitive incentives tax policies can provide).

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Re: Yale scholars on tax treatment of stock buybacks

Post by qwertyjazz » Wed Jun 08, 2016 3:21 pm

Where this becomes an issue is when for whatever reason the dividends are sticky - for an individual company not much of an issue given statue of limitations of 3 years - strangely actionable for me as I was thinking about using dividend stock ETF as art of a Complicated TLH strategy - shifting the likelihood over time of such an ETF with a possible change in IRS rules gives an increased non zero risk of it disappearing and large sudden capital gains risk - as I was not that wedded to the idea to begin with - this effectively kills the idea

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Re: Yale scholars on tax treatment of stock buybacks

Post by TJSI » Wed Jun 08, 2016 4:02 pm

When a company executes a buyback someone or some entity sells their stock. That is a taxable event. If a capital gain, the piper gets paid.

For the non-participating stockholders they may see their stock go up in price or if the market things it was a mistake, they may see their stock price go down. Price changes so far are not taxable. The value of the stock surrendered by selling stockholders is often forgotten in the analysis of buybacks.


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Re: Yale scholars on tax treatment of stock buybacks

Post by dmcmahon » Wed Jun 08, 2016 4:32 pm

ralph124cf wrote:As a practical matter it would seem very hard if not impossible to identify who sold stock to the company versus sold it to somebody else if this was a normal transaction using a broker. My understanding is that in general most stock buybacks do not exceed 1% of the trading in a given stock on any trading day to avoid moving the market excessively.

I agree that this is non-actionable, and the thread will probably be locked shortly.

Ralph


Well, but if the buyback reduced the number of shares outstanding, that means that as a group shareholders sold stock to the company. This means that some shareholders are going to pay cap gains taxes on the shares. If you now turn around and try to hit up the rest of them who didn't sell, it seems like you're taxing the same distribution twice.

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