The market shrugged at Biden’s repurchase tax. Will it regret?

Former chairman of the Securities and Exchange Commission, Jay Clayton is no lover of the new 1% tax on stock buybacks.

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

If so, shareholders have not shown the same level of interest as the former SEC chairman. While stocks fell for the first week in five weeks last week, the market’s recent rally continued shortly after the announcement that a 1% tax on repurchases was introduced into the Inflation Reduction Act. from President Biden. The tax is half the 2% tax on acquisitions that Congress sought in an earlier attempt to pass the law, and is a far cry from legislation proposed by some Senate Democrats in recent years. recent years to ban the use of buybacks.

When the 2% tax rate is being considered, many CFOs on CNBC CFO Council survey by CNBC shows that taxes will influence their decision-making. More than half (55%) of US CFOs said a 2% share buyback tax would cause their company to buy back fewer of their own shares, while 40% of US CFOs said such a tax would ” no impact” on their acquisition plans. .

For Clayton, changing the mindset of CFOs about using buybacks becomes a more fundamental issue of how U.S. capital markets work. In his view, taxes go against the idea of ​​”free capital” that has always been one of the biggest advantages to the American economic system. “The capital that goes to new things, to new ideas, is what has kept the United States at the forefront of the world in terms of funding,” he said.

Clayton worries about imposing tariffs against the concept. “I am always worried about anything that impedes capital flow,” he said.

It is clear that the ease of use of acquisitions over the past decade has become at the core of capital flows for corporations. Therefore, any change is likely to be significant.

“Many capital market features arose in the context of share buybacks becoming easy,” said Jesse Fried, an expert on buybacks at Harvard Law School.

Buybacks, by taking stock out of the total number of shares, act as a supplement to equity compensation paid in shares, shares used for mergers and acquisitions, and stock repurchases. bonds issued to raise capital. All of those actions weaken existing shareholdersand acquisitions can offset that effect. That’s one of the reasons that the new law allows companies to reduce the buyback tax associated with the number of shares repurchased for specific business purposes.

Bruce Dravis, past chairman of the corporate governance committee of the American Bar Association, studied $1.23 trillion in acquisitions by 60 Fortune 100 companies in the ten years following the financial crisis. main. His research shows that on average:

• The equity offset – no buyback – would likely increase the number of shares to dilute shareholders by 7.6% over the base year.
• The dollar value of buybacks used to offset dilution of equity offset (“compensation buybacks”) accounted for 36.9% of total acquisitions – just over a third.
• “Pure” buybacks (repurchases that reduce the number of shares in addition to offsetting the equity premium) accounted for 63.1% of total buyback spending.

Oppositions have been firm in their position – either acquisitions are always bad, or taxes are always bad – but Dravis wrote in an email that he thinks Congress has done a fair job in recognizing it. The anti-dilution offset that the acquisition has come to serve in the market. A 1% excise tax on “pure play” buybacks during a company’s tax year – excluding compensatory buybacks, as well as certain other stock issues – tells Dravis that “Congress seems to have navigated well between both camps with the IRA.”

Taking into account all the fees associated with acquisitions, he’s not even sure that a 1% excise tax would affect companies’ pure willingness to buy back. “Companies that authorize a pool of dollars for redemption cannot pinpoint the exact number of shares they will repurchase – market volatility, financing or expertise fees may account for 1% or more than that cash even without the 1% excise tax – and he wrote.

But Fried is worried about the future. He’s not a custodian of all buybacks – used for insider trading and by regulators to boost bonuses with game earnings metrics – there are significant flaws , he said, but those flaws can be addressed with regulations, from agencies like the SEC, rather than taxes. With the tax already in place, he thinks it will only increase in the future.

That’s because Fried is troubled by the view among Senate Democrats that corporations are wasting cash on acquisitions that could be spent on better investments. “There are eight trillion dollars on the balance sheets of American corporations,” he said, adding that that amount has grown by several trillion dollars in recent years amid record acquisitions. . “They’re not short of cash, they’ve got too much cash,” says Fried.

This made him realize that the risk of companies overinvesting in efforts to reduce capital outflows for acquisitions was just as prominent as the risk from acquisitions. Neither overinvesting nor hoarding cash is good for shareholders, he said.

“Top Senate members over the past five years have introduced about 10 bills to significantly limit or even eliminate buybacks,” Fried said. “They seem to think that buybacks are an important source of problems in the US economy. With that in mind, when the White House and Democratic-controlled Congress are ready to raise taxes again, and let’s say Dems have power, they will probably use this acquisition tax to gradually raise revenue.”

The higher the acquisition tax, the more Fried thought that companies would eventually become more money.

In the short term, Fried said the immediate problem with the acquisition tax is a matter of timing: while the new law includes compensation for business-specific acquisitions, companies do not always up to the time of the dilution stock offering and anti-dilution repurchase. in the same tax year. Equity compensation is an example. “Repurchases and issues related to the equity payout cycle do not always happen in the same year,” says Fried.

In practice, it is difficult to be certain that these additional measures are compatible with each other because its compensation aspect depends on when the employee decides to exercise the option to buy the units and the restricted option. . If they haven’t already done so, companies will need to update the amount of stock that is about to expire in a tax year to ensure that they can manage the new tax rate and achieve as much offset as possible. But there’s a catch: CFOs may not want to buy back shares when their stock prices are high, and that’s when employees are most likely to want to exercise their stock options.

The inability to manage this time factor can cause companies to reduce their use of equity, which in turn will potentially reduce the use of buybacks. Fried said companies can pursue additional financing options, such as issuing aggregate stock to employees. And even, at least in theory, there could be tax benefits from Congress’ new approach, with the decision to issue shares for business purposes such as compensation for potentially closing equity. acts as a 1% tax subsidy on acquisitions.

There is also speculation that this will be a boom year for acquisitions as companies rush to leave before the law goes into effect. And that’s been a record amount of time for acquisitions. In the past 12 months ending in June, business acquisition activity has been strong, nearly hit a record of 1 trillion dollars, according to S&P Global. This is nearly double the $547 billion that companies have returned to shareholders in the form of dividends over the past 12 months.

For companies that primarily buy back shares to reduce the number of shares and increase earnings per share, without any business offset in terms of capital issuance, 2022 will be, says Fried. years to buy back more.

But for many companies that have used buybacks in the context of offsetting declining equity issues, he says we don’t know what the specific impact of the 1% repurchase tax will be. What we do know, however, is: “It’s unlikely you can impose a tax and not affect the behavior,” says Fried.

“Many companies issue shares in the same year they buy back the tax, which will reduce or eliminate taxes. But many companies that buy back over-issue and there will be taxes on that delta,” he said. ” he said.

Largest total acquisitions, in the last 12 months:

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

Source: S&P Global