Should an Excise Tax on Stock Buybacks Also Apply to Cash M&A Deals?

It's a roughly $85 billion question

Sep 10, 2021

Senators Sherrod Brown (D-Ohio) and Ron Wyden (D-Oregon) introduced legislation this morning to impose a 2 percent excise tax on stock buybacks—a proposal that could serve as a significant “payfor” in the budget reconciliation bill moving through Congress now. An important decision in designing the excise tax is whether the tax should apply to transactions in which one corporation purchases another corporation’s stock (rather than repurchasing its own stock). The late William Andrews, a Harvard Law School professor and leading corporate tax scholar, considered this question in the early 1980s and concluded that the answer is “yes”—at least when the acquiring corporation ends up with majority control of the target. The current text of the legislation would not apply the tax to those transactions, though hopefully Andrews’s argument will persuade lawmakers to make a change.

Note to congressional Democratic staffers in search of budget reconciliation payfors: A lot of money rides on the answer to Andrews’s question. According to Federal Reserve data, “retirements” of equities by U.S.-domiciled nonfinancial corporations averaged $866 billion per year over the five-year period ending in 2020. Of that amount, slightly more than half (51 percent) was attributable to buybacks, and slightly less than half (49 percent) was attributable to cash acquisitions. Back-of-the-envelope calculation: If equity retirements over the next decade stay at 2016-2020 levels, the revenue haul over the budget window would be $173 billion if the tax applies to buybacks and cash acquisitions, but only $88 billion if it’s limited to buybacks (an $85 billion delta!).

The back-of-the-envelope calculation in the previous paragraph is very back-of-the-envelope. Retirements of equities might rise—both because of overall asset appreciation and because corporations are now holding a lot of cash that they’ll ultimately look to unload. Or retirements of equities might fall because of the disincentive effect of an excise tax. Also note that the figures in the previous paragraph don’t include financial corporations. But even on the back of the envelope, it’s already clear that whether to apply the excise tax to cash acquisitions is a really big question that will have multibillion-dollar budgetary implications.

Aside: The current text of the legislation limits the tax to publicly traded corporations. It’s really hard to see why large private corporations (e.g., Cargill, Mars, and Fidelity Investments) should be exempt from the tax. Buybacks by those corporations raise the same tax policy problems as buybacks by publicly traded corporations. The $1 million-per-year exemption in the legislation should be enough to spare small enterprises that take the corporate form.

Why tax buybacks in the first place?

An excise tax on stock buybacks would strike at a problem long recognized by tax scholars: the disparate tax treatment of stock buybacks and cash dividends. Stock buybacks and cash dividends are both ways for corporations to return earnings to shareholders. However, stock buybacks enjoy a number of significant tax advantages vis-à-vis dividends:

Repurchases from foreign shareholders aren’t subject to outbound withholding, whereas cash dividends to foreign shareholders are subject to withholding at a 30 percent rate (reduced to 10 percent or 15 percent for investors in most tax-treaty jurisdictions);
Capital losses can be used to offset capital gains on buybacks without limit, whereas capital losses can be used to offset only up to $3,000 of non-capital income (note that dividend income is non-capital income even though most dividends are taxed at long-term capital gains rates);
Taxable individuals who participate in buybacks pay tax on gross proceeds minus adjusted basis, whereas taxable individuals who receive cash dividends pay tax on the entire dividend amount (or put differently, buybacks lead to earlier recovery of basis); and
Taxable individuals who invest in corporations that return cash to shareholders via buybacks can avoid all tax on their gains by holding their stock until death and stepped-up basis, whereas taxable individuals who invest in corporations that return cash to shareholders via dividends generally can’t avoid tax on those dividends.

This is a significant problem apart from any concerns about buybacks draining corporations of cash. The current tax laws distort corporations’ choices between different methods of cash distributions (and potentially distort capital allocation across different corporations based on their distribution methods). Beyond that, the tax advantage for buybacks allows some corporations to avoid shareholder-level tax on their earnings.

Chirelstein’s approach

Yale Law School professor Marvin Chirelstein highlighted the buyback/dividend differential in a 1969 Yale Law Journal article and proposed an innovative solution. Under Chirelstein’s proposal, a corporation’s repurchase of its own stock would constitute a recognition event for all shareholders regardless of whether they participated in the buyback. Shareholders would recognize dividend income equal to the amount of the buyback multiplied by their ownership interest in the corporation (e.g., a 1 percent shareholder in a corporation that bought back $100 worth of shares would recognize a dividend of 1% x $100 = $1). Shareholders’ basis would then be adjusted upward by the amount of the imputed dividend.

Gregg Polsky and I—in an article in the Yale Journal on Regulation published this past winter—revisited Chirelstein’s proposal and emphasized its continued relevance. As we argued, buybacks exacerbate federal tax law’s “Panama Papers problem” and its “Mark Zuckerberg problem.” The Panama Papers problem is the nontaxation of foreign portfolio investments in U.S. corporations (and especially, the nontaxation of investors who hold assets in tax-haven countries). The Mark Zuckerberg problem is the nontaxation of what is essentially the labor income of successful entrepreneurs. For example, when Facebook buys back shares, Zuckerberg doesn’t pay a tax (unless he tenders shares in the buyback). If Facebook paid a dividend, he would. (Note that Facebook—like Alphabet (Google), Amazon, Tesla, and Berkshire Hathaway—doesn’t pay a dividend. Those are five of the seven largest U.S. corporations by market cap!)

Andrews’s approach

Chirelstein’s proposal sought parity between buybacks and dividends, but parity would come at a cost: shareholders who haven’t sold stock or received any cash distribution would still owe tax—a result that might be challenging to explain to some taxpayers (and some lawmakers). In the early 1980s, William Andrews—in his capacity as reporter for the Subchapter C component of the American Law Institute’s Federal Income Tax Project—proposed an alternative to Chirelstein’s approach: a flat-rate excise tax on stock buybacks.

Andrews’s alternative is a rough-justice approach to the buyback/dividend differential. What it lacks in precision it makes up for in simplicity and administrability. Andrews’s approach is particularly appealing in the current moment for two reasons. First, the tax would formally fall on corporations and so appears to be consistent with President Biden’s pledge not to raise taxes on any individual making less than $400,000 (whereas Chirelstein’s approach would increase the tax liability of some individuals with income below $400,000 who own stock in corporations that buy back shares). And second, the simplicity of Andrews’s approach makes it much easier to draft—a not-inconsiderable advantage as the House and Senate race to finish a reconciliation bill this month.

What about cash acquisitions?

Importantly, Andrews did not limit his excise tax proposal to buybacks. He also would have applied it to retirements of corporate stock that occur through cash acquisitions. Why? Because cash acquisitions are tax-favored relative to dividends in precisely the same way that buybacks are tax-favored relative to dividends.

To return to first principles: Corporate stock is valuable because it represents a right to future distributions. Those distributions typically take the form of cash (though in theory, Apple could pay its shareholders in iPhones). And there are three basic ways of returning cash to shareholders of a corporation: (1) the corporation can pay a cash dividend; (2) the corporation can redeem some or all of its shares in a buyback; and (3) another corporation can buy the first corporation in a cash acquisition.

From a federal tax law perspective, there’s no shareholder-level difference in the treatment of a buyback versus a cash acquisition. Either way, shareholders who sell stock have a capital gain (with immediate recovery of basis). And either way, foreign shareholders aren’t subject to U.S. withholding (because outbound withholding applies to dividends, not capital gains).

Consider the case of Whole Foods. Whole Foods was a profitable company that returned very little of its cash to shareholders via dividends. In May 2017, it announced a $1.25 billion stock buyback program. But the next month, it revealed an alternative strategy for cashing out its shareholders: Amazon would buy Whole Foods for $13.7 billion in cash. If Amazon had acquired Whole Foods in an all-stock deal and then bought back $13.7 billion of Amazon-Whole Foods shares, the proposed excise tax would apply to the buyback. Why should the result be different when the nondividend distribution occurs as part of the acquisition rather than immediately afterwards?

Moreover, not applying the excise tax to cash acquisitions would potentially create a bias for bigness. A corporation could avoid the excise tax on buybacks if, instead of buying back shares itself, it combines with a second corporation and the second corporation buys back the first corporation’s shares as part of the merger. The result would be larger corporations, potentially with more market power. That’s the exact opposite of what the Biden administration antitrust agenda seeks to accomplish.

Finally, some people dislike buybacks because buybacks divert cash that otherwise could have gone toward higher wages or more capital investment. Gregg and I evaluated those arguments in our Yale Journal on Regulation article, and we were ultimately unconvinced. But if you dislike buybacks for those reasons, you should feel the same way about cash acquisitions. For example, Senator Wyden—in his press release announcing the excise tax—says that instead of distributing profits to shareholders in buybacks, corporations should have “reinvested more of that capital into the workers and communities who make those profits possible.” Well, the $13.7 billion of cash that Amazon paid out in its acquisition of Whole Foods was cash that passed out of the corporate form just the same as if either corporation had repurchased its own stock. The fact that it was Amazon’s cash shifting to Whole Foods’ shareholders is a distinction without an obvious difference.

Should we be raising the effective tax rate on corporate equity?

An excise tax on nondividend distributions—whether limited to buybacks or also applied to cash acquisitions—would raise the effective tax rate on corporate equity. Over time, that probably would have some negative effect on capital investment. At a rate of 2 percent, the effect on capital investment wouldn’t be large. But it’s worth asking whether we should be raising the effective tax rate on corporate equity in the first place.

I think the answer is “yes,” because I’m persuaded by the case for positive long-run capital taxation (and an excise tax on nondividend distributions is a politicly plausible way of raising taxes on capital). But even if your answer is “no,” there’s still a potential efficiency rationale for trying to reduce the existing distortion of corporate distribution decisions. As Andrews put it: “The case for imposing an excise [on cash acquisitions] is not … that acquisitions ordinarily represent a case of prominent tax abuse, but rather just that the tax rules introduce an unjustified bias into the assessment and balancing of other factors influencing acquisition behavior.” We could address the distortion by reducing the tax rate on dividends, which is not going to happen in the current political or fiscal environment. Or we could address the distortion by raising the effective tax rate on nondividend distributions—including cash acquisitions.

Lingering questions

Applying an excise tax to cash acquisitions raises a few interesting implementation questions:

1. What happens when a U.S. acquirer buys a foreign target or vice versa? I would suggest applying the excise tax based on the target’s domicile, on the theory that we’d generally prefer more multinational corporations to be U.S.-domiciled rather than fewer.

2. What happens when a corporation purchases a minority interest in another corporation? (For example, Berkshire Hathaway owns 9 percent of Coca-Cola. Microsoft used to own 6 percent of Apple.) Andrews suggested that the excise tax should not apply to acquisitions of minority interests. Intercorporate portfolio investments are generally tax-inefficient because they transform a two-level tax into a three-level tax. If corporations want to avoid the excise tax by paying more in corporate income tax, then fine! (And to further disincentivize avoidance via portfolio investments, Andrews would have eliminated the dividends received deduction for portfolio stock—50 percent under current law.)

3. What about noncorporate acquirers and targets? There’s a strong case for applying the excise tax when a non-C corporation entity (e.g., a partnership or S corporation) acquires a C-corporation target for cash. That’s just another way of cashing out the target corporation’s shareholders. What about when a C-corporation acquires a partnership or S corporation for cash? I don’t have an immediate answer to that question—but it’s a question that lawmakers would need to answer (or punt to Treasury).

Finally, it’s worth noting that Andrews also proposed an entity-level dividends-paid deduction for newly contributed equity that would have alleviated the effect of his proposal on capital investment. As Andrews recognized, though, designing a dividends-paid deduction that rewards only newly contributed equity is very hard—and would negate some of the simplicity/administrability benefits of an excise tax. Moreover, Andrews was contemplating a much higher excise tax rate than what lawmakers are now considering (between 35 and 40 percent). If the excise tax rate is just 2 percent, offsetting the effect on new equity through a dividends-paid deduction is probably a game not worth the candle.

Substance Over Form

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