How the IRS Wrongly Allows Stock Buybacks to Evade the Dividend Tax
Yale Law School
Yale School of Management
July 30, 2015
In 1976, the Internal Revenue Service (IRS) took the stance that public companies may evade the dividend tax through stock buybacks so long as at least one shareholder elects not to participate in the buyback. The IRS has since overlooked $5.7 trillion in dividends disguised as buybacks — $553 billion in 2014 alone.
The IRS’s stance on buybacks is not as well-founded as presumed by the tax bar. This Article walks through three approaches to statutory interpretation — textualism, public interest, and substance over form. Each yields the same conclusion: The IRS is wrong.
First, we apply a textualist lens to show that the IRS misconstrues the Internal Revenue Code (Code) to establish different standards for minority and majority shareholders. In all cases brought before the judiciary, courts rejected the IRS’s stance — holding that minority shareholders are just as capable of receiving disguised dividends as majority shareholders.
Second, we propose a theoretical model to demonstrate that the IRS’s stance is contrary to public interest. This stance distorts corporate capital allocation — encouraging shareholders to take excessive risk in exchange for tax deferral, reducing liquidity for retirees, and entrenching CEOs to the detriment of shareholders.
Third, we show how the IRS’s stance elevates form over substance by disregarding shareholders’ waiver of their right to equal participation in buybacks. We draw on empirical finance research to demonstrate that buybacks indeed function as disguised dividends, motivated by tax avoidance alone.
In doing so, we hold the IRS accountable and uphold the integrity of the Code.
How The IRS Wrongly Allows Stock Buybacks To Evade The Dividend Tax – Introduction
The Coca-Cola Company made history as the first public company to disguise a dividend as a stock buyback. In January 1929, Coca-Cola offered to buy 20% of its stock back from shareholders for $50 per share. If all Coca-Cola shareholders accepted the offer, the result would be mathematically equivalent to a dividend. But so long as at least one shareholder elected not to participate, the stock buyback was no longer exactly mathematically equivalent—merely a very close approximation.
Congress recognized that this sort of sham dividend is a possibility in 1920 and incorporated the dividend equivalence standard into every Revenue Act from 1921 to the present.3 That is, any transaction that is “essentially equivalent” to a dividend will be treated as a dividend.
The Fifth Circuit found Coca-Cola’s close approximation to be essentially equivalent. “What was done was clearly equivalent to the payment of a cash dividend. No statute is needed to make the facts speak the truth.” The court held it irrelevant that some stockholders decided not to participate: “[I]t is enough that those entitled to participate had the right to demand a pro rata distribution of cash.”
Coca-Cola’s financial statements certainly did not help the company’s case. Coke accountants booked the funds used for the stock buyback “as a dividend on common stock.”
47 years later, with the same dividend equivalence standard in the Code, the IRS unilaterally, without public comment, relying solely on its interpretation of legislative history, blessed what Coca-Cola attempted to do. It took the stance that public companies may disguise dividends as buybacks, so long as at least one shareholder elects not to participate.
The IRS has since turned a blind eye to more than $5.7 trillion in buybacks. In 2014 alone, S&P 500 companies spent $553 billion on buybacks—61% of their earnings. Public company stock buybacks have exceeded dividends in 9 of the last 10 years. Figure 1 highlights the exponential growth in stock buybacks since the IRS made its stance clear.
Disguising dividends as buybacks has become standard practice. Indeed, 460 of the 500 companies that make up the S&P index bought back stock between 2004 and 2011. The most aggressive are household names, as shown in Figure 2.
Why would public companies attempt to disguise a dividend as a buyback? This disguise changes the character of the distribution from a dividend to the more favorable capital gain.
Historically, the dividend tax rate has been higher than the capital gains tax rate. The Bush tax cuts equalized the dividend tax rate and capital gains tax rate in 2003. This reduced but did not eliminate the incentive to disguise dividends as stock buybacks.
After the Bush tax cuts, the primary allure of buybacks shifted to the deferral of taxes. Even when both dividends and capital gains are taxed at the same rate, shareholders still prefer capital gains treatment because the tax on capital gains is deferred until shareholders sell their stock. The benefit of deferral is the time value of money—the concept that a dollar today is worth more than a dollar in the future. Deferral allows shareholders to delay paying their taxes, earning interest in the meanwhile on the taxes they owe. This is especially valuable for long-term shareholders, who may defer taxes for decades. Empirical research suggests that the effective tax rate on stock buybacks, accounting for the value of deferral, is as low as 3%, well below the 23.8% rate imposed immediately on dividends.
To illustrate the value of capital gains treatment, suppose that Investor A, a California resident, owns $100 of stock in a public company and holds it for 20 years before selling. The company earns a 10% return on equity and distributes all of its earnings to shareholders via buybacks. The federal tax rate is 23.8% and the California tax rate is 13.3%, meaning that Investor A faces a 37.1% combined rate on both dividends and capital gains.
Figure 3 compares the impact of capital gains versus dividend treatment on Investor A’s returns under three scenarios:
- Investor Scenario—This scenario shows the value of deferral. By paying the capital gains tax at the end of twenty years instead of the dividend tax each year, Investor A earns 323% instead of 239%, improving his return by 84%.
- Old Investor Scenario—This scenario shows another benefit of capital gains treatment—unrealized capital gains are forgiven at death16 or when the stock is gifted to charity. Those Americans wealthy enough to leave a large estate or make large charitable gifts can thereby avoid taxes on buybacks entirely. If Investor A passes away in 20 years and leaves his stock to his wife, who then sells it, he will earn 573% instead of 239%, improving his return by 334%.
- Foreign Investor Scenario—This scenario shows that foreigners benefit even more than U.S. investors from capital gains treatment. Foreign investors face a higher tax rate on dividends than on capital gains (30% versus 23.8%18), even after the Bush tax cuts. If Investor A were a Brazilian who moves back home to São Paulo and sells his stock after 20 years, he will earn 413% instead of 287%, improving his return by 126%.
See the full study here.