TaxProf Blog op-ed: Senator Rubio’s Mysterious Buyback Tax Proposal, by Gregg Polsky (Georgia):
Senator Marco Rubio has recently argued that stock buybacks are taxed more favorably than dividends and that this preference should be eliminated. In a recent Atlantic article, Senator Rubio criticizes stock buybacks because he believes that they harm workers, and he proposes to tax “stock buybacks at the same rate as dividends.” One problem with this proposal is that stock buybacks (or redemptions, as they are called by tax experts) are already taxed at the same rate as dividends!
When a shareholder redeems shares pursuant to a buyback, the shareholder is generally taxed at the long-term capital gains rate on the gain. (If the shareholder has not held the redeemed shares for more than one year, then the shareholder is taxed at the short-term capital gains rate, which equal to the higher ordinary income rates.) If a shareholder receives a dividend, the shareholder is taxed at the special dividend rate, which is the same as the long-term capital gains rate. Therefore, Senator Rubio’s proposal—taken at face value—doesn’t make any sense at all, at least under current tax law. Before 2003, dividends were taxed at ordinary rates, while redemptions were taxed at the much lower long-term capital gains rate.
This leads to two questions. First, who is Senator Rubio’s tax advisor and has he been asleep for the past decade and a half? Second, assuming Senator Rubio is aware of current tax law, what is he possibly getting at? My best guess is that Senator Rubio was—inelegantly—referring to three far more technical, subtle, and relatively insignificant distinctions.
First, if a taxpayer has capital losses (such as from the sale of other stock that has gone down in value), those can be used to absorb capital gains, but not dividends. Thus, loss-harvesting techniques (the selling of stock losers at year-end) can be used to shelter redemption gains but not dividends. Second, if a foreign shareholder receives a dividend from a U.S. company, the dividend is subject to a withholding tax. But the withholding tax doesn’t apply when a foreign shareholder realizes a capital gain from redemptions. These two distinctions could be resolved quite easily by recharacterizing redemption gains as dividend income.
A final possibility relates to the utilization of tax basis. In a redemption, the shareholder uses the tax basis of the shares to offset the sales proceeds in calculating capital gain (or loss). In a dividend, the shareholder cannot use of this tax basis. This distinction could be resolved by requiring the redeemed shareholder to recognize a dividend equal to the full sales price. But in a complete redemption, the shareholder’s basis would presumably result in a capital loss. After all, the shareholder’s investment in the corporation has been eliminated. If so, the results (dividend plus capital loss) are much the same as under current law. If a shareholder only partially redeems, the basis of the redeemed shares would presumably shift to the shareholder’s other shares, resulting in some acceleration of income. The fix here would be more complicated than just recharacterizing redemption gains as dividend income.
All three of these distinctions are relative small potatoes in the scheme of things and surely won’t change corporate behavior much, if at all. Fixing them would also increase complexity and produce counterintuitive results. Many buybacks are accomplished through open market transactions, where corporations anonymously buy back their shares through public stock exchanges. Fixing the distinctions between redemptions and dividends would simultaneously create distinctions between selling shares to a stranger and selling them back to the corporation, even though the sales are made through the same stock exchange transaction. The tax consequences would now counter-intuitively depend on the identity of the heretofore nameless, faceless purchaser. Plus, there would be a significant clientele effect: tax-exempt shareholders, who don’t care at all about any of these distinctions, would be free to sell back to the corporation, while other shareholders would sometimes (but not always) prefer to sell to other shareholders.
The bottom line is that Senator Rubio’s tax proposal—even with some friendly amendments to make it coherent—is not worthwhile.
One final note: it is clear the non-redeemed shareholders in a redemption are undertaxed relative to the results of an equivalent transaction involving cash dividends, where the non-redeemed shareholders use the dividends to purchase additional shares in the company. Thus, there is a good theoretical argument that the non-redeemed shareholders should be taxed, even though they are mere bystanders to the redemption transactions. I have assumed that this is not what Senator Rubio was suggesting because he appeared to be focusing on the tax treatment of the redeemed shareholders and because this would be a rather radical change in the law. For further reading on the proper tax treatment of non-redeeming shareholders, see Marvin Chirelstein, Optional Redemptions and Optional Dividends: Taxing the Repurchase of Common Shares, 78 Yale L. J. 739 (1969); Ethan Yale, Corporate Distributions Tax Reform: Exploring the Alternatives, 29 Va. Tax Rev. 329 (2010); Bret Wells, Reform of Corporate Distributions in Subchapter C, 37 Va. Tax Rev. 365 (2018).
Wall Street Journal, Rubio’s Buyback Tax