Before the COVID-19 pandemic, one of the hottest topics in the U.S. capital market was the rise in the volume of corporate share repurchases, also known as stock buybacks. In 2018, U.S. corporation stock buybacks topped $1 trillion, a record-breaking volume. In 2019, stock buybacks remained the single biggest source of demand for U.S. public equity. Despite the pandemic in 2020, stock buybacks continued to be in high demand. This trend has attracted attention from commentators and bipartisan politicians who have raised concerns about the surge. In recent days, most recent criticisms have focused on securities law issues; however, tax scholars have been considering the problem for decades. A monumental example is Marvin A. Chirelstein's seminal article, Optional Redemptions and Optional Dividends: Taxing the Repurchase of Common Shares, published in the Yale Law Journal in 1969.
Chirelstein explained that tax law treats buybacks and cash dividends differently even though they are economically equivalent. He argued that buybacks should therefore be taxed the same way as dividends at the shareholder level. Daniel Hemel (Chicago) and Gregg Polsky (Georgia) point out that the recent surge in the volume of corporate share repurchases has alerted politicians to the importance of this issue, offering a new window of opportunity to realize Chirelstein's proposal to improve the U.S. capital-taxation regime. However, Chirelstein’s proposal is more than 50 years old and needs to be modernized. Taxing Buybacks by Hemel and Polsky (38 Yale J. Reg. 246 (2021)) updates the proposal and offers tax-based solutions to the contemporary problems posed by stock buybacks.
Let me start with a primer on the corporate taxation of buybacks and dividends. A corporation can distribute earnings and profits to shareholders by either repurchasing outstanding shares or issuing cash dividends. The former is also referred to as "redemption of stock" or "stock buybacks." In general, the Internal Revenue Code treats buybacks more favorably than cash dividends because section 302 treats redemption of stock as the disposition of capital assets and only the amount realized over the taxpayer's basis in stock is included in gross income as capital gains. By contrast, the entire amount of cash dividends is included in gross income under section 301. Since 2003, both long-term capital gains and qualified dividend income have been taxed at preferential tax rates in section 1(h). But despite the rate equivalence, section 302 distribution is still more favorable than section 301 to U.S. individual taxpayers because the former includes lesser amount in gross income than the latter. Foreign shareholders have more reason to prefer stock buybacks to cash dividends because, for foreign taxpayers, capital gains from the sale of U.S. securities are exempted from tax whereas dividends are subject to withholding tax.
Hence, the conventional wisdom in tax law is that buybacks are tax advantageous relative to dividends. However, this may be somewhat oversimplified, because 1) U.S. corporate shareholders may not share that tax preference due to the dividend received deduction rules and the possibility of capital loss offset, and 2) tax-exempt investors, such as pension plans and nonprofit institutions, are indifferent between the two forms of corporate distributions. Assuming that conventional wisdom concerning buybacks holds, Chirelstein perceived the asymmetrical tax treatment of buybacks and cash dividends as a tax policy problem and proposed a new income tax regime for buybacks that treats the buyback amount as a cash dividend paid out to all shareholders on a pro rata basis. This makes all (taxpaying) shareholders subject to dividend tax obligations. Then, those shareholders who choose to cash out their shares (redeeming shareholders) would be deemed to sell their shares to non-redeeming shareholders, thus having capital gains or losses. In short, the proposal eliminates the tax advantage of the buybacks, and thus levels the tax playing field between buybacks and cash dividends.
Chirelstein's proposal was criticized as politically infeasible by tax scholars, such as Ethan Yale (Virginia; Google Scholar) and Bret Wells (Houston; Google Scholar). Chirelstein's proposal requires non-redeeming shareholders who received no cash, in reality, to pay tax on the phantom income because non-redeeming shareholders are also considered to receive cash dividends. As a result of not having actually received any income, they may not have the cash to pay the tax they owe. Hemel and Polsky offer a clever solution to the phantom income and liquidity problem by requiring corporations to pay a cash dividend of at least $0.43 for every $1 they expend on buybacks when the highest withholding tax rate on dividends is 30%. Chirelstein's proposal also requires basis tracking, resulting in compliance complexity. However, Hemel and Polsky consider this to be a marginal problem because existing law already requires tracking of stock basis in many cases, such as stock splits, spinoffs, and mergers. Additionally, brokers have been tracking stock basis since 2011.
The more important task for Hemel and Polsky is to justify Chirelstein's proposal from a normative perspective. The tax treatment of buybacks and dividends indeed differs. But why should the solution be to tax buybacks like cash dividends rather than vice versa? In fact, Ethan Yale has offered a reverse solution, referred to as the "exchange equivalent distributions (EED) tax," which would treat all corporate distributions as stock sales. Both the EED tax and the Chirelstein proposal would equalize the tax treatment between dividends and buybacks. However, Yale's EED tax proposal would not cause the phantom income and liquidity problem for non-redeeming shareholders. So why does this paper nonetheless prefer Chirelstein's proposal? Chirelstein offered his own justification for this by criticizing stock buybacks, stating that stock buybacks cannibalize long-term investment and benefit corporate executives at the expense of other shareholders. But Hemel and Polsky found them not well-supported. However, the authors' main contribution is finding modern and more powerful arguments in favor of Chirelstein's proposal in the 21st century. Buybacks exacerbate two of the U.S. tax system's most severe flaws discussed below, and Chirelstein's proposal may be an effective solution.
First, Chirelstein's proposal may resolve what the late Edward Kleinbard (USC) called the "Mark Zuckerberg problem." Founders of enormously successful companies, like Mark Zuckerberg of Facebook (now Meta), may avoid taxation on their fortunes by making zero-dividend policies in the company and holding the shares until death. In the meantime, the corporation can distribute earnings to shareholders other than the founders via buybacks instead of dividends. The founders will not be liable to pay tax as long as they do not redeem their shares. The basis of the founders’ stock will step up to the fair market value upon their death, effectively eliminating taxation on the built-in gains of the founders' stock. Chirelstein's proposal may mitigate this problem even if the stepped-up basis rule in section 1014 remains because the proposal can neutralize companies' preference to buybacks over cash dividends.
Second, Chirelstein's proposal may address the "Panama Papers problem." As previously explained, foreign shareholders' capital gains arising from U.S. stock sales are exempted from U.S. taxation. This tax-free treatment of capital gains gives incentives for foreign shareholders to invest equity in the U.S. via entities located in tax-haven jurisdictions. Hemel and Polsky refer to this as the "Panama Paper problem." When U.S. companies distribute earnings and profits via buybacks instead of cash dividends, they in effect generate tax-free returns to tax haven investors. Chirelstein's proposal would close this opportunity by extending the withholding tax to all cash distributions—whether it be by cash dividends or buybacks.
This review briefly presents Taxing Buybacks as an exemplary exercise of applying modern-day virtues to classic tax theory. The paper is accessible not only to tax lawyers who understand the difference between section 301 and section 302 distributions, and recognize the problem caused by the stepped-up basis rule in section 1014, but is also accessible to business lawyers who would like to understand the tax implications of buybacks. Hemel and Polsky's witty analysis combined with many examples makes reading the article intellectually enjoyable. It is a must-read on business tax theory.