Reading: Payout Basics

Generally speaking, shareholders who sell their shares in a buyback program are subject to capital gains taxes whereas, as we have discussed before, dividends are taxed at the (qualified) dividend income tax rate.

Even though, in the U.S., the capital gains tax rate and the qualified income tax rate are the same for many investors (see here),  this gives share buybacks a considerable tax advantage over dividend payments:

• Buyback: The capital gains tax rate is only applied to the capital gain the investor realizes when selling the shares, that is, the difference between the selling price and the original buying price.
• Dividend: In contrast, in the case of dividend payments, the tax rate is applied to the full amount of payout.

Example: 

Suppose a firm has 1 million shares of common stock outstanding that are trading at a price of $100 each. Now the firm considers paying out $20 million to its shareholders, either by paying a dividend of $20 per share or by repurchasing 200'000 shares of common stock in the open market at a price of $100 per share. Let's assume that the relevant qualified dividend income tax rate and capital gains tax rate are 15% and that the selling shareholders bought their shares at a price of $90.

How does the form of distribution (dividend vs. share repurchase) affect total shareholder wealth?

• Dividend payment: In the case of a dividend payment, the full payout of $20 million is subject to the qualified dividend tax rate of 15%. Consequently, dividend income taxes will amount to $3 million (= 20 × 0.15) and the shareholders will pocket a payout of $17 million after taxes (= 20 - 3).
   
• Buyback: In the case of a buyback, the selling shareholders realize a capital gain of $10 per share:
  
  Capital gain = Selling price - Buying price = 100 - 90 = 10.
  
  This, and only this part of the repurchase price is subject to the capital gains tax of 15%, whereas the remaining 90 of the repurchase price are tax free.
  • On a per-share basis, the tax bill will therefore amount to $1.5 (= 10 × 0.15).
  • Consequently, after taxes, each selling shareholder will pocket a cash consideration of $98.5 (= 100 - 1.5).
  • Given that the firm repurchases 200'000 shares, the total capital gains tax paid by shareholders will be $300'000 and the total cash consideration after taxes will be $19.7 million. 

This illustration shows how much more tax favorable buybacks can be compared to dividend payments. In our example, the total cash consideration for shareholders is $2.7 million larger (19.7 vs. 17 million) if the firm engages in a buyback rather than a dividend payment.

Put differently, given the assumptions of the example, since only 10% of the repurchase price are tax relevant (i.e., the capital gain of 10%), the shareholders only pay 10% of the taxes that they would pay on a dividend, namely 1.5%.

In light of these vast tax differences, it is not surprising that buybacks have become very popular among (listed) U.S. firms.

International comparison

Different have different rules with respect to the taxation of share buybacks. A discussion of these differences would go beyond the scope of this introduction. 

• Germany: For the investor, buybacks are generally treated as share sales and therefore subject to capital gains taxes (up to 95% exemption for corporate shareholders; 60% of the personal income tax for shareholders that have held at least 1% at some point in time within the last five years; 26.375% capital gains tax of other private individuals).
• U.K.: The default position is that the part of the repurchase price that exceeds the original share subscription amount is taxed as a distribution of income. However, if a number of conditions are met, buybacks by unquoted companies will automatically be taxed as capital gains (see here for more details). The relatively unfavorable tax situation for quoted companies could explain, in part, why buybacks are not very popular in the U.K. (see introductory chapter).
• France: If the buyback is conducted within a buyback offer or if the repurchased shares are allocated to the company's employees, share buybacks are subject to capital gains taxes. In contrast, if the purpose of the buyback program is to reduce the company's share capital, a distribution of income is assumed for the part of the repurchase price that exceeds the amount of the shareholder's contribution (limited to the actual profit made by the shareholder) and/or a capital gain is assumed for the difference between the shareholder's contribution and the tax basis of the repurchased shares (see here for more details)
• Switzerland: There are no capital gains taxes for private individuals in Switzerland. However, if the purpose of the buyback is to reduce the company's share capital, the difference between the face value of the share and the repurchase price constitutes a taxable income for private shareholders. For institutional shareholders, the difference between the book value and the repurchase price is treated as revenue from securities. Therefore, it is financially unattractive for private individuals to participate in share repurchase programs. One workaround is for the repurchasing company to issue transferable put options, as the sales proceeds from these options qualify as tax-free capital gains for private shareholders.