Stock Repurchase

Stock repurchase is a special type of dividend. If there were no separate tax treatments between ordinary income and capital gains, and if a proportionate number of the shares were acquired from all stockholders, the economic effects would be almost identical for stock repurchase as for a cash dividend. If the stock is not acquired proportionately from all investors, stock repurchase is a special type of dividend, since it goes only to the stockholders who prefer cash compared to increased ownership. Those stockholders preferring to increase their investment compared to receiving cash do not sell. The self-selectivity of the process is an advantage for the stockholders as a group. The foregoing conclusion assumes zero taxes. Once taxes are considered, stock repurchase is advantageous. The tax savings to stockholders of a stock repurchase compared to a cash dividend may be sizable. Suppose an investor owns and sells stock for $1,200 with a tax base of $1,000.The marginal tax rate for ordinary income is 35 percent and for capital gains, 15 percent. With a $1,200 cash dividend, the stockholder would net out $780 (the tax would be $420).With the $1,200 disbursed in the form of a stock repurchase, the stockholder would net out $1,170 (the tax would be $30 on a capital gain of $200).

The advantage of repurchase over ordinary dividend distribution is present for two reasons. First is the difference between the two tax rates. The second reason: with the repurchase plan, part of the payment is considered a repayment of principal tax purposes and so is not taxed at all. Although systematic repurchase over time would eventually drive the cost base close to zero, the present value methodology weighs the early tax savings high, and so the difference between systematic repurchase and ordinary dividend is still consequential when both capital gains and ordinary income are taxed at the same rate. If both personal and corporate tax rates were zero, either method of income distribution would lead to the same intrinsic value. The introduction of tax considerations, however, can affect the value of different “packages”. Tax laws can provide powerful incentives for firms with liquid assets available for distribution to purchase shares rather than pay larger dividends. Many persons will prefer capital gains to ordinary income if the marginal rate of taxation on ordinary income is large while the rate on long-term capital gains is small. Given these incentives can be used for returning cash to stockholders by repurchasing shares, a relevant question would seem to be: Why do firms ever pay dividends? An important reason is that there are significant investors who pay zero taxes. The second explanation is related to the attitude of the Internal Revenue Service toward share repurchasing. The current Internal Revenue Code clearly seeks to prohibit firms from disguising dividends in the form of share repurchases. Proportional repurchases from all shareholders, for example, are treated the same as dividends for tax purposes.

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