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Taxing share buybacks in a slow economy: understanding the fiscal and financial implications

Both the American and Canadian governments are on the path to taxing share buybacks. What does this mean for corporations, shareholders, and the governments themselves?

On the release of its 2022 Fall Economic Statement, the Canadian government announced a new 2% tax on share buybacks for public companies in Canada. Finance Minister Chrystia Freeland justified the measure as "[making] sure that large corporations pay their fair share, and to encourage them to reinvest their profits in workers and in Canada."

In taxing distributions to shareholders, Canada followed the U.S. government, which recently introduced a 1.0% buyback tax as part of a revenue package included in the 2022 Inflation Reduction Act. In both countries, the fiscal impact of the buyback tax is expected to be modest: 0.1% of total expected revenue, or CAD$2.1 billion over 5 years in Canada and USD$54.9 billion over 10 years in the United States.1

Although companies should continue to prefer buybacks to dividend distributions due to their tax advantage,2 the Tax Policy Center estimates that a 1.0% increase in buyback tax could boost dividend payouts by 1.5%; therefore, governments could end up collecting less revenue than anticipated due to shifts in company behavior. Moreover, in both countries, the government will apply the tax to the net value of buybacks; in other words, after controlling for newly issued shares. That implies executives and senior employees exercising their stock options in a larger proportion than usual would decrease the net value of buybacks and the tax take. Finally, from a capital and operational perspective, some have argued that buybacks occur when the expected rate of return on other investment opportunities is simply too low, refuting the commonly accepted thesis that companies buy back shares instead of productively reinvesting in their capital and employees. 

Which companies buy back the most shares?

Over the past five years, the financials sector in both the S&P/TSX Composite Index and S&P 500 Index have had the highest gross buyback yield. In Canada, other sectors that would be most affected by the 2% buyback tax are consumer discretionary, consumer staples, and industrials. 

Buybacks vary considerably across industries

5-year average buyback yield (%)

Bar chart of buyback yield, by sector, of the S&P 500 and S&P/TSX Composite Indexes. Financials , IT, and healthcare are the highest for the S&P 500 Index, while financials, consumer discretionary, and consumer staples are the highest for the S&P/TSX Composite Index.
Source: Bloomberg, Manulife Investment Management, as of November 25, 2022. It is not possible to invest directly in an index.

Revenue-wise, for the Canadian federal government, the sectors that would contribute the most to tax revenue if recent buyback trends were to persist are financials, energy, and industrials. In fact, if all companies in the S&P/TSX Composite Index had to pay a 2% gross tax on buybacks over 2021, this would equate to an incremental tax of over CAD$1.1 billion. The financials and energy sectors would have contributed over CAD$500 and CAD$100 million to that total, respectively. We note that on a net value basis, this number would be much lower due to the reasons mentioned above regarding the exercise of stock options. We also note that energy companies have been a frequent area of focus for U.S. lawmakers this year. Similar to the European Union and the United Kingdom, the U.S. government is actively considering a windfall tax on oil and gas “excessive” profits. In Canada, no such tax has been considered, but we highlight that energy companies would pay the second-largest share of the 2% buyback tax (on a gross basis) if it would be applied today.

 

Outlook for buybacks

Buybacks have generally been on the rise in Canada over the past two decades, and we don’t expect the proposed tax to end this trend; the reality is that buybacks are still one of the most effective ways to increase shareholder returns. Instead, we see economic growth as the true determinant of buybacks. While policy could, at the margin, encourage a stronger dividend policy, we believe the relationship between buybacks and economic growth will overtake the distortionary effect of the taxes.

Buybacks have declined as growth weakens

U.S. GDP vs. growth in buybacks

Line chart of U.S. GDP and S&P 500 Index buyback growth since 2001. It shows a strong correlation between the two.
Source: Macrobond, Bloomberg, Manulife Investment Management, as of November 25, 2022. The transparent lines represent the last data points, which are estimates for 2022. It is not possible to invest directly in an index.
Softening profits will be a headwind to buybacks

S&P 500 Index profit margins vs. growth in buybacks

Line chart of S&P 500 Index profit margins vs. S&P 500 Index buyback growth since 2001. It shows a strong correlaton between the two.
Source: Macrobond, Bloomberg, Manulife Investment Management, as of November 25, 2022. It is not possible to invest directly in an index.

Given our weak 2023 economic outlook, we see the potential for buyback yields to soften as corporate profits will increasingly be put under pressure in the near term. Historically, buybacks and profit margins have held a close relationship: Lower profit margins have been a clear headwind to buybacks. Nonetheless, buybacks should resume in the medium term. 

 

1 Department of Finance, Canada and U.S. Tax Foundation, 2022. 2 Companies often buy back shares from shareholders that face no or little capital gain taxes (pension funds and low-income investors). The other taxable shareholders can then simply choose to defer capital gains to avoid taxation. 

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Dominique Lapointe, CFA

Dominique Lapointe, CFA, 

Global Macro Strategist, Multi-Asset Solutions Team

Manulife Investment Management

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Erica Camilleri, CFA

Erica Camilleri, CFA, 

Senior Global Macro Analyst, Multi-Asset Solutions Team

Manulife Investment Management

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