What are share buybacks and why is Ottawa taxing them?

‘It’s not a dirty thing. It’s not something we should say, ‘ew, that’s gross’

By Bianca Bharti

Deputy Prime Minister and Minister of Finance Chrystia Freeland attends a news conference about the fall economic statement in Ottawa. PHOTO BY BLAIR GABLE/REUTERS

There’s been plenty of noise since the federal government announced plans last week to tax companies that use their profits to buy shares back from investors. Below is a base-level explainer of share buybacks, their purpose and why Ottawa is setting its targets on one of the ways corporations reward their investors.

What are share buybacks?

On a basic level, share buybacks, or stock buybacks, are one of five ways a company can spend its profits, said Barry Schwartz, chief investment officer and co-owner of Baskin Wealth Management. When a company has cash after subtracting its costs to run the business, executives can allocate the leftover in the following ways by:

  • paying dividends to its shareholders at the end of a quarter or fiscal year;
  • paying off incurred debt;
  • investing back in the business in the form of hiring or increasing wages, growing its customer base by building more physical stores or pouring more resources into research and product development — to list a few examples;
  • buying or merging with other businesses that the company sees as beneficial to growing its core business;
  • and/or through share buybacks, wherein the company will use its profits to buy back stocks of its business from investors willing to sell those stocks.

“It’s not a dirty thing. It’s not something we should say, ‘ew, that’s gross,’” Schwartz said of share buybacks. “It’s part of your five tools of capital allocation as a CEO or a CFO.”

Why do companies buy shares back from investors?
There are several reasons companies might choose to execute share buybacks and it’s “a function of a properly formed stock market,” Schwartz said. When a company buys back its shares, it reduces the number of outstanding shares in the stock market and theoretically its share price should rise. If the investor did not sell her shares back to the company, she still has the same number of shares but her stake in the company has increased without her having to spend money to buy more stocks.

If a company’s board has created an incentive or bonus structure for executives based on the performance of a stock price, a CEO could decide he or she will use the company’s profits to repurchase its investors’ stocks. Schwartz said this isn’t inherently a negative motivation for executives, especially if the board decided increasing the value of the share price is one of its focus areas in growing the business.

“Now, share buybacks, like any other capital allocation decisions, can be problematic if you’re using them to artificially prop up the stock without regard for the value of your company,” Schwartz said.

Companies can also decide to repurchase shares if executives believe the current stock market price is trading below what they think it’s worth. Leaders can run calculations, determine what the value of the product they sell might be in the future, take into account current production levels, among a whole host of other considerations, and deem that the price ought to be higher. Natural supply and demand math kicks in there when companies repurchase shares, Schwartz said, and the stock price goes up, further making the share attractive to investors who might pour more money into the company’s shares.

Shareholders also sometimes prefer buybacks over receiving quarterly or annual dividends because Canada’s tax structure has lighter levies on capital gains earned from share repurchases compared to taxes on income earned from dividends.

“Over time, if a company continues to reduce the number of shares outstanding, and you don’t sell, your ownership will increase tremendously,” he said.

Why is the federal government taxing buybacks?
Deputy Prime Minister and Finance Minister Chrystia Freeland introduced the plan to tax companies two per cent on their share buybacks last week in the Fall Economic Statement and said details of the tax will be in the upcoming April budget. The Liberal government framed the tax as a way to incentivize companies to deploy their profits in their workers and grow their business, rather than paying out those profits to investors.

The tax should come into effect on Jan. 1, 2024 and would bring in $2.1 billion over five years, the federal government said. It’s similar to a one-per-cent buyback tax the United States introduced this year as part of its inflation fighting bill.

Some say the planned tax directly targets Canada’s energy sector, which has enjoyed windfall profits in recent quarters due to high oil and gas prices from inflation and the invasion of Ukraine by Russia, one of the world’s biggest energy producers, limiting supply in the global market.

For other sectors, the tax might not present a huge hindrance when a company makes capital allocation decisions, Schwartz said. “Buybacks are not a huge part of capital allocation in Canada. They’re much more prevalent in the U.S.”

Citing banks and railway companies as examples, Schwartz said, “A lot of our Canadian large-cap companies are very mature businesses and very much dividend-focused. … These companies don’t buy back stock.”

Source: Financial Post