2% Share Buyback Tax: What to Expect?

January 5, 2023

Prepared by Andersen in Canada, Montreal Partner Danny Guérin with support from Stéphanie Perras.

The 2022 Federal Fall Economic Statement announced a two-percent tax that would apply
on the net value of all types of share buybacks made by public corporations in Canada. The
tax would come into effect on January 1, 2024. The statement indicates that more details
will be provided in the Federal Budget of 2023.
This announcement is similar to the one-percent tax on stock buybacks announced by US
President Joe Biden in August 2022. This new measure was included in the Inflation
Reduction Act (“IRA”) introduced by the Biden administration which is expected to come
into force in 2023 (referred to as the “US IRA”). The Democrats initially proposed a 2%
excise tax, but Republicans lobbied to reduce the tax to 1%.
In this article, we will first outline what represents a buyback and its fiscal and economic
impacts. Second, we will shortly analyze the US IRA and speculate on what it could mean
from a Canadian perspective as well as alternative means of taxation that could have been
used to accomplish similar results.

What is a “Share Buyback”

Share buybacks happen when companies – publicly traded companies in the context of the
new tax – buyback a portion of their own shares. There are four different methods that can
be used to carry out a buyback: open market buyback, fixed-price tender offer, Dutch
auction tender offer, and direct negotiation. In an open market buyback (most common
method used for share repurchases), the transaction is executed directly on the stock
market, and companies have the flexibility to cancel the buyback program at their
discretion. With a fixed-price tender offer, the company would buyback the shares at a
fixed price on a specific date, which is a faster option. With a Dutch auction tender offer,
the company would provide a range of different prices, with the minimum price being
above the market value. After the bids from the shareholders are received, the company
can determine the appropriate price for the buyback program. Finally, with a direct
negotiation, a company can approach directly certain shareholders and directly negotiate
a price with them.
There are various reasons for a corporation to repurchase their shares, and such an event
can trigger various effects, which will be discussed hereunder.

Why Issue a Buyback

Share buybacks, along with dividends, are ways for a company to return excess cash to
their shareholders. Buybacks may represent an appealing option when no other
investment alternative seems fitting, whether there are not enough growth opportunities,
or that potential investments are too risky or expensive.
Share buybacks can also be a way to return money to shareholders without having to
commit to a long-term dividend policy, thereby providing more flexibility for
management.
After a buyback, the company can choose to cancel the shares, therefore reducing the
number of outstanding shares, or choose to hold the shares as treasury. Cancelling the
shares would result in higher earnings per share (“EPS”) ratio, thereby elevating the
market value of the shares outstanding.
Buybacks could also be used to consolidate ownership. Having fewer shareholders can
simplify corporate governance. Additionally, during uncertain times, share buybacks are
used as a tool to stabilize stock prices.
Moreover, when companies issue stock options as a compensation mean to retain or
attract key employees, it increases the number of shares outstanding, thereby diluting
existing shareholders investments. Buybacks can be used as a mean to prevent or mitigate
such effect.
The decision to consider whether or not to pursue share buybacks is wholly dependant on
an entity’s financial situation. If a company’s shares are undervalued while the operations
are doing very well and the company has extra cash, a buyback can be very beneficial to
investors. By increasing demand, the stock price consequently increases, which creates
value for all investors. However, if a company is prioritizing short-term gain and
neglecting investments that could create long-term growth, then it might not be so
beneficial to the investors in the long run.

What are the main implications of a share buyback

There are currently no tax consequences for a corporation that repurchases its shares in
cash. However, if the shares are purchased by transferring non-cash assets to a
shareholder, the corporation is deemed to have disposed of the assets at fair market value,
which can result in a gain or loss for the corporation half of which would be
taxable/deductible from a Canadian tax perspective.
From a Canadian tax perspective, the amount received by Canadian shareholders upon
the buyback of their shares that exceeds the Paid-Up Capital (“PUC”) is taxed as a deemed
dividend. Subsection 84(3) of the Income Tax Act¹ (“ITA”) applies to Canadian
corporations and deems as a dividend any payment to its shareholders. Such shareholders
would in turn be deemed, under subsection 84(9), to have disposed of their shares in
question to that corporation and capital gains or losses would have to be computed on
such disposal (the proceeds of which would have to be reduced by the deemed dividend
computed under 84(3) as described above). An exception to subsection 84(3) deemed
dividend would be if a public corporation would have proceeded by way of a purchase of
its own stock in “the open market” (i.e., the shares must be purchased on a stock exchange
or over the counter through an independent middleman in accordance with the
procedures and requirements of the relevant securities legislation and the bylaws of the
relevant stock exchange. If the vendor and the purchaser have made an arrangement
with respect to the purchase and sale of the shares in question, the purchase will not be
considered to be carried out in the manner in which any member of the public would
normally purchase shares in the open market² ). Where paragraph 84(6)b) applies, the
recipient would tax themselves on a capital gain instead of a dividend (while the
corporation purchasing those shares on the market could face Part II.1 tax on such
purchase amount).
On a different note, share buybacks can also mean that a company is prioritizing short-term
share price gain over investing in further development or the corporation’s resources
(e.g., human, capital). When interest rates are low, companies sometimes go into debt to
finance buybacks to increase stock prices temporarily, which can be seen as an imprudent
strategy.
There is actually no precise way to determine how the stock market would react to a share
buyback. Such corporate practice has either been seen in the past as a poor treasury
management strategy of a company’s excess cash use, or signal that an entity has little growth opportunities or limited investment alternatives in which to invest their excess
capital. In particular (and limited) circumstances, buybacks have also been interpreted
positively on the market for companies being financially successful with undervalued stock
prices that would be on a stage of growth.

US IRA: New excise tax and intended purposes

Starting January 1st, 2023, a new US non-deductible excise tax of 1% calculated on the fair
market value of the stock will apply on the repurchase of stock by a covered corporation.
The term “covered corporation” refers to any domestic corporation whose stock is traded
on an established securities market as per Sec. 4501 of the Internal Revenue Code (“IRC”).
Furthermore, the tax will apply to all classes of stocks of a covered corporation whether
the class is publicly traded or not and regardless of the net earnings or loss position of the
firm. At this time, the Treasury Department was provided with regulatory authority by the
IRA to apply this tax to any other transactions that would be deemed to be economically
similar to share buybacks. Even if 1% is not a significant tax in comparison to the current
top tax rate on dividends and capital gains in the US, the joint Committee on Taxation is
now estimating a $74 billion gain over the next 10 years from this new 1% excise tax.
However, the tax base on which that 1% would be applicable will benefit from a deduction
equivalent to the value of the stocks issued to employees and any new stocks issued to the
public.
The 1% excise tax should also not be applicable to the following situations:

The repurchases value in the year are less than $1 million;
The repurchased stocks are contributed to an employer-sponsored pension plan,
employee stock ownership plan or any other similar plan;
The repurchased stock is taxed as a dividend;
The repurchased stocks are part of a reorganization where no gain or loss is
recognized; and
The stocks are repurchased by regulated investment companies, real estate
investments trust (“REIT”) and dealers in securities in the ordinary course of
business.

As mentioned earlier, dividends and stock buybacks are two ways of distributing income
to shareholders that have different tax treatments. From a US tax perspective, the tax rate
is similar in both cases, but stocks buybacks are only taxed on the capital gain portion,
making shares repurchasing more appealing to stockholders. In the US, the short-term
capital gains on stocks owned for less than a year are taxed at their ordinary income
bracket. However, when owned for a longer period, the long-term capital gains are taxed
at a rate of 0%, 15% or 20% depending on the taxable income, thus making share buybacks
significantly more attractive to taxpayers which have hold on to their shares for a longer
period.
Stock repurchases in the US have significantly increased in the last decade as compared to
dividends payments, to the point where they now greatly exceed them as a form of earnings
distribution to shareholders. In 2021, these buybacks have reached more than $900
billion, primarily driven by Apple, Facebook, Google, Microsoft and Bank of America. As
a result, concerns over these higher levels of share buybacks and their impact on firms and
markets were raised by legislators, individuals in the financial services industry and some
academics. Firstly, it was argued that firms were now using share buybacks as a way to
meet short-term share price targets and boost earnings per share instead of investing in
capital expenditures and research and development, which are both essential to the longterm
sustainability of any corporations. Stock buybacks were therefore mainly benefiting
short-term shareholders selling their stocks after prices went up at the expense of longterm
shareholders. They also believed that the long-term rise of the price of the share
should not be dependent on the artificial price manipulation caused by the firm’s
repurchase of its own shares.
Secondly, in the cases of both dividend payments and share buybacks, the value of the firm
is generally reduced following the distribution. The Securities and Exchange
Commission’s “safe harbor” rule, which prohibits market manipulations, recommends
that companies limit their buybacks programs within considerations of their volume and
timing conditions. However, the share buybacks seem to have the opposite effect on the
stock price, driving it to rise as the outstanding number of shares in the market decrease.
Some critics have claimed that stock buybacks might cause the redistribution of earnings
from public shareholders to corporate insiders who usually own a significant amount of
the firm’s equity and whose financial compensations are directly linked to the earnings per
shares of the company. They have dubbed this practice as “indirect insider trading”, as the
corporate insiders would initiate the stock buybacks based on information obtained
internally that leads them to believe the stock is undervalued. Furthermore, it was also
argued that the increased levels of stock buybacks have caused the shareholders to benefit
from these programs for their own financial gain, thus widening economic inequality at
the expense of the workers and corporate stakeholders.
Thirdly, concerns were raised over the fact that share buybacks were often debt-financed,
which could jeopardize the firm’s financial stability. When incentivized by low interest
rates, compagnies would use debt to finance their buyback programs, also known as
“leveraged buybacks”.

What It Means for Canadian taxpayers

Whether the extent to which the impacts on the Canadian market of such proposed tax
should be similar to the effects of the tax implemented in the US is still uncertain. This
new tax is certainly in response to Biden’s administration IRA adopted earlier this year.
However, the great disparity between these two economies is leading some to believe that
the tax was proposed (by Justin Trudeau’s Liberal government) without a better
understanding of Canada’s corporate finances.
The new share buyback tax is evidently expected to raise money for Canada, but the larger
goal of the Liberal government seems to be about incentivizing public corporations to
make more investments with their profits and pay their “fair share” through this “smart
tax”. The government wants to make sure that large corporations reinvest their profits in
what they consider to be the right incentives, such as workers, operations and the energy
transition, amongst other things. Although the government wants to incentivize all public
companies, public oil and gas corporations, who have been the most active in the past year
in the buyback programs, have been especially criticized for making record profits and
issuing share buybacks instead of reinvesting their excess capital in clean energy.
Energy producers have been vocal about how they believe that this tax will hurt
investments in the energy sector, despite them contributing massively to the country’s
economy during this inflationary period. Petroleum associations have also raised
concerns over the fact that the increased rate of 2% in Canada would put them at a
competitive disadvantage with other US energy companies, thus discouraging investment
into Canadian businesses.
On the other hand, certain academics, economic experts and financial market gurus
believe that this new tax would impose limits on how companies allocate their capital, in
turn creating economic uncertainty. As investors use the money from share buybacks from
mature companies to reinvest in smaller firms with better growth prospects, a tax on
buybacks could lead to a less efficient use of available capital. Indeed, the new tax will be
hindering buybacks, which is often a tool used to lower volatility. There are also
circumstances in which it would be sounder to return money to the shareholders rather
than making risky investments. Therefore, the new tax would not have the desired effect
to drive investments and innovations.
The higher rate announced by the Liberal government might be in correlation to the rate
of 2% initially proposed by the Democrats in the earlier attempted legislation. Even if this
tax is proposed to take effect as of January 1st, 2024, it is not believed, amongst the
financial community, that it will drive companies to spend more on stock repurchase in
the upcoming year (i.e., 2023) as most firms have capital allocation policies that prevent
them from arbitrarily spending on buyback programs.
Furthermore, the latest Q4 2022 reports from Canada’s largest banks are signaling a
potential recession in 2023. In a context where interest rates keep on increasing and the
economy is slowing down, it might not be wise for companies to borrow funds to finance
their buyback programs before the implementation of this new tax.
On a different perspective, many individuals in the financial sector believe that the new
tax is not significant enough to alter or influence the capital allocation strategy of
companies in which the public and investment funds are currently invested in. The
sentiment in Canada is that companies are already allocating their capital efficiently
through a combination of capital expenditure investments, dividend payments and share
buyback programs. Judging by the billions of dollars that have been injected into the
domestic energy sector, one might think that it would be a false belief to state that the
money is mainly redistributed to investors (through buybacks) at the expense of capital
investments, workers, innovation, while detrimental to the future growth of Canadian
public companies.
Alternative taxing measures could also be explored by governments to try to mitigate the
so-called capital allocation malfunctions as it pertains to public corporations. Indeed, a
transaction tax that would be applicable on all market transactions at a fixed price (let’s
assume 0,01$ per transaction) would bring every financial actor on the same level playing
field while generating substantial income for the government that could be redistributed
to workers (through tax cuts or credits). Such additional revenue could also be used to
enhance governmental programs which would entice Canadian public company’s
innovation, capital expenditures, etc. and help on fostering the future growth of such
entities.
To conclude, Canadian businesses will now have to weigh the pros and cons of this
proposed excise tax and determine when time comes to raise funds if it is still worthwhile
for them to issue shares during difficult times if buying them back when times are better
now comes at a cost.

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¹ Income Tax Act (R.S.C., 1985, c. 1 (5th Supp.));
² “Revenue Canada Round Table,” in Report of Proceedings of the Forty-Second Tax Conference,
1990 Conference Report (Toronto: Canadian Tax Foundation, 1991) 50:1-68, question 50, at 50:26.