The 2017 Tax Cuts and Jobs Act (TCJA) lowered taxes for US corporations, with the stated goal of creating jobs throughout the US. In 2018, however, large US corporations spent more than $1.1 trillion to repurchase their stock rather than invest in new plants and equipment or pay their workers more.  In response, Senator Marco Rubio (R-FL) says he’d tax buybacks more heavily, by treating buybacks like dividends. Rubio is on the right track, but he’s only partially addressing the real problem: The TCJA’s large windfall to foreign shareholders of US corporations, many of whom would still retain a large tax cut even if Rubio’s proposal becomes law.

In theory, a corporation repurchases its shares or distributes dividends when it cannot invest the excess cash attractively. Thus, stock buybacks may be a sensible corporate strategy, given limited investment opportunities. But should the stock buybacks also enjoy tax benefits over dividends, which largely accomplish the same corporate objective of returning cash to shareholders?    

Rubio’s idea is based on a 1969 law review article by the late law professor Marvin Chirelstein. In that paper, Chirelstein proposed taxing buybacks and dividends in the same way.  The professor objected to corporations that “packaged” cash distributions as capital gains, which were taxed at a maximum 25-percent rate in the mid-1960s, rather than dividends, which were taxed at a maximum 70-percent rate.

Chirelstein’s proposal would work like this: If a company buys back some of its shares, all its investors— even those who did not sell—would be treated for income tax purposes as if they had received a dividend and reinvested the proceeds. The investors’ cost basis in their shares would be increased to reflect the deemed dividend. Investors whose shares were purchased in the buyback, or sold their shares later, also would pay a tax on capital gains if their sales price exceeded their adjusted basis.  The bottom line: many shareholders would have been taxed on their deemed dividends, at rates up to 70 percent.

But today’s world is much different than the 1960s for two reasons. First, the rate differential between long-term capital gains and qualified dividends no longer exists for US shareholders. Second, foreign ownership of US shares, where a rate differential remains, is much greater.  

For US taxable shareholders, long-term capital gains and qualified dividends are taxed at the same maximum rate of 23.8 percent, not the 1960s-era rates of 25 percent for capital gains and 70 percent for dividends.  So, many of these shareholders now are indifferent between buybacks and dividends.  (There still is some, albeit smaller, advantage for US taxable shareholders who hold their shares beyond the buyback.  In these cases, they may defer a tax on their unrealized gains and perhaps avoid it completely by holding their shares until their death.)

However, foreign shareholders of US companies still pay a zero rate on capital gains but a 30 percent tax on dividends (typically reduced to 15 percent if they reside in a country that has a tax treaty with the US).  Thus, they still favor buybacks. In addition, today, foreign and taxable US shareholders own roughly the same amount of US publicly-traded shares, about 25 percent, with the remainder held mainly by non-taxable US shareholders, like pension funds, IRAs and non-profit institutions. But, in the mid-1960s, foreigners owned 2 percent, while taxable US shareholders owned almost 85 percent of US publicly-traded stock. (Today, foreign shareholders own about 35 percent of total US corporate equity, both public and private.)

So, what do these shifts mean for Rubio’s idea? In today’s economy, unlike that of 50 years ago, fewer taxable shareholders would be affected—with smaller overall effects. Under the updated Chirelstien proposal, some taxable US shareholders might report additional dividends but also would increase the basis in their stock. However, foreign shareholders would report additional taxable dividends, which could increase US tax receipts appreciably given their sizable holdings, unless they took specific avoidance steps. 

Some foreign shareholders might not object to the increased US withholding tax if they could credit any additional US taxes on deemed dividends against their home country’s income tax liability. Other foreign shareholders might sidestep the proposal by selling shares before the buyback program created the deemed taxable dividend, and repurchasing them afterwards. It would be difficult to create an anti-abuse rule to curb this avoidance mechanism.

Perhaps a Rubio proposal would recover a small amount of the tax jackpot foreign shareholders received when the TCJA reduced US corporate tax rates benefitting existing shareholders. But a larger question looms: Why did Congress lower taxes for corporations if so many of them had limited investment opportunities?