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THE BUYBACK TAX RUSE

Its a Free Tax Ride for Corporations

Published 07-07-14

What do corporate CEOs and Boards know which everyone is missing and that is driving them to executing corporate buybacks approximating $2 Trillion over 24 months? The answer is a free tax ride thanks to the Macroprudential Strategy of the Fed's ongoing game of Financial Repression. A game which may be quickly getting out of control!

UNPRECEDENTED BUYBACKS LEVELS

In case you are in the 1% who have been too busy counting your startling increase in net worth, let me first highlight the velocity with which corporate buybacks have accelerated to.

90% of all S&P 500 profits are presently being spent on corporate Buybacks and Dividends. This is historically unheard of.

Approaching almost panic buying by corporations before Tax Loophole is closed.

We are approaching nearly $2 Trillion in buybacks by the S&P 500 members within a forecasted 2 year period.

So why is this distortion happening?

A FREE TAX RIDE

We presently have one of the biggest tax ruses in history going on as the Fed and US Treasury desperately try and increase the wealth effect to elevate asset prices and finance government debt. To make low bond yield seem relatively attractive (at present historic lows), the Fed needs to get stock yields down via elevating stock prices. Corporations have been willing accomplices in this charade.

GENERIC TAX EXAMPLE

Assumptions:

    • Dividend payout rate approximates the S&P 500 average of 2.25% per annum.
    • Borrowing costs approximate 3.5% per annum
    • Corporate nominal US tax rate 35%
    • Assume stock trades at $100/share with 100 shares outstanding,
    • Market Capitalization of $10,000 (100 X 100)

A 2.25% Dividend rate means a $2.25 Dividend payout per year.

If we were to borrow $225 to buyback 2 1/4 shares it would cost $7.89 ($225 @ 3.5%)

The tax deductibility of $7.89 at a nominal tax rate of 35% would be $2.76

Therefore our model corporation would save $0.51 ($2.76 - $2.25)) by borrowing to buyback their shares.

  Rates EXAMPLE  
Borrowing Cost 3.5% If we were to borrow $225 to buyback 2 1/4 shares it would cost $7.89 ($225 @ 3.5%)

$7.89

Tax Rate 35% The tax deductibility of $7.89 at a nominal tax rate of 35% would be $2.76 $2.76
Dividend Rate 2.25% A 2.25% Dividend rate means a $2.25 Dividend payout per year. $2.25
Savings   Saving of $0.51 ($2.76 - $2.25)) by borrowing to buyback corporate shares. $0.51
    This would be a return of 6% on borowing of $7.89 ~6.3%

APPLE

As the Washington Post reported over a year ago:

About two-thirds of the $145 billion in cash on Apple’s books is held in overseas subsidiaries, and Apple would have to pay U.S. income tax if it used that money in the United States. So instead of bringing back money from overseas to pay for its stepped-up stock buybacks and higher cash dividend, Apple will borrow money instead.

It’s a perfect tax arbitrage. Let’s say Apple borrows money at an interest rate of 3 percent a year (which is more than it would probably pay), and uses it to buy back stock at the current price of about $410 a share. Each share that Apple buys back will reduce its annual dividend obligation by $12.20 a share, at the company’s current dividend rate. The interest on the borrowed money would be $12.30 a share — about the same as the dividend. But interest is tax-deductible, and dividends aren’t.

At a 35 percent tax rate, the borrowed money would cost Apple $8 after taxes for each share it bought back. That’s significantly less than the $12.20 after-tax cost of its $12.20 dividend. At a 25 percent tax rate, the borrowing would cost $9.23 after taxes—but that’s still less than $12.20. So lowering the tax rate to 25 percent from 35 percent doesn’t remove Apple’s incentive to play the deduct-interest-to-retire-stock tax game. It would be less lucrative than it is at 35 percent — but it’s still lucrative. And, by the way, the borrowing-to-buy-back maneuver would not only reduce Apple’s taxes but also increase its earnings per share.

With tax rates at 35 percent, it’s considerably cheaper for Apple to borrow money in the United States than it would be for it to repatriate cash held in foreign subsidiaries. But even if the tax rate were only 25 percent, it would still be cheaper for it to borrow than to repatriate.

IBM

IBM buyback activity has been startling as shown below. What may be more startling is that during this same period in 2013 its nominal tax rate fell from 25.5% in 2012 to 11.2%. How does this abruptly happen in a corporation the size of IBM operating in as many tax codes as it does? The answer is simple. Thank Uncle Sam and the Federal Reserve.

2013 Rates EXAMPLE  
Buybacks    

$13.9B

Revenues   Saving of $0.51 ($2.76 - $2.25)) by borrowing to buyback corporate shares. $99.8B
Debt Increase   IBM Increased its total debt outstanding by $6.4B $6.4B
Tax Reduction   The EFFECTIVE tax rate for 2013 as reported in the annual report was 15.6%, a decrease of 8.6% versus 2012. 8.6%
Tax Savings   This would be a return of 6% on borowing of $7.89 $8.6B
Cash Dividends   Cash Dividend on ALL IBM Shares outstanding. $4.1B
Dividend Yield   IBM paid 4.1B Dividends on 1.054 Shares outstanding trading at $187.57 on December 31, 2013. 2.0%
Dividend Savings   Buybacks of $13.9B in shares paying 2% yield is dividend payout reduction of $278M $278M
    Debt Increase ($6.4B) plus Tax Reduction ($8.6B) was $15.0B on $13.9B in Buybacks  
    Tax Savings were over 2X IBM's total Dividends paid  
Return   IBM's reported 15.6% effective tax rate on $13.9B shares resulted in a $3.1B tax savings for these Buybacks versus dividends against those shares of $278B. This is 11X 11X

Debt Increase ($6.4B) plus Tax Reduction ($8.6B) was $15.0B on $13.9B in Buybacks.

2013 Tax Savings were over 2X IBM's total Dividends paid on ALL outstanding shares.

IBM's reported 15.6% effective tax rate on $13.9B shares resulted in a $3.1B tax savings for these Buybacks versus dividends against those shares of $278B. This is 11X return.

 

Consider the above tax savings in light of the size of others doing the same thing:

ORACLE

    Q4          $2B in Buybacks
    2014       $10B YTD
    2 Yr         $21B

CATERPILLAR

    2013       $7.5B in Buybacks
    2014       $10.0 ANNOUNCED

This buyback activity is now outpacing EBITDA which is nearing contraction or negative burn for corporations with major free cash flow contributions from within the G4.

CONCLUSIONS

We may be witnessing one of the biggest orchestrated "tax loop holes" in history. Clearly corporations are wasting no time taking full advantage of it.

The question now is whether the game has gotten out of control and whether the Fed is afraid to stop it?

We discuss all of this and more in our latest UnderTheLens subscriber Video - Liqudity is not Wealth, Nor Collateral

 

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Gordon T Long is not a registered advisor and does not give investment advice. His comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While he believes his statements to be true, they always depend on the reliability of his own credible sources. Of course, he recommends that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that you are encouraged to confirm the facts on your own before making important investment commitments.

© Copyright 2013 Gordon T Long. The information herein was obtained from sources which Mr. Long believes reliable, but he does not guarantee its accuracy. None of the information, advertisements, website links, or any opinions expressed constitutes a solicitation of the purchase or sale of any securities or commodities. Please note that Mr. Long may already have invested or may from time to time invest in securities that are recommended or otherwise covered on this website. Mr. Long does not intend to disclose the extent of any current holdings or future transactions with respect to any particular security. You should consider this possibility before investing in any security based upon statements and information contained in any report, post, comment or suggestions you receive from him.

 

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