The $2T Buyback Tax Ruse

By: Gordon Long | Tue, Jul 8, 2014
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Tax Loophole

Its a Free Tax Ride for Corporations

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 Macro-Prudential Strategy of the Fed's ongoing game of Financial Repression. A game which may be quickly getting out of control!


Unprecedented Buyback 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.

S&P500 Quarterly Buybacks Chart

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.

Buybacks and Dividends Since 2001

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

Stock Repurchased in Q1 2014

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

Apple Buyback in Q1 2014

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 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.

IBM Buyback in Q1 2014

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 - Liquidity is not Wealth, Nor Collateral

 


 

Gordon Long

Author: Gordon Long

Gordon T. Long
Publisher - LONGWave

Gordon T. Long

Gordon T. Long has been publically offering his financial and economic writing since 2010, following a career internationally in technology, senior management & investment finance. He brings a unique perspective to macroeconomic analysis because of his broad background, which is not typically found or available to the public.

Mr. Long was a senior group executive with IBM and Motorola for over 20 years. Earlier in his career he was involved in Sales, Marketing & Service of computing and network communications solutions across an extensive array of industries. He subsequently held senior positions, which included: VP & General Manager, Four Phase (Canada); Vice President Operations, Motorola (MISL - Canada); Vice President Engineering & Officer, Motorola (Codex - USA).

After a career with Fortune 500 corporations, he became a senior officer of Cambex, a highly successful high tech start-up and public company (Nasdaq: CBEX), where he spearheaded global expansion as Executive VP & General Manager.

In 1995, he founded the LCM Groupe in Paris, France to specialize in the rapidly emerging Internet Venture Capital and Private Equity industry. A focus in the technology research field of Chaos Theory and Mandelbrot Generators lead in the early 2000's to the development of advanced Technical Analysis and Market Analytics platforms. The LCM Groupe is a recognized source for the most advanced technical analysis techniques employed in market trading pattern recognition.

Mr. Long presently resides in Boston, Massachusetts, continuing the expansion of the LCM Groupe's International Private Equity opportunities in addition to their core financial market trading platforms expertise. GordonTLong.com is a wholly owned operating unit of the LCM Groupe.

Gordon T. Long is a graduate Engineer, University of Waterloo (Canada) in Thermodynamics-Fluid Mechanics (Aerodynamics). On graduation from an intensive 5 year specialized Co-operative Engineering program he pursued graduate business studies at the prestigious Ivy Business School, University of Western Ontario (Canada) on a Northern & Central Gas Corporation Scholarship. He was subsequently selected to attend advanced one year training with the IBM Corporation in New York prior to starting his career with IBM.

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, we encourage you confirm the facts on your own before making important investment commitments.

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