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Dividends vs buybacks: Which is better?

Both reward shareholders, but buybacks offer a tax deferral advantage

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Stock buybacks have become a political target on both sides of the border as governments hold them up as greedy face of capitalism, rewarding shareholders  at the expense of jobs and investment.

The Biden administration’s Inflation Reduction Act in the United States includes a 1-per-cent tax on stock buybacks. Federal finance minister Chrystia Freeland one-upped that with a 2-per-cent tax on share buybacks in her fall economic statement. The Canadian tax takes effect Jan. 1, 2024.

The question for investors is what to do? Should they steer clear of tech giants like Microsoft, Apple and Alphabet who spent billions on buybacks in 2021, or view it as political theatre and ignore it.

“In the scheme of things, [the tax] is minor,” says Tom Bradley, chair and co-chief investment officer at Steadyhand Investments Ltd. “It wouldn’t impact what companies we invest in.” 

Dan Hallett, vice president of research and principal at Highview Financial Group in Oakville, Ont., agrees the tax won’t make much difference and is political posturing that demonstrates a misunderstanding of corporate finance.

Tom Bradley says a tax on share buybacks is unlikely to change Steadyhand’s investment decisions. Credit: Steadyhand Investments

“In most cases, companies are already doing a combination of things – making capital investments, paying dividends, and buying back shares.” he says.

Mr. Hallett says companies reinvest profits if they believe they can do so profitably with the result being higher revenues and profits. In the absence of attractive investments, it makes sense to return cash to shareholders, either as dividends, or by repurchasing shares. It is a reward for the company doing well.

“The notion that buybacks are some kind of windfall is baseless,” he says.

Investors like buybacks because they offer a number of advantages over dividends. They raise a company’s earnings per share by reducing the number of shares outstanding. That tends to raise the price of the shares. There is also a tax advantage. The gain is deferred until you sell the shares, unlike cash dividends which are taxed in the year they are paid.

Companies with the highest levels or buybacks tend to be the most profitable. This is precisely because they have made investments in their operations which have paid off.

According to statistics compiled by S&P Global this spring, S&P 500 companies bought back a record U.S. $881.7 billion of their stock in 2021. Five of the companies were nicknamed ‘buyback monsters’ for the size of their buybacks. They were Apple, Google parent Alphabet, Facebook parent Meta, Microsoft and Bank of America who made up a quarter of the dollar value of the buybacks. The companies are also among the most widely held stocks by small investors and among the most profitable global entities.

Not coincidentally, Amazon, Apple,  Alphabet Microsoft and Meta are among the highest global spenders on research and development, with each spending billions a year  and employing scientists, engineers and other experts who command high salaries. The work they do leads to new products which over time create more jobs and more investment. 

In 2021, Alphabet (NDQ: GOOGL) spent $31.5 billion, or 15.1 per cent of revenues to do such things as enhance its search engines, improve YouTube and experiment with driverless cars. Amazon.com (NDQ: AMZN) spent US$42.74 billion in 2020 (11.1 per cent of sales) on ‘technology and content.’ This year, Microsoft (NDQ: MSFT) will spend 12 per cent of revenues or US$24.5 billion to enhance its cloud and AI capabilities and explore such things as the metaverse and augmented reality. 

In Canada, banks and energy companies are among those with the biggest buyback plans, but according to Research Infosource Inc., a data analytics company, car parts firm Magna International Inc. (TSX: MG) was top of the list in 2020 with R&D spending of $1.1 billion in 2020 or 2.5 per cent of sales. It was followed by Constellation Software (TSX: CSU) and Shopify Inc. (TSX: SHOP)

Mr. Hallett notes that the money used to pay a cash dividend or buyback a share has already been taxed. That’s why Canadians get a dividend tax credit for investments in Canadian companies.

The dividends are grossed up for tax purposes to a number that approximates the pre-tax equivalent of the dividend. Shareholders then receive a credit to approximate the taxes already paid by the company.

“It avoid doubles taxation,” he says.

He agrees with Mr. Bradley that the tax is unlikely to encourage businesses to invest more in their businesses than they already do. He also agrees that the tax is unlikely to change an individual investor’s decision.

Neither expects a land office business in share buybacks in 2023 to beat the 2024 deadline, but  companies may make more or fewer repurchases based on their conditions.

 “But I do not expect an avalanche of buybacks specifically because of this proposed tax,” Mr. Hallett said.

This article appeared in the Globe Advisor section of the Globe & Mail’s Report on Business on Dec. 2, 2022. For reprint information please view this page.

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1 comment on “Dividends vs buybacks: Which is better?

  1. Reblogged this on Imagine life platform and commented:
    Time, investment and incasement… Dreams over the market

    Like

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