By Gordon T. Long
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
- 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.
|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%|
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 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.
|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:
Q4 $2B in Buybacks
2014 $10B YTD
2 Yr $21B
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.
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?