J. Ari Pandes is an associate professor of finance and an associate dean at the University of Calgary’s Haskayne School of Business.
The Carney government moved quickly to scrap the previous government’s proposed capital-gains tax increase. One policy it has yet to revisit is the 2-per-cent tax on share buybacks that came into effect on Jan. 1, 2024. The tax deserves a second look.
Stock buybacks are the poster child for what critics see as shareholder or managerial greed. The common narrative is that companies juice their stock price by nefariously buying back shares. In reality, buybacks are simply a return of surplus cash to the owners of the company – the shareholders. In that sense, they are just like dividends. Investors supply capital to companies and expect a return. Buybacks are one way of delivering that return.
A stated motivation for the buyback tax was to encourage companies to invest more. But that reflects a misunderstanding of how buybacks actually work. Companies do not decide on buybacks first and then make investment decisions. They invest first – in their operations and in all opportunities that meet their cost of capital – and then distribute whatever cash is left over through dividends or buybacks. This is what is meant by surplus cash.
One of the key advantages of buybacks over dividends is flexibility – a company that repurchases shares is not committed to future buybacks. This flexibility is particularly valuable in volatile or uncertain markets, the kind we are living through today. Dividends, by contrast, lock firms into continuing payout commitments. Because dividend cuts are typically met with sharp negative stock-price reactions, managers are reluctant to cut them, implicitly committing the company to future cash payouts regardless of business conditions.
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Consider oil and gas and other commodity-based companies today. The recent spike in commodity prices will likely generate large, temporary windfalls. We will get a glimpse starting this week as Canadian energy producers begin to report their first-quarter results. Where these companies have limited value-creating investment opportunities, the prudent balance sheet response is to return that cash to shareholders through repurchases, rather than binding the company with long-term dividend commitments that may be costly to reverse later. The buyback tax nudges firms towards that rigid path. If companies choose not to invest, it is typically because they do not see opportunities that yield a return high enough to justify the risk. In that case, distributing the cash through buybacks allows shareholders to redeploy it toward more productive uses elsewhere in the economy.
And this is where buybacks offer another important advantage. Unlike dividends, which are paid to all shareholders, buybacks go only to those who choose to sell. Shareholders who sell are likely doing so because they have better investment opportunities elsewhere. That cash can flow toward companies that need it to grow and scale. It is a more efficient reallocation of capital. This is also why special dividends – another flexible way to distribute temporary surplus cash – do not have the same effect. Dividends are distributed to all investors, regardless of whether they have other investment opportunities, increasing the chances that cash remains idle or less productive within the economy.
As for the claim that executives use buybacks to artificially boost share prices and hit compensation targets, the empirical evidence simply does not support it. In 2019, PwC and Alex Edmans, professor of finance at London Business School, published a study commissioned by the British government to examine the alleged misuse of buybacks. Examining FTSE 350 firms over a nine-year period, they found no evidence that buybacks come at the expense of investment, and no evidence that buybacks were used to meet executive pay targets.
For many critics of buybacks, the smoking gun is that announcements of repurchases are, on average, met with positive announcement returns. But this is best explained by the fact that companies tend to repurchase shares when managers – based on inside knowledge of the business – believe those shares are undervalued. The more reasonable interpretation, then, is that the market infers the same, not that buybacks artificially inflate prices. Consistent with this interpretation, research shows that firms continue to outperform comparable peers in the years following buybacks.
The Carney government has shown it is willing to revisit tax policy inherited from its predecessor when it cancelled a proposed hike in the capital-gains inclusion rate. The buyback tax is a good candidate for that same scrutiny, especially now when Canadian companies need the flexibility to manage through one of the more uncertain stretches in recent memory.