Buybacks: what are they, are they tax avoidance schemes and should we legislate against them

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Buybacks what are they, are they tax avoidance
schemes and should we legislate against them?

• Introduction to buybacks by John Polichronis (15
  mins)
• They are tax avoidance schemes that we should
  get rid off, by Blake Ford (15 mins)
• No, we shouldnt because they have a good reason
  by Jayne Dillon (15 mins)
• Group Discussion

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Definition

• When a firm wishes to pay cash to its owners
  (shareholders) it normally pays a cash dividend.
  Another way to distribute cash is to repurchase
  shares from its shareholders.

3
Microsoft (US)

• Prior to 2003 Microsoft had a policy of paying no
  dividends. All funds were ploughed back into
  growth
• Since then cash surplus and tax changes have
  induced a change in management policy
• Now paying dividends and making share repurchases
  in the order of 30 billion

4
APN (Australia)

• APN recently had a buyback. Its press releases
  indicate that its motives included
• a desire to mop up dilution due to the
  increased number of share created by conversion
  from debt to share (convertible securities)
• Accretion in EPS

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Buyback History (Australia)

• Prohibited or very difficult (costly) to
  undertake prior to 1989
• Changes in legislation 1989 and 1995 has led to
  an increase in popularity
• 1995 share repurchases 770 million
• 2004 share repurchases 7.7 billion

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International Scene

• Big increase in share buyback in other developed
  financial markets where prohibition was lifted
• Huge increase in the US where they have been
  allowed for a long time 1999 and 2000 more paid
  in buyouts than in dividends

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WHY?

• Why are they so popular?
• Do they add value? Are they good or bad for
  shareholders?
• Are the advisors reaping the benefits?

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Procedures in Australia

• Equal Access buybacks
• Selective buybacks
• On- market buybacks
• Employee share scheme buybacks
• Minimum holdings buybacks

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Example - Polycorp

• Share price 2
• 1,000,000
• V E 2x1,000,000 2,000,000
• PCM no taxes or frictions maximising NPV
• Earnings 200,000
• EPS 200000/1000000 20cents per share
• P/E 10
• Has 200,000 available for distribution
• Dividend or Share buyback?

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Example in a world without tax and legislation
Polycorp Pays Dividend

• On ex-dividend day price will fall by the amount
  of the dividend 20 cents per share (dividend
  dropoff).
• SP 1.80
• V 1,800,000 (1,000,000 x 1.80)
• EPS 200,000/1,000,000 .2
• P/E 9
• Shareholder (10 shares before worth 20) has 18
  (10 at 1.80) in shares and 2 in cash after
  giving total 20.

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Example Polycorp Makes Buyback

• Buys back 100,000 shares to value of 200,000
• Share Price 2.00
• V 1,800,000
• EPS 200,000/900,000 22.22 cents
• P/E 9
• Shareholder (10 shares before worth 20) has 18
  (9 x 2) in shares and 2 in cash after giving
  total 20.

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Conclusion

• It does not matter whether Polycorp pays a
  dividend or makes a buyback

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Share buybacks are a tax evasion scheme

• Blake Ford

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Legislation

• Pre 1989 Buybacks difficult to enact
• Following legislation to make this less costly
  and favourable imputation and capital gains tax
  laws
• substantially more buybacks occurred

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Particulars taxes on income versus capital gain

• if you earn, from income including
  dividends21601 - 63000 you pay 2340 plus 30c
  for each over 21600if you earn63001 -
  95000 you pay 14760 plus 42c for each over
  63000 and if you earn95001 and over you pay
  28200 plus 47c for each over 95000.
• The clue is that a realised capital gain counts
  only for 50 as income if the asset was bought
  more than 1 year ago. Hence the tax paid will be
  less than half the tax paid on an otherwise
  equivalent amount of (pre-tax) dividends if you
  earn 95000 in capital gain from an asset older
  than 1 year, you pay the same tax as you would
  with an income of 47500 or a pre-tax dividend of
  47500.

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Common reasons why its not tax evasion

• Ratios
• Signals
• Investment

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Reasons why these arent reasons

• Ratio changes dont necessarily show a change in
  firms actual, intrinsic value.
• Thus, this isnt a good investment, so there
  must be an offsetting benefit Tax!
• Signals Valid in specific cases so why have
  there been prolonged buybacks?

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Other reasons

• Directors have ulterior motives
• Ikenberry et al. Scepticism of buybacks not an
  investment reason must be tax
• Agency costs (and tax benefits)

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Legislation

• This is harmful to other taxpayers
• Buybacks, encouraged by current legislation
  achieve no productivity objectives
• Education/Disclosure

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Conclusion

• The current tax system means less net tax is paid
  on the capital gain that is realised via share
  buyback than would be levied on the dividends.
• This is cheating the other tax payers and hence
  should be legislated against.
• I advocate reversing the beneficial tax treatment
  

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Jayne Dillon buybacks are efficient. Leave them
alone
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Outline of the argument

• Buybacks can not be attributed to tax motivations
• Buybacks increase shareholders proportion of
  equity per share
• act as a signalling device to the market
• Allow firms to obtain a good capital structure
• Mitigate the agency problem
• Mitigate dilution from ESOPs

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A) Buybacks increase shareholders proportion of
equity

• Assume a company has market capitalisation of 5
  mill, no growth in earnings
• Shares are traded at 50 therefore
• 100 000 shares are available
• Buyback will entail 20 000 shares
• Results in a 25 per cent increase in equity per
  share from no growth in earnings.

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B) Signalling device to the market

• Could be a positive or negative signal,
  regardless the market is obtaining news (Weston
  and Sui, 2002)
• Signalling for undervaluation (Rappaport, 1998)

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Signalling for possible investment opportunities
and FCF

• Assisting the market in pricing news into the
  stock
• Buybacks also allow for the efficient use of FCF
  when this appears to be the most beneficial
  alternative available

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C) Obtaining optimal capital structure and
improving ratios

• Buybacks enable the manipulation of ROA and ROE
• Realise an optimum leverage ratio (Wansley, Lane
  and Sarkar, 1989)

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D) Mitigating the agency problem

• An increase in the equity proportion of each
  share may provide more incentives for management
  to think like owners (Weston and Siu, 2002)

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E) Mitigate dilution from ESOPs

• ESOP employee stock option plans
• Constriction of labour market may lead to
  increased exercising of ESOPs causing dilution