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Let's say a company with a market cap around 100 millions USD manages to make this year around 6 millions USD in "profit". Let's say at the end of the year there are one million shares, each one valued at 106 USD.

Option A: company declares the 6 millions profit, pays about 2 millions in taxes (assuming rate = 33%) and pays 4 millions to shareholders in dividends. (In most countries, this 4 million will also be taxed as income to shareholders.)

Option B: company buys 6 millions USD / 100 (average price) ~= 60 000 of its own shares and cancels them. Assuming the company will be able to turn in the same 6 millions USD profit next year and assuming a constant earning per share, the new 940 000 shares should be valued at 106.38 USD.

If I understand correctly what you and ATinNM are telling me zero taxes are paid by company in option B.

The shareholder in option A will pay near or no capital gain if he sells his share (initially bought at the beginning of the year) after the dividend, and in option B he will pay capital gain tax.

From the state point of view, seems to be close, a more accurate model (real taxation rates, interest rates, company valuation model taking into account profit taxes) would be needed.

Any reference?

by Laurent GUERBY on Sat Dec 23rd, 2006 at 05:27:00 AM EST
[ Parent ]
In option B...

  1. does the company sell the shares at $100 or at $106? Wouldn't it be selling 56600 shares at $106 rather than 60000 shares at $100? That would leave 943400 shares valued at $106. In your calculation the share buyback results in a +$0.38 bump to the share price, which seems inconsistent.

  2. aren't the assumptions about performance in the next year supposed to be factored in the share price already? [constant earnings per share is indeed a necessary assumption]

In any case, it seems share buybacks are "better" than dividends because the shareholders do not have to implicitly pay any tax on the company's profit: they get $6M as opposed to $4M.

If corporations pay tax only on profit, does this mean that they can use share buybacks to pay no tax at all?

Those whom the Gods wish to destroy They first make mad. -- Euripides

by Migeru (migeru at eurotrib dot com) on Sat Dec 23rd, 2006 at 06:06:14 AM EST
[ Parent ]
My model is not good enough for this level of accuracy (as I said) and is indeed not consistent.

Since you can't buy groceries with your shares, the shareholder wil have to sell, when he sells he will pay capital gain tax (or income tax), which can be more than company profit taxes.

If you bought at 100 and sold at 106, you make 6 in additional income which is taxed. If you hold on your share longer, you need to take into account risk-free interest rate, etc...

I don't know if retirement funds are taxed on capital gain, if not, we now know why they vote for share buybacks.

by Laurent GUERBY on Sat Dec 23rd, 2006 at 06:36:45 AM EST
[ Parent ]
Retirement funds can be legally organized, in the US, in so many ways a general answer is impossible.  

But, if your ready for this one, the US goverment, in its wisdom, allows corporations to put their own stock in their internal retirement plan.  So when they buy back shares they also increase the estimated net worth of that  fund as well.  

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sat Dec 23rd, 2006 at 12:36:09 PM EST
[ Parent ]
The risk-free interest rate doesn't exist...

Those whom the Gods wish to destroy They first make mad. -- Euripides
by Migeru (migeru at eurotrib dot com) on Sat Dec 23rd, 2006 at 05:14:52 PM EST
[ Parent ]
Well, let's call it the best approximation of it and forget about the approximation :).
by Laurent GUERBY on Sat Dec 23rd, 2006 at 06:12:57 PM EST
[ Parent ]
I have a serious point to make with that, and that is that the assumption that there is a single lowest interest rate at which it is possible to both lend and borrow is simply not true. Well, it might be true for banks (i.e., market makers), for instance in London they can all borrow from each other at LIBOR, but other market participants don't have access to that, and can borrow and lend at different rates.

Those whom the Gods wish to destroy They first make mad. -- Euripides
by Migeru (migeru at eurotrib dot com) on Sat Dec 23rd, 2006 at 06:17:41 PM EST
[ Parent ]
The risk free rate is when someone lends to the state, and in France at least you can buy various "BTAN", "OAT"  that gives you this rate (with a tiny spread, France being one of the best borrower of the eurozone and also near zero bank margins), the government recently announced measures to ease the access to state debt for consumers.

By definition lending to any other entity will get a higher rate.

And of course banks take their margin for most products, I believe I would get interest of EURIBOR 3 or 6 monthes minus 15 basis point if I block money for the duration at my bank.

by Laurent GUERBY on Sun Dec 24th, 2006 at 04:48:31 AM EST
[ Parent ]
And only the state gets the risk-free rate when they borrow, banks get interbank rates (LIBOR, EURIBOR...) and people get the shaft.

Those whom the Gods wish to destroy They first make mad. -- Euripides
by Migeru (migeru at eurotrib dot com) on Sun Dec 24th, 2006 at 04:52:13 AM EST
[ Parent ]
In the US - Your Tax Laws May Vary - OK?

In option B neither the Corporation nor the investor has to pay taxes on the $.38 increase in share value.  Focusing on the latter, no money has been "constructively received" by the shareholder thus there is no tax event.

In your example, the $.38 can be viewed, by the investor, as the monetarized value of a tax-free compounding rate which increases the Internal Rate of Return of the investment.  (Does that make any sense?)

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Sat Dec 23rd, 2006 at 12:26:56 PM EST
[ Parent ]
$0.38 means nothing here, it is far below the errors and approximations I made.
by Laurent GUERBY on Sat Dec 23rd, 2006 at 06:14:04 PM EST
[ Parent ]
No and I apologize if my previous answer was confusing.  In both option A and B the company will pay the taxes.  So the company pays $2 million in both cases.  

the difference comes with the shareholders.  When the shareholder receives the dividend at the end of the year, he/she pays taxes at the dividend rate, now 15% in the US.  The difference really comes for those shareholders who are long term investors, and don't want the annual dividend payments.  If no dividend is paid, and the money is left in the company, and the company continues profit growth as you suggest, the individuals money grows without any of it being taxed.  Then say at the end of 10 years he sells, he then pays a 15% capital gains tax--but all of "his earnings" in the company have grown without him paying the 15% tax on the annual dividend.  So the 10 year holder not paying dividends, gets the full compounding effect on his portion of the earnings.  

If he invested in an identical company that paid the dividend every year, he would pay the personal tax on the dividend each year, and thus lose the opportunity to compound his gains on the portion paid in taxes.

This is less of an issue in the US than it was in the past.  So for example, 6 years ago the top federal income tax for individuals for ordinary income was about 40%, and that rate also applied to dividends.  So this meant earnings were taxed at (using your example) 33% by the corporation,,,and then the dividend was paid after the corporate tax was taken out,,,,,and the dividend was taxed again at the 40% level.  So just to play that out, if my portion of the corporate earnings was $10,000, the company was going to pay $3,333 in taxes to the government.  Then if the company was paying all after tax earnings out as dividends, I would get the remaining $6,667 paid to me as a dividend, and I would pay another $2,667 to the Federal Government.  So of my $10,000 portion of the earnings, I would be taxed twice and pay $6000 in total to the government, and receive only $4000--a combined tax rate of 60%.  And in New York or California, state tax would take at least another $667.

This "double taxation" effect on dividends caused companies to reduce their dividend payouts as a % of after tax earnings from something like 3.5% in the '70's to 1.2% in the early 2000 (from memory, but it was dramatic).  The view of companies was that it was better for the shareholder if the money was left in the company, not double taxed as a dividend, and then the shareholder could sell shares when he needed money, and the capital gains tax rate was lower than the ordinary income tax rate, so the shareholder did better.  Now at lower and equal dividend and capital gains tax rates of 15%, this is less of an issue, and companies are gradually starting to pay more in dividends.

by wchurchill on Sun Dec 24th, 2006 at 01:57:43 AM EST
[ Parent ]
Thanks for those precisions.

Here is what I know about taxation in France for 2006 income and profits:

Company profit taxation is at 33.33%.

Marginal effective income tax rate is at 40% (kicks in  after 66 679 euros of income).

When you receive a dividend, up to 1 525 euros per person, you can remove 40% of the amount, the rest is counted as income.

Some fixed interest products (including state debt) has a marginal rate of 27% (if you choose "prélèvement libératoire" as most "rich" people do, otherwise it is taxed as income - interesting for low revenue).

French "Plan d'Epagne en Action" (financial vehicle where you can put pretty much whatever you want: shares, indices, ...) capital gain is taxed at 11% after 5 years, but there is a investment cap at 132 000 euros per person (current value can be above).

The big french saving product is "assurance vie", after 8 years capital gains are taxed at 7.5% for the part above 4600 euros per person per year (if I understand correctly, I have no such product).

Unsurprisingly "assurance vie" is the most popular financial product in France, and I guess managers of such funds encourage share buybacks.

by Laurent GUERBY on Sun Dec 24th, 2006 at 05:46:54 AM EST
[ Parent ]
thanks, this was very interesting.  I'll take some time later and go back and work with the articles in French--dificile pour moi, mais une bonne methode a apprendre (forgive my French).

it does look like for truely long term investing, l'assurance vie would be good, particularly if the investment was in well diversified funds, such as index funds.  Investing in individual companies would be problematic, because their fortunes may turn downward and you have to sell early.  but investors that have invested over truely long periods of time in the S&P 500, for example, have done pretty well,,,,so 10,000 EU may double every 7 years, and at the end of 21 years be worth 80,000--taxed at only 7.5% would leave one with 74,750.  or better yet, invest 10,000 this way at 30 years old, and cash in at 65--theoretically it doubles 5 times to 320,000, minus the 7.5%. that is "theoretically" of course.

I didn't realize the top french ordinary income tax rate was 40%, if I understand you right.  the US is 35%, but not much difference.  I think the french rate takes effect at a lower income, however.

thanks again, i enjoyed the comments and links.

by wchurchill on Sun Dec 24th, 2006 at 11:26:40 AM EST
[ Parent ]
One problem with the french tax code is that it's full of holes, there are more than 600 tax holes. There are some top income people who pay zero income tax.

The legislator passed a law to cap the amount of exemption at some number, but constitutional court rejected the article as "too complex" (it was the same as a cap of taxes on income at 60% which was not censored by the same court - a real scandal).

So take the frenhc marginal tax rate with a grain of salt.

by Laurent GUERBY on Sun Dec 24th, 2006 at 12:34:46 PM EST
[ Parent ]


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