Will this brand new tax change hurt stock market returns?

Congress recently passed the Inflation Reduction Act, which contains a number of provisions. It aims to increase revenues and fight inflation by introducing an alternative minimum tax of 15% for businesses, allowing Medicare to negotiate prescription drug prices, and the IRS enforcement on high taxpayers. to increase income. And it plans to invest $437 billion in energy security, climate change and an extension of the Affordable Care Act.

However, one last-minute tax change has been added that could have a major impact on some stocks in your portfolio: a 1% excise tax on the redemption of company shares.

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Image source: Getty Images.

The new tax on share buybacks

The short version of the new tax is that when most companies buy back their own shares, a 1% tax is levied on the amount spent. In other words, if a company spends $100 million on stock repurchases, it faces a $1 million tax bill. The idea is to discourage buybacks that are solely intended to increase profits and stock prices, and to encourage profits to be spent in other, more productive ways.

There are a few exemptions. For example, REITs (real estate investment trusts) are exempt from the new tax, and the same is true if the repurchased shares are contributed to an employee stock plan or similar.

Why share buybacks are a target?

Companies buy back shares for a few reasons. For example, if management thinks its stock is worth more than the current market price, it can mean a large expenditure of capital and can help increase value over the long term. And from an earnings perspective, fewer shares outstanding may give the impression that earnings per share growth is stronger than it actually is.

While stock buybacks certainly have a valid and practical use, they have been questioned by several key lawmakers in recent years. For example, some in power were hesitant to help the airlines during the initial COVID-19 shutdowns after it was revealed that these companies had spent billions buying back their own shares rather than building reserves. The common argument of many politicians is that companies should spend their profits on their employees, or reinvest in their growth, instead of simply buying back shares and increasing their share price for investors.

Will your favorite companies stop buying back shares?

This is certainly negative news for companies that regularly buy back shares, but whether it will actually affect the volume of the buybacks is another matter.

Sure, some companies could choose to shift some of their earnings from buybacks to dividends, but it’s not likely to happen on a large scale. After all, the new tax of 1% on share buybacks is the nothing but additional tax due when companies use their profits in this way.

On the other hand, if a company were to decide to pay dividends instead, investors who own stock in a standard brokerage account could face tax rates as high as 23.8% on that income.

Let’s take a look at how this can actually affect a business. During the first three quarters of the current fiscal year, Apple (AAPL -0.09%) generated $79.1 billion in net income and spent $65 billion on share buybacks. Under the new tax law, the company would pay a $650 million tax on these buybacks — 1% of the amount.

That $650 million may sound like a big tax bill, and it is. However, it represents an earnings hit of just $0.04 per share for the tech giant. And think what would happen if Apple paid that $65 billion as a dividend instead. Assuming an average tax rate of 15% on qualifying dividends, shareholders could face nearly $10 billion in tax bills.

The bottom line is that while the new share buyback tax could certainly reduce the revenues of your favorite companies, it’s unlikely that company behavior will change significantly when it comes to capital allocation. It’s also not likely to be a major drag on the stock’s long-term performance. In short, investors need not panic.

Matthew Frankel, CFP® has no position in any of the listed stocks. The Motley Fool holds positions in and recommends Apple. The Motley Fool recommends the following options: Call $120 long on Apple in March 2023 and call $130 on Apple short in March 2023. The Motley Fool has a disclosure policy.

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