Business

What are stock purchases and why does Ottawa tax them?

What are stock purchases and why does Ottawa tax them?

Canada's Prime Minister and Finance Minister Chrystia Freeland has participated in the press conference on the autumn economic statement in Ottawa.

Canada’s Prime Minister and Finance Minister Chrystia Freeland has participated in the press conference on the autumn economic statement in Ottawa.

There has been plenty of noise from the federal government announced last week plans to tax companies that use their profits to return shares to investors. Below is a basic explanation of share buybacks, their purpose and why Ottawa is setting its targets as one of the ways corporations reward investors.

What are stock buybacks?

At a basic level, stock buybacks, or stock buybacks, are one of five ways a company spends its earnings, said Barry Schwartz, Chief Investment Officer and co-owner of Baskin Wealth Management. When a company has cash after deducting the costs of running the business, executives can distribute the remainder in the following ways:

  • paying dividends to its shareholders at the end of the quarter or year;

  • payment of accrued debt;

  • investing in the business by re-hiring or increasing salaries, growing its customer base by building more physical stores or investing more resources in research and product development—to list a few examples—;

  • acquiring or merging with other businesses that the company deems beneficial to the growth of its core business;

  • and/or through share buybacks, where the company will use its profits to buy back shares of its business to investors who are willing to sell those shares.

“It’s not a dirty thing. It’s not something we should say, ‘huh, that’s gross,'” Schwartz said of stock buybacks. “It’s part of your five capital allocation tools as a CEO or CFO.”

Why do companies buy shares from investors?

There are a number of reasons why companies might choose to do stock buybacks, and it’s “a function of a properly formed stock market,” Schwartz said. When a company buys back its stock, it reduces the number of shares outstanding and should theoretically increase its stock price. If the investor does not sell his shares back to the company, he still owns the same number of shares, but his stake in the company has increased without having to spend money to buy more shares.

If a company’s board has created an executive incentive or bonus structure based on stock price performance, a CEO may decide to use the company’s earnings to repurchase shares from its investors. Schwartz said that this is not inherently a negative motivation for executives, especially if the board decides that increasing the value of the stock price is one of the focuses of growing the business.

“Now, stock buybacks, like any other capital allocation decision, can be problematic if you use them to artificially boost your stock without considering your company’s value,” Schwartz said.

Companies can also decide to buy back shares if executives believe the current stock price is below what they are worth. Leaders can make calculations, determine what the value of the product they sell in the future may be, take into account current production levels, among many other considerations, and think that the price should be higher. The math of natural supply and demand comes into play when companies buy back stock, Schwartz said, and the stock price rises, making the stock attractive to investors who can throw more money into the company’s stock.

Shareholders also sometimes prefer buybacks to receiving quarterly or annual dividends because Canada’s tax structure has lighter rates on capital gains from share buybacks compared to income taxes on dividends.

“Over time, if a company continues to reduce the number of shares, and you don’t sell, your ownership will increase dramatically,” he said.

Why does the federal government tax purchases?

Deputy Prime Minister and Minister of Finance Chrystia Freeland unveiled a plan to tax companies two percent on stock purchases last week Autumn economic statement and details of the tax will be in next April’s budget. The Liberal government envisioned the tax as a way for companies to spread their profits to workers and grow their business, rather than paying those profits out to investors.

The tax should take effect on January 1, 2024 and would bring in $2.1 billion over five years, the federal government said. It’s similar to a one percent shopping tax that the United States introduced this year inflation bill fight

Some say the proposed tax directly targets Canada’s energy sectorwhich has seen huge gains in recent quarters due to inflation due to high oil and gas prices and the invasion of Russia, one of the world’s largest energy producers, limiting global market supply.

For other sectors, taxes may not be much of a barrier when a company makes capital allocation decisions, Schwartz said. “Buyouts are not a big part of capital allocation in Canada. They are much more widespread in the US”

Citing banks and railroad companies as examples, Schwartz said, “Many of our Canadian large-cap companies are mature businesses and very dividend-oriented. … These companies don’t buy stocks.”

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