Stock Buybacks and Strategies to Reduce Capital Gains Taxation

In markets where dividends are taxed, many companies prefer to use their cash to repurchase their own shares (buybacks) instead of distributing dividends directly to shareholders. This happens because buybacks can provide tax benefits to investors, allowing them to defer capital gains taxes and, in some cases, offset losses. In this article, we will explain how this strategy works and how investors can use it to optimize their taxation.

1. How Do Buybacks Work?

A stock buyback occurs when a company purchases its own shares on the market, reducing the number of shares in circulation. This generally leads to an increase in the price of the remaining shares, benefiting shareholders who retain their holdings.

While dividends are paid directly to shareholders and, in many countries, are subject to withholding tax, the appreciation generated by a buyback is only taxed when the investor decides to sell their shares for a profit. This means that those who do not sell their shares can defer capital gains taxation to a more favorable moment.

2. Taxation on Stock Buybacks

If an investor decides to sell their shares during a buyback, the gain will be taxed as a capital gain, with progressive tax rates. In Brazil, for example, these rates range from 15% to 22.5%, depending on the profit earned.

However, there is an important tax planning opportunity: if an investor has stocks with accumulated losses in their portfolio, they can sell them on the open market and use these losses to offset the gains from the buyback, reducing or even eliminating the taxable base.

3. Loss Compensation Strategy

Investors can use a strategy known as tax loss harvesting to minimize capital gains taxation when selling shares in a buyback. Here’s how it works:

1. Sell loss-making stocks: Before selling shares in the buyback, the investor sells other stocks in their portfolio that are at a loss on the open market.

2. Participate in the buyback: Then, they sell shares to the company during the buyback process, realizing a capital gain.

3. Offset losses: The loss from the open market sale can be used to offset the capital gain from the buyback, reducing or even eliminating capital gains taxation.

   
   

Practical Example

Imagine an investor bought shares of Company X for $50 each and is now selling them in a buyback for $80. This would result in a $30 profit per share, subject to capital gains tax.

At the same time, the investor owns shares of Company Y, which were purchased at $100 but are now worth $70. Selling these shares in the open market would generate a $30 loss per share.

By selling Company Y’s shares first, the investor can offset this loss against the $30 per share gain from selling Company X’s shares in the buyback, reducing or even eliminating capital gains tax.

4. Limitations and Considerations

• Losses can only be offset in the open market: If an investor sells shares directly to the company in a buyback without first selling other shares on the open market, they cannot use accumulated losses for tax offsets.

• Losses must be offset within the same tax category: In Brazil, for example, stock losses can only be used to offset capital gains from other stock sales. They cannot be used to offset gains from other investments such as real estate funds or fixed-income securities.

• Buybacks are not always advantageous: Before selling shares in a buyback, investors should evaluate whether the price offered by the company is competitive compared to the market and whether they wish to maintain their stake in the company.

A buyback strategy combined with loss compensation can be a powerful tool for investors looking to minimize capital gains taxation. By strategically planning stock sales, investors can defer taxes and legally reduce their tax burden.

However, it is essential that investors understand the applicable tax rules and closely monitor their portfolio to identify tax optimization opportunities. Consulting a tax specialist or financial advisor is also a good practice to ensure the strategy is executed correctly.