How To Explain Why Share Repurchase Is More Profitable In The United Kingdom

Transcription

1 P. Raghavendra Rau Purdue University Theo Vermaelen INSEAD Regulation, Taxes, and Share Repurchases in the United Kingdom* I. Introduction Share buybacks are extremely popular in the United States: from 1985 to 1999, U.S. corporations announced intentions to repurchase roughly $750 billion worth of stock (Grullon and Ikenberry 2000). Despite its growing popularity, the causes and consequences of share repurchase activity are still controversial. Moreover, the idiosyncrasies of the U.S. tax and regulatory system raise questions as to whether the results documented for the United States are unique to this country. Finally, the fact that repurchasing firms in the United States earn positive abnormal returns in the long run after the repurchase announcement raises important questions about market efficiency. The purpose of this article is to examine the motivations and consequences of share buybacks in the United Kingdom. The United Kingdom is of particular * We would like to thank Kimberly Rodgers and Orlin Dimitrov for able research assistance and Caroline Goodall for providing information on the U.K. regulatory and tax treatment of share buybacks. We would also like to thank an anonymous referee, Wolfgang Aussenegg, Jay Dahya, David Denis, David Douglas, David Reeb, Doug Emery, and seminar participants at Case Western Reserve University, Purdue University, the University of Miami, the University of Strathclyde, the European Finance Association meetings (Vienna, 1997), the Financial Management Association meetings (Chicago, 1998), and the European Financial Management Association meetings (Paris, 1999) for their helpful comments. We examine share repurchase activity in the United Kingdom over a period when the tax and regulatory environment changed drastically. We find that the form and intensity of repurchase activity in the United Kingdom is influenced by the tax consequences for pension funds. We also find that firms announcing share repurchases earn smaller excess returns, both in the short run and the long run, than those earned by firms in the United States. This is because of regulatory provisions in the United Kingdom that make it less likely that firms can use superior information to buy back shares when their shares are undervalued. (Journal of Business, 2002, vol. 75, no. 2) 2002 by The University of Chicago. All rights reserved /2002/ $

2 246 Journal of Business interest for two reasons. First, companies and regulators face a different tax and regulatory environment than they do in the United States. In particular, companies are not allowed to buy back shares in periods when managers are most likely to have superior information about future earnings. Second, the tax treatment of dividends and share repurchases changed on several occasions in our sample period. This specific tax and regulatory environment enables us to test to what extent repurchase activity is driven by the tax code and the ability of managers to take advantage of an undervalued stock price. We choose the United Kingdom rather than other European countries by default. Historically, share repurchases have not been very important in continental Europe. From January 1980 to June 1998, Securities Data Corporation (SDC) reports only 489 share repurchase announcements made by European firms. Approximately 60% of these announcements were made by companies listed in the United Kingdom (see fig. 1). The reasons for the lack of European share repurchase activity are fourfold. First, in some countries (e.g., France and Germany) share repurchases were illegal until recently. Second, in other countries with high taxes on dividends and low capital gains taxes (such as the Netherlands), specific tax provisions exist to discourage share buybacks. Third, in many European countries, companies do not have to disclose share buyback authorizations. Hence, (completed) share buybacks are only mentioned in the annual report. And, finally, as most continental European companies traditionally have emphasized maximizing stakeholder value rather than shareholder value, share buybacks do not fit the European corporate culture. Indeed, apart from shareholders, other stakeholders (such as managers, banks, and labor unions) are not interested in share buybacks. Managers prefer to maximize firm size, as the lack of incentive schemes tied to stock prices (such as stock options) makes firm size the most important determinant of executive compensation. Banks prefer the company to preserve its capital, and union leaders want the company to create more union members through additional capital expenditure. Hence, it is not surprising that, historically, European buyback activity mainly took place in the only European country with an Anglo-Saxon corporate governance model. The gradual acceptance of this model may explain why share buybacks are becoming more popular in recent years in Europe. We analyze a sample of 264 substantial share repurchase announcements in the United Kingdom, reported by SDC between January 1985 and June Our sample includes all open-market share repurchases, private repurchases, and tender offers reported by SDC in the sample period. The repurchases analyzed in this article are substantial in the sense that, on average, companies announce that they may buy back 9.8% of their own stock in the open-market sample, while the corresponding percentages for tender offers and private purchases are 23.4% and 17.2%, respectively. We can distinguish four major tax regimes during our sample period. Prior to September 1994, all open-market share repurchases were unattractive for pension funds (relative to dividend payments and relative to repurchase tender

3 Fig. 1. Share repurchase announcements in Europe. This graph shows the number of common stock share repurchases for cash, announced in Europe between January 1985 and June Regulation, Taxes 247

4 248 Journal of Business offers). In September 1994, investment banks invented the agency buyback, an innovative open-market repurchase mechanism that increased the tax attractiveness of stock repurchases in the open market. In October 1996, the tax authorities abolished the loophole, making all open-market share repurchase programs tax inefficient again. Finally, in July 1997, the government changed the tax laws in such a way that pension funds, as in the United States, became indifferent between dividends and share buybacks. We find that the tax changes have a major impact on the importance and method of share repurchase. The introduction of tax-favored agency buyback programs in September 1994 caused a substantial increase in the number of open-market repurchase programs. Simultaneously, tender offers essentially disappeared, with only one tender offer being announced between September 1994 and October When the tax credit given to tax-exempt pension funds in agency buybacks was abolished in October 1996, dividends became more profitable as a method of returning cash to shareholders. We find that the number of open-market repurchase completions fell significantly. Finally, when all tax credits, including those paid to dividends, were abolished in July 1997, the relative attractiveness of share repurchases rose again, with an increase both in the number of repurchases announced and repurchases completed. The finding that corporate payout policy is sensitive to tax law changes in the United Kingdom seems to be inconsistent with the fact that, after the 1986 U.S. tax reform, buyback activity did not decrease (Bagwell and Shoven 1989). As the 1986 tax reform increased the capital gains tax, one would expect the volume of share repurchases to decrease. However, both results are consistent with the hypothesis that it is the tax treatment of important investors such as pension funds, and not individual investors, that determines company payout policy. We should note that, both in the United Kingdom and the United States, individual investors prefer share buybacks to dividends for tax purposes. However, unlike those in the United Kingdom, U.S. pension funds always have been tax-indifferent. We find that share repurchases intentions generate statistically significant average abnormal returns of 1.14% in the 11-day window surrounding the announcement, which is significantly smaller than that reported in similar studies on U.S. data. This small announcement return is not an underreaction. When we examine long-term returns, we find that firms making open-market share repurchase announcements earn significant negative abnormal returns of 7% in the year after the announcement of the repurchase intention. However, this is almost solely driven by the performance of firms announcing socalled agency buybacks. Agency buybacks are open-market repurchases that are purely tax driven, where the seller is aware that he is selling to the corporation. These firms underperform up to 1 year after the announcement of the acquisition, earning significant negative cumulative abnormal returns of 13.35% in the year following the repurchase announcement. In contrast, firms announcing on-market (nonagency) repurchase programs earn insignif-

5 Regulation, Taxes 249 icant negative abnormal returns of 2.01% in the year after the announcement date. We reject the hypothesis that, unlike the typical U.S. or Canadian firm (see Ikenberry, Lakonishok, and Vermaelen 1995, 2000), U.K. firms are repurchasing shares to take advantage of an undervalued stock price. The fact that excess returns are much smaller in the United Kingdom, both in the short run and the long run, is consistent with the hypothesis that the U.K. regulatory environment discourages share repurchases designed to take advantage of an undervalued stock price. As this is a major motivation behind repurchase programs in the United States, it is not surprising that share repurchases remain relatively unpopular in the United Kingdom. The rest of the article is organized as follows: Section II reviews the literature on share repurchases. Section III discusses the tax and legal environment of U.K. buybacks. Section IV summarizes the hypotheses, while Section V describes the data. Section VI describes our methodology and results. Finally, Section VII concludes. II. Review of the Literature As a share repurchase can be considered, at the same time, a change in the payout, capital structure, and ownership structure of the firm, there is no shortage of theories to explain the average positive announcement return of around 3.5% that is observed in the United States (see, e.g., Dann 1981; Vermaelen 1981; Comment and Jarrell 1991; Ikenberry et al. 1995). According to the personal tax savings hypothesis, repurchases are beneficial because they are more tax efficient than paying out dividends. However, Bagwell and Shoven (1989) report that buyback activity in the United States, as measured by the total dollars distributed, did not decrease following the 1986 Tax Reform Act, which abolished the differential taxation between dividends and capital gains. In contrast, Lie and Lie (1999) show that managers were less likely to choose open-market share repurchase programs over regular dividend increases after the 1986 act. They also show that managers are more sensitive to the tax situation of the shareholders if a large fraction of the shares is held by institutional investors. To the extent that share buybacks are financed with debt, it can be argued that repurchases lower corporate taxes and, hence, lower the company s cost of capital. However, this explanation seems less relevant for open-market repurchase programs, which are often financed with excess cash. 1 Another popular explanation has been that firms use share repurchase announcements to signal to the market that their shares are undervalued (see, e.g., Dann 1981; Vermaelen 1981; Hertzel and Jain 1991). The problem with considering open-market repurchase programs as costly signals is that these programs are not firm commitments it is costless to announce a repurchase 1. Unless, of course, the cash is invested in bonds that generate taxable income for the corporation. In this case, excess cash can be considered negative debt.

6 250 Journal of Business and not carry it out later. Accordingly, Stephens and Weisbach (1998) study a sample of 450 open-market share repurchase announcements in the United States between 1981 and 1990 and find that between 74% and 82% of the shares targeted at the time of announcement are later repurchased. They find that these actual share repurchases are negatively related to stock price performance after the buyback announcement. Similar findings are reported by Ikenberry et al. (2000), employing data on Canadian open-market repurchase programs. The strategic behavior reported by Stephens and Weisbach (1998) and Ikenberry et al. (2000) is consistent with the good investment hypothesis, which argues that companies buy back stock because their shares are undervalued. Note that, in contrast to the signaling story, this hypothesis assumes that the market s response to the announcement is incomplete. Indeed, in a semistrong efficient market, after the announcement, the stock will no longer be undervalued, and it will be impossible for the average firm to buy back undervalued stock. Hence, the significant positive postannouncement excess returns reported by Ikenberry et al. (1995, 2000) in the United States and Canada are consistent with the good investment hypothesis. An alternative explanation is that share repurchases reduce the agency costs of free cash flow: stock prices increase because the market is pleased that excess cash is not wasted in value-destroying projects. Nohel and Tarhan (1998) examine a sample of 282 fixed price and Dutch auction share repurchases announcements between 1978 and 1991 in the United States and conclude that the positive investor reaction to share repurchases is better explained by the free cash flow hypothesis than the signaling hypothesis. However, unlike repurchase tender offers, open-market programs are not firm commitments to distribute excess cash, so again it is not obvious that the agency-cost hypothesis can be extrapolated to open-market programs. It is also difficult to reconcile agency costs with the long-term drift in share prices and strategic buying behavior. Specifically, the agency-cost hypothesis (as well as other hypotheses assuming that share prices only increase if a buyback actually takes place) is inconsistent with the Ikenberry et al. (2000) finding that companies that do not repurchase any shares during the year after the repurchase authorization actually earn a much larger excess return than do firms that complete the buyback. Besides saving taxes, correcting or exploiting undervaluation, or reducing agency costs, a number of other repurchase motivations, which are not necessarily expected to increase stock prices, have been proposed, such as fighting takeovers (Brown and Ryngaert 1991), getting rid of temporary nonoperating cash flows (Jagannathan, Stephens, and Weisbach 2000), or avoiding earnings per share dilution from executive stock option plans (Weisbenner 2000). The last explanation may not be very relevant for the United Kingdom, as repurchased shares have to be cancelled and cannot be held as treasury stock. In the United States, firms often take advantage of a low share price

7 Regulation, Taxes 251 to buy shares that will be reissued to executives later on, after the stock has increased in value. In the United Kingdom such a hedging strategy is not possible: when executives exercise stock options, the company has to issue new shares. In a study that considers all motivations simultaneously, Dittmar (2000) employs U.S. data to provide empirical support for these nonvalue creating motivations as well as for the good investment hypothesis. Of course, this is not surprising because regardless of why companies buy back stock, managers who care about the wealth of the long-term investors (such as themselves) should only repurchase shares when the stock is correctly valued or undervalued. To our knowledge, the only research on repurchases in the United Kingdom is by Rees (1996), who reports a 0.25% abnormal return in the 5 days surrounding the announcement of 882 open-market repurchases made by U.K. firms between 1981 and His results, however, are not comparable with the 3.5% positive abnormal performance reported around the announcement date for share repurchases in the United States Unlike U.S. studies, which define the announcement date as the date when a company receives its buyback authorization, Rees defines the announcement date as the date when the company is effectively buying shares (the so-called effective date). Unlike in the United States, U.K. companies have to notify the Stock Exchange before 12:00 noon on the day following a repurchase. As companies typically spread out an openmarket repurchase over several weeks or months, it is not surprising that, in his sample, companies repurchase only 0.5% of their shares, on average. 2 III. Share Repurchases in the United Kingdom: Regulatory and Tax Framework A. Regulation In order to develop our working hypothesis, it is important to understand fully the legal and tax frameworks governing U.K. share repurchases and the difference, if any, between these frameworks and those in the United States. Although share repurchases were legalized in the United Kingdom by the Companies Act of 1981, various regulatory bodies have put restrictions on buyback activity. In general, these regulations reflect four main concerns. First, share repurchases could allow a company to manipulate its stock price. Therefore, the Listing Rules of the London Stock Exchange specify that purchases within a period of 12 months of 15% or more of the company s share capital must be made by a tender offer. Purchases below the 15% limit may be made in the open market as long as the price paid is not more than 2. For example, between October 20, 1989, and August 1, 1990, B.A.T Industries made 94 repurchases of ordinary shares at prices ranging between 581p and 840p and amounts between 100,000 to 7,850,000 shares at a time. Rees (1996) treats these as 94 different events, while we consider the event to be the announcement of the program itself on September 26, 1989.

8 252 Journal of Business 5% above the average of the market value of those shares for the 10 business days before the repurchase is made. 3 Second, by reducing the company s capital, share buybacks could hurt creditors. Hence, the U.K. Companies Act states that only distributable profits or the proceeds of a fresh issue of shares (made for the purpose of the purchase) can be used to finance the purchase. A similar restriction exists in the United States. Moreover, debt covenants will often restrict the amount of buybacks, in the same way as do dividends. Third, if managers will only buy back shares when their shares are undervalued, an open-market purchase program where the seller is not aware that he is selling to the corporation essentially allows a company to engage in insider trading. The U.S. regulatory approach to this concern is to emphasize disclosure: companies should announce in advance that they have created an option to buy back stock. Moreover, U.S. regulators are generally not very concerned about insider trading as long as the insider trading profits flow back to the company. For example, section 16b of the Securities and Exchange Act of 1934 requires insiders to return all trading profits to the company if they buy and sell the company s stock within a 6-month period. The U.K. approach is drastically different. Under the Model Code, companies are not allowed to buy back shares during periods when officers and directors are not allowed to trade in their company s shares. In practice, this means that share repurchases are not allowed in the 2-month period preceding the publication of annual earnings or semiannual earnings and in the 1 month before the publication of quarterly results. Moreover, under the Criminal Justice Act, the company cannot purchase shares when the directors are in possession of unpublished, price-sensitive information. Finally, U.K. regulators are concerned about the preemption rights of shareholders and therefore require a company to cancel all repurchased shares. So, the U.S. concept of treasury stock (i.e., shares that are repurchased but can be reissued without shareholder approval) does not exist in the United Kingdom, which means that repurchases are a much less flexible tool for managing the firm s capital. B. Taxation The tax treatment of share buybacks in the United Kingdom is rather complicated and has been changed at various points in time. The complication arises from the fact that the United Kingdom has an imputation system, which 3. The U.S. antimanipulation provisions are summarized in Securities and Exchange Commission rule 10b-18, introduced in The rule specifies that (1) trades should be made through one broker; (2) none of the trades should be made at the opening transaction during the last half hour of trading on a given day; (3) none of the trades may be completed at a price exceeding the highest current bid price or the last independent sale price, whichever is higher; and (4) the total of such purchases in a day should not exceed 25% of the average daily trading volume for the preceding 4 weeks. Hence, by putting limits on price movements and trading volume, regulators have significantly reduced a company s ability to manipulate its stock price.

9 Regulation, Taxes 253 is meant to reduce the double taxation of dividends. Under this system, shareholders receive credit for taxes paid by the company on earnings distributed as dividends and on the distribution element of share buybacks. The distribution element is defined as the difference between the market value of the repurchased shares and the book value of the corresponding paid-in-capital. We start by first describing the tax regime for individual investors, as this regime has remained constant during our sample period. Next, we describe the tax regime for pension funds during four different tax regimes: (a) prior to September 21, 1994; (b) from September 21, 1994, to October 7, 1996; (c) from October 8, 1996, to July 1, 1997; and (d) after July 2, Taxation of Individual Investors For the sake of clarity, we illustrate the taxation regime with a simple numerical example. The example, as well as the general principle, is summarized in table 1. Assume a company with 100 shares outstanding and a share price of 1, which is considering distributing 10 either through a dividend of 10p per share or a repurchase of 10 shares at the current market price of 1. Assume that the original subscription price of the share is 20p per share. Assume further that the investor cost base (i.e., the price at which he purchased the shares plus an inflation allowance) is 50p and that his marginal tax rate is t. Hence, the investor cost base is higher in price than the subscription price, a reasonable assumption in an actively traded public corporation. Dividend payment. If the company pays out 10 as a dividend, it has to pay ACT (advance corporation tax) on this dividend at a rate of 25%, or 2.5. This ACT can be offset against the company s mainstream corporation tax. However, as ACT has to be paid within 14 days and other corporate taxes are paid much later, companies are effectively giving an interest-free loan to the Inland Revenue. The value of the dividend after personal taxes is t 2.5 p 12.5(1 t), (1) where t is the investor s marginal tax rate. In other words, the investor pays tax on the grossed-up dividend ( 12.5) but then can claim the ACT of 2.5 as a tax credit. Note that, for an investor with a tax rate of 20%, no additional taxes are due, and the dividend is worth 10. In this case, the imputation system avoids the double taxation of distributed profits. For the high tax bracket taxpayer ( t p 40%), the value of a 10 dividend after all taxes is 7.5. Share repurchase. In order to calculate taxes, a distinction has to be made between an off-market repurchase (such as a repurchase tender offer or a private repurchase) and an on-market repurchase (or open-market repurchase). Note that in the first case the seller is aware that he is selling to the corporation, and in the second case he is not. Off-market repurchase. The difference between the repurchase price, 1,

10 TABLE 1 Taxation of Dividends and Share Repurchases for Individual Investors The General Case The Investor Receives Numerical Example Case 1: Company pays 10 dividends after all taxes: 10 Dividend before taxes # 10t tax on the dividend grossed up by 25% (company ACT) dividend tax credit equal to 25% of the gross dividend # (1 t) Net dividend after tax 7.5 Case 2: Company makes an off-market repurchase of 10 shares at 1: 10 Proceeds from repurchase before tax # (1 S) # 10t tax on the imputed dividend grossed up by 25% 4.25 # (1 S) # 10 imputed dividend tax credit 2 (S B) # 10t tax on capital gain/loss # { # (1 S) # t.25(1 S) (S B)t} Net proceeds after tax 9.2 Case 3: Company makes an on-market repurchase of 10 shares at 1: 10 Proceeds before tax # (1 B)t tax on capital gains 2 10(1 t Bt) Net proceeds after tax 8 Note. This table shows the cash flows after taxes for an individual investor who either receives 10 as a dividend or sells 10 shares to the company for 1 per share. The investor s marginal tax rate is t. He is assumed to have bought the shares for a price B (the basis). The original issue price of the stock is S. An off-market repurchase is a tender offer, a private purchase, or an agency buyback; an on-market repurchase is an open-market repurchase. The imputed dividend is the number of shares repurchased multiplied with the difference between the repurchase price ( 1) and the original issue price per share (S). In the numerical example, S p 0.2, B p 0.5, and t p 40%. 254 Journal of Business

11 Regulation, Taxes 255 and the original subscription price, 20p, is defined as the distribution element. As in the case of dividends, the corporation has to pay ACT on this dividend at a rate of 25%. Hence, in our numerical example, the total distribution element is (1 0.2) # 10 p 8, and the corporation has to pay ACT of 2, which can be offset against the company s mainstream corporation tax. The ACT can then be used as a tax credit: the investor who pays a tax of 10t on the grossedup dividend can claim a tax credit of 2, so that the net tax paid on the distribution element is 10t 2. However, this is not the end of the tax story: the difference between the investor s cost base (50p) and the original issue price of the shares (20p) on his 10 shares is considered a capital loss of 10 # ( ) p 3, which is subject to the same tax as ordinary income. However, capital losses can only be offset against capital gains. Hence, for individual investors, the value of a 10 repurchase is worth (in ): 10 (10t 2) 3t p 12 7t. (2) Recall that, if, alternatively, the company had paid a 10 dividend, the after tax value would be equal to 10 (12.5t 2.5) p 12.5(1 t). (3) For t p 20%, the value of the repurchase alternative is 10.6, which exceeds the value of the dividend alternative ( 10). For the taxpayer in the top bracket, with t p 40%, the value of the repurchase alternative is also higher: 9.2 versus 7.5. However, this results from the fact that we assumed: that the investor purchased the stock above the original subscription price (a reasonable assumption for most established companies) and that, without the repurchase, he would be subject to capital gains taxes. If the investor was not subject to capital gains taxes, the value of the repurchase alternative is 12 10t. In this case, taxpayers at a low rate ( t p 20%) would be indifferent between a dividend payment and a repurchase, as in both cases they will receive 10. Taxpayers at a high rate ( t p 40%), however, would still prefer a repurchase ( 8) to a dividend payment ( 7.5). The reason is that, for high-tax-bracket individuals, the dividend tax credit does not entirely eliminate the double taxation of corporate income. So, as by definition, the distribution element is always smaller than the total payout, in general, we can state that individuals prefer off-market share buybacks to dividend payments, as long as they are not liable for capital gains taxes (i.e., as long as the individual s cost basis is significantly below the paid-in-capital per share.) On-market share repurchases. When a shareholder sells on-market, he will not know that the ultimate purchaser of the shares is the company itself. As he is selling to a market maker, his profit will be taxed as a capital gain, so no tax credit can be claimed. In this case, no general conclusions are possible as the attractiveness of the buyback program depends on the investor s capital gains tax liability. Specifically, if the company repurchases 10/P shares at the market price P, and the investor purchased the shares at an average

12 256 Journal of Business TABLE 2 Tax Regimes Taxation of Dividends and Share Repurchases for Pension Funds and Tax-Exempt Investors Dividend ( ) Share Repurchase After-Tax Cash Flow Prior to September 21, Off-market! 12 Prior to September 21, 1994 On-market 10 September 21, 1994 October 7, 1996 Off-market:! 12 Tender offer/ private purchase September 21, 1994 October 7, Off-market: 12 Agency buyback September 21, 1994 October 7, 1996 On-market 10 October 8, 1996 July 2, Off-market/ 10 On-market After July 2, Off-market/ On-market 10 Note. This table shows the cash flows after taxes received by a pension fund when a company either pays out 10 as a dividend or repurchases 10 shares at 1 per share. Cash-flows are shown under four different tax regimes: (1) prior to September 21, 1994; (2) from September 21, 1994, to October 7, 1996; (3) from October 8, 1996, to July 2, 1997; and (4) after July 2, An off-market repurchase is either a repurchase tender offer, a private repurchase, or an agency buyback. An on-market repurchase is a repurchase in the open market. price B (the basis price), the total taxes (in ) owed after the repurchase are equal to [10(P B)/P] # t. (4) If, alternatively, the company paid out the 10 as a dividend, the total tax would be 12.5t 2.5. (5) A share repurchase is more profitable than a dividend payment if (5) 1 (4). For an investor in the 40% tax bracket, this means if (P B)/B is smaller than 62.5%. If the investor had been in the low tax bracket (20%), he would always prefer dividends to repurchases, unless if P! B. Summarizing, in the United Kingdom, high tax individuals tend to prefer share repurchase to dividends (unless the repurchase would generate substantial capital gains taxes), but, ceteris paribus, they would prefer an offmarket repurchase (tender offer or private purchase) to an open-market buyback. 2. Taxation of Pension Funds Table 2 shows the value of 10 paid as a dividend or through a share repurchase during the four different tax regimes: regime 1 (prior to September 1994), regime 2 (September 1994 October 1996), regime 3 (October 1996 July 2, 1997), and regime 4 (after July 1997). Table 2 compares, during each regime, the cash flows received by the pension fund if the company decides to pay out 10 as dividends or through a share repurchase.

13 Regulation, Taxes 257 Dividend payments. Prior to July 2, 1997 (this means during three out of the four tax regimes), pension funds were entitled to a 25% dividend tax credit, despite the fact that they were exempt from taxes on dividends and capital gains (so, in this case, the name tax credit is somewhat misplaced). Hence, a 10 dividend was worth 12.5 after taxes. This law was changed after July 2, 1997, when U.K. tax authorities eliminated all tax credits for pension funds. Share repurchases. Taxation prior to September For off-market repurchases, pension funds are entitled to a tax credit of 25% on the distribution element of the repurchase. Recall that in our numerical example, the distribution element was (1 0.2) # 10 p 8, which entitles the investor to a 2 tax credit. Hence, for these investors, the 10 buyback will be worth 12. However, if the company had paid a 10 dividend, the tax-exempt investor would have received Hence, in contrast to individuals, tax-exempt investors should prefer dividends to off-market share buybacks for tax purposes. However, pension funds could find an off-market share buyback attractive for two reasons. First, for those pension funds that plan to sell their shares, selling to the company is more profitable than selling in the open market, for by selling to the company, they would receive a tax credit. Second, tax exempt investors could theoretically earn arbitrage profits by buying shares in the open market and tendering them to the company. The Inland Revenue has tried to prevent this type of arbitrage by specifying that a pension fund that buys shares after the announcement of a buyback and sells them to the company cannot claim a tax credit. Of course, this rule is ineffective if pension funds can predict which companies might shortly announce a buyback. It will also be ineffective if there is a long time lag between the announcement of buyback authorization and the actual repurchase. Discussions with bankers revealed that the Inland Revenue tries to counter such behavior by making the granting of any tax credit subject to antiavoidance rules. In particular, pension funds or other tax exempt investors have to convince the Inland Revenue that they are not simply selling the shares to the company in order to get the tax credit. For example, a pension fund that would sell its shares to the company and buy them back in the market a short period (less than 2 months) thereafter would not be able to claim the tax credit. In on-market repurchases, no tax credits exist. Hence, as individual investors, pension funds prefer off-market purchases to on-market purchases. We conclude that, prior to September 1994, unlike (high-tax-bracket) individuals, pension funds prefer dividend payments to share buybacks, regardless whether they are off-market or on-market. However, for pension funds that decided to sell their shares, selling to the company in an off-market repurchase (tender offer or private transaction) was significantly more profitable than selling in the open market. Moreover, all investors prefer offmarket repurchases to on-market repurchases, because of the tax credit on the implied distribution.

14 258 Journal of Business This analysis seems to imply that, before September 1994, a company that decides to repurchase shares and would like to ensure that its institutional investors are entitled to a tax credit should choose the tender offer route over announcing an open-market share repurchase. The basic problem with the tender offer method, however, is that, without paying a large repurchase tender premium, there exists a significant probability that the stock price after the repurchase announcement, but prior to the offer expiration, will exceed the tender price. This will either make pension funds reluctant to tender or make them lose the tax credit because of antiavoidance rules. The Inland Revenue will not allow a tax credit if it can show that the pension fund tendered the shares only because of the tax credit. For example, if, after a repurchase tender offer at 20 per share, the stock price increases to 22, it is obvious that a pension fund only tendered (rather than sold in the market) because of the tax credit. This is effectively what happened in the 1993 Reuters tender offer. On July 23, 1993, Reuters announced a tender offer for 5.84% of its shares at a price of 14 per share. Although at the expiration date of the offer the stock price increased to 15.5, pension funds still tendered their shares at 14, because the tax credit attached to each share repurchased was worth Because the Inland Revenue had given its guarantee prior to the offer that all tax-exempt investors would be entitled to the tax credit, pension funds received tax credits for more than 20 million. After the Reuters buyback, the Inland Revenue announced that it would no longer give guarantees to investors that they would be entitled to the tax credit. Selling shares to the company through a private transaction also does not guarantee that a pension fund will be entitled to a tax credit. The selling institution has to convince the Inland Revenue that it is not simply selling the shares to the company in order to obtain the tax credit. This will be difficult, unless the company buys back the stock at a premium. However, other investors are likely to object to a transaction that so obviously favors one investor over another. Because of all of these legal uncertainties, we indicate in table 2 that, prior to September 1994, the expected value of a 10 off-market repurchase was less than 12, which makes the case for dividend preference even stronger. Taxation after September 1994: Introduction of agency buybacks. Agency buybacks were invented by innovative bankers at Barclays de Zoete Wedd, who arranged the first agency buyback in September 1994 for Northern Electric. In an agency buyback the shareholders sell their shares to a broker who is acting as an agent for the company. Because the agent (i.e., a bank) would contact pension funds in advance and give them priority over individual shareholders, the open-market repurchase effectively became a private repurchase directed at specific institutional clients. In contrast to a normal open-market repurchase (as in the United States or in the United Kingdom prior to September 1994) where the buyback is completed in several small transactions over several months, agency buybacks were often completed in a few hours. For example, Anglian Water s share buyback program for 10% of its shares

15 Regulation, Taxes 259 was completed in less than a couple of hours by 10:00 a.m. on August 16, Moreover, because an agency buyback appears to be a repurchase in which all shareholders participate, it is easier to convince the Inland Revenue that the antiavoidance rules do not apply. This made agency buybacks much more attractive than other off-market mechanisms (such as tender offers and private purchases) or on-market repurchases (see table 2) Taxation after October 8, On October 8, 1996, the tax treatment of share buybacks was modified significantly for tax exempt investors such as pension funds. These investors could no longer recover any tax credits associated with the distribution element of the off-market repurchase. Hence, as table 2 shows, for pension funds, all off-market repurchases and on-market repurchases became equally unattractive. Hence, if the tax consequences for pension funds is an important factor in deciding to repurchase shares, buybacks aimed at these investors (i.e., mainly off-market share buybacks) should have fallen dramatically. Taxation after July 2, In July 1997, the U.K. tax authorities did not change the tax treatment of repurchases, but, as mentioned before, it eliminated all tax credits for dividends. Hence, after this, pension funds became indifferent between dividends and share repurchases, as is the case in the United States. Hence, we expect that share repurchases should become more popular after July 2, IV. Hypotheses In this article, we test three hypotheses regarding (1) the choice of repurchase mechanism, (2) the size of announcement returns, and (3) the difference in long-term return between agency buybacks and other open-market repurchase programs. Hypothesis 1. Repurchase mechanisms in the United Kingdom are driven by tax considerations of pension funds. As pension funds have a major influence on corporate decisions, we expect them to have a substantial impact on the method chosen by the company to repurchase shares. In particular, we expect that, during the period in which agency buybacks existed and pension funds were entitled to tax credits (September 21, 1994 October 8, 1996), agency buybacks will be the predominant form of repurchase, at the expense of other mechanisms such as tender offers or privately negotiated share repurchases. Because agency buybacks are openmarket share repurchases that provide tax benefits to pension funds, we expect open-market repurchase activity to intensify after September 1994 and to decline after October Finally, the abolition of the imputation system after July 1997 should lead to an increase in share repurchase activity again, as dividends and buybacks now have no more tax consequences for pension funds, as in the United States.

16 260 Journal of Business Hypothesis 2. Announcement returns following U.K. buyback authorizations will be smaller than the ones typically observed in the United States. Because of the restrictions on buying back shares prior to 2 months before earnings announcements and the need to disclose partial repurchases almost immediately, companies will find it more difficult to take advantage of an undervalued stock price. The announcement returns will be small, in particular for agency buybacks, as in these cases the buyback is tax driven and the seller is aware that he is selling to the corporation. Hypothesis 3. Long-term returns after agency buybacks will be much smaller than they are after other open-market share repurchase programs. One often mentioned reason for U.S. share buybacks is that the management believes that its shares are a good investment. Consistent with this hypothesis, positive long-term excess returns are observed after U.S. and Canadian open-market share repurchase programs of high book-to-market stocks (Ikenberry et al. 1995, 2000) and after the expiration of repurchase tender offers made by small firms (Lakonishok and Vermaelen 1990). Recall that agency buybacks (i.e., open-market share repurchases between September 1994 and October 1996) were designed to ensure that pension funds could claim a tax credit. Hence, we expect these repurchases to be less motivated by the fact that the company s shares were a good investment. V. Data Our sample is drawn from the SDC online Mergers and Corporate Transactions database, using the following criteria: The transaction is classified either as a self-tender offer or a repurchase. The firm is listed in the United Kingdom. The consideration sought in the transaction is listed as common shares. The announcement date lies between January 1, 1985, and June 30, We further exclude all firms classified by SDC as a closed-end investment trust. We also eliminate all firms where, according to SDC listings, the target financial currency is not pounds sterling and firms where the deal currency was not pounds sterling. In order to ensure against possible mistakes made by SDC, all announcement dates were double-checked by searching the Financial Times. Table 3 summarizes the sample screening process for the analyses. The SDC database lists 293 repurchases and 18 tender offers during the period from January 1980 to June Applying the screens above reduces the sample to 264 repurchase announcements and 14 tender offers. Of these repurchases, 198 are open-market share repurchases and 68 are privately ne- 4. The SDC database does not contain any announcements by U.K. firms before January 1, 1985.

17 Regulation, Taxes 261 gotiated. Of the 14 tender offers, 12 are fixed-price, self-tender offers and 2 are Dutch auction self-tender offers. We analyze two types of announcements. First, we analyze announcements that the company intends to repurchase shares, repurchase intentions. This will typically be an announcement that the board has approved a stock repurchase program and will be seeking approval of this program at the next shareholders meeting. The second announcement is an announcement that the company has completed a stock repurchase (program), repurchase completions. 5 Of the 198 open-market repurchases, 144 were classified as repurchase intentions, while 101 were classified as repurchase completions. 6 Similarly, we have 42 privately negotiated repurchase intentions and 45 privately negotiated repurchase completions. Panel B in table 3 reports the number of firms with data available to measure performance. For short-term performance, we obtain daily returns data from Datastream. The panel reports the number of repurchase firms that announced (or completed) open-market or privately negotiated repurchases or self-tender offers listed on Datastream. Long-term performance is measured using monthly returns obtained from the London Share Price database (LSPD), which covers monthly returns up to December Since we measure performance for the 1 year after the announcement of the repurchase, we eliminate from our analysis all firms that made announcements after January Further, since we test abnormal performance after adjusting for market capitalization (from LSPD) and priceto-book ratio (from Datastream), panel B in table 3 also lists the number of firms that are listed on both LSPD and Datastream. VI. Methodology and Results A. Descriptive Statistics Tables 4 and 5 report some descriptive statistics for the overall repurchase sample. Table 4, panel A, reports the distribution of the announcements and the value of the transaction by year for open market, privately negotiated share repurchases, and self-tender offers. As is the case in the United States, open-market share repurchases are more common than privately negotiated transactions and tender offers. As can also be seen, open-market share repurchase activity increases significantly in 1994, when agency buybacks were 5. Note that, in many cases, these repurchase completions will actually be only partial completions, i.e., the company may continue with a repurchase program even after announcing that the current program is over. 6. We classified a repurchase as a repurchase announcement if it was an intended announcement or if the completion date differed from the announcement date in the SDC database. A repurchase was classified as a repurchase completion if the completion date was listed in the database, regardless of whether the announcement date differed from the completion date. For these repurchases, the event date was the effective date. Six intended announcements are counted both as an open-market transaction as well as a private transaction.

18 TABLE 3 Sample Selection Criteria A. Data on Repurchases and Self-Tender Offers Number of Buybacks Sample Criteria Repurchases Self-Tender Offers I. Number of transactions listed by Securities Data Corporation as having announced a repurchase or a tender offer between January 1985 and June 30, 1998, in the United Kingdom II. Number of repurchases and self-tender offers, excluding closed-end investment trusts, firms listed in New York or Nasdaq making repurchases in the United Kingdom or U.K. firms making repurchases in currencies other than pounds sterling III. Number of repurchases in II classified as: Open-market share repurchases: 198 Repurchase intentions: All repurchases where the effective date of the repurchase is not the same as the announcement date Repurchase completions: All repurchases that have an effective date listed Privately negotiated share repurchases: 68 Repurchase intentions 42 Repurchase completions Journal of Business

19 B. Performance Measurement Repurchases Number of Buybacks Open Market Privately Negotiated Self-Tender Offers Sample Criteria Intentions Completions Intentions Completions Intentions Completions IV. Short-run performance: Number of buyback firms in III listed on Datastream V. Long-run performance: Number of buyback firms in III that made repurchases before January VA. Number of buyback firms in V listed on both Datastream and the London Share Price database Note. This table describes the number of repurchases analyzed in the various tests based on different sample selection criteria used. Regulation, Taxes 263

20 264 Journal of Business TABLE 4 Share Repurchase Activity by Year A. Number and Value of Share Repurchases and Self-Tender Offers Announced Each Year between January 1985 and June 1998 Year All Repurchases Open Market Privately Negotiated Self-Tender Offers N Value N Value N Value N Value , , , , , , , , , , , , , , Total , , , B. Number and Value of Repurchase Intention and Repurchase Completion Samples by Year Open Market Share Repurchases Repurchase Intentions Repurchase Completions Privately Negotiated Share Repurchases Repurchase Intentions Repurchase Completions , , , , , , , , Total , , , ,640.4 Note. Value measured in millions of pounds. Panel A reports the number and total value of repurchases and self-tender offers by U.K. firms, listed on the Securities Data Corporation s (SDC) Mergers and Corporate Transactions online database, announced each year between January 1985 and June 30, The value of the transaction (in millions of pounds sterling) is taken from the HOSTVALUE variable in the SDC database, where available. Panel B reports the number and total value of open market and privately negotiated share repurchases, listed on the SDC Mergers and Corporate Transactions online database, announced each year between January 1985 and June 30, 1998, classified as repurchase intention or repurchase completion samples. The value of the transaction (in millions of pounds) is taken from the HOSTVALUE variable in the SDC database. There were no repurchase announcements on SDC in introduced, quintupling from five and six open-market announcements in 1992 and 1993 to 34 in Privately negotiated share repurchases also increase, though less markedly than open-market repurchases. In contrast, self-tender offers disappear in both 1994 and When off-market repurchases lost