Synthetic Buybacks

• In Event: Tax and Finance

Abstract

A corporation with warrants as part of its capital structure can carry out a synthetic stock buyback by repurchasing a combination of warrants and debt. Tax-indifferent investors can tender their instruments in the synthetic stock buyback and then use the cash received to purchase equity from taxable shareholders who wish to redeem their stock. In this way, the economics of a stock buyback can be accomplished from both the corporate and investor perspectives without triggering the excise tax on stock buybacks under §4501.

We develop a model in which regularly replenished finite-lived warrants can form a sustainable part of firm capital structure and be used regularly for synthetic stock buybacks. We also show how tax-indifferent investors can maintain their desired exposure to a corporation’s underlying assets by managing a dynamically updated portfolio of stock, debt, and warrants, and how they can rebalance so that participation in a synthetic buyback does not adversely affect their investment goals.

Our results provide a channel for avoiding the §4501 tax that we believe is novel to the literature. They also provide a new way to highlight the economic incoherence in taxing a distribution of capital from a firm differently depending upon whether it is paid in exchange for, or with respect to, one type of financial instrument or another.

Authors

• Thomas J. Brennan, Harvard Law School

• Claire Lazar