When Nirmala Sitharaman, FM of India, last year taxed the buybacks, a lot of people who were making money through this, wonder whether this would be the end of this instrument. Before that, there was no tax on buybacks. However, the recent budget( 2020 ) has again made buyback attractive. Before we discuss in detail, let us first understand briefly how the company rewards shareholders.
a) XYZ company is making a profit of Rs.100 Cr and has 1 Cr shareholders.
b) The company wants to distribute say Rs.50 Cr to shareholders and keep Rs.50 Cr in the reserve for future use.
c) How a company can do that? They can do that via the Buyback or the Dividend.
It is an instrument through which a company can buy shares from the market generally at a rate higher than the market price. Once taken back, these shares are extinguished by the company. Reducing the number of shares also helps to improve the earnings per share for remaining shareholders and also increases ROE.
Say, the share value of XYZ company in the market is Rs.100 per share, the XYZ company may come up with buyback at Rs. 200 per share, for worth Rs.50 Cr assigned for distribution to investors and promoters.
This instrument was tax-free earlier, however, the govt has introduced a 20% tax on buyback in the 2019 budget.
The company generally rewards investors and promoters by distributing dividends. However, it attracts DDT( Dividend Distribution Tax ). Before the money distributed to shareholders, the company needs to deduct DDT, which is just above 20%, and rest what is left given to them. Dividend received in the hands of investors was tax-free up to Rs.10 lakh, after that it is taxed at 10%.
Buyback or Dividend?
Buybacks can be done either through the tender route or via open market purchases. In the tender route, the company fixes a buyback price and accepts shares on a proportionate basis during the buyback period. Here, the ‘acceptance ratio’ plays a role in deciding how many shares an investor can actually sell. This means that an investor may not be able to participate fully in buybacks. Therefore, the dividend method is a better deal for investors, as the surplus is paid out to all shareholders based on their holdings.
However, until the last budget(2019), the companies preferring to reward investors by Buyback rather than dividends due to tax exemption. After the introduction of the buyback tax, the dividend becomes a preferred choice. However, again the pendulum shifts to Buyback in the current budget(2020).
Changes in Budget-2020
In the current budget, the Govt has removed DDT and make dividends taxable in the hands of investors, which was free up to 10 lakh, and only 10% above 10 lakh. Now, this has made the situation difficult for the investors who are in higher slab. The promoters and high networth investors ,who were before this budget( 2020) announcement was paying only 10% on dividend, now has to pay as per their income slabs, which is as high as 39% to 42.74%. On the other hand, in the buyback, the company is only paying around 20% tax. The retail investors, too, have to pay more tax on dividends. Generally, most of the retail investors were not paying any taxes as normally they have income less than 10 lakh from dividends.
This taxing of Dividends in the hands of investors has made dividends less attractive and Buyback more attractive. However, buyback has a limitation, if a company has higher debt on books as compared to its net-worth, it can’t come with buyback.
In our point of view, the buyback will again come in flavor in FY2020-21, giving tax arbitrage for promoters and investors over the dividend method.