All you need to know about...Buyback tax

Finance Minister Nirmala Sitharaman in her maiden Budget, proposed to levy a tax on buybacks by listed companies. The tax, at 20 per cent, may nudge companies to payout surpluses through dividends rather than resort to buybacks, which has been the norm in recent years. Currently, buyback tax is applicable only for unlisted companies.

A buyback essentially is a scheme by which a company repurchases a certain amount of its outstanding shares. Once taken back, these shares are extinguished by the company.

Reducing the number of shares in this case helps in improving the earnings per share for continuing shareholders and perks up the return on equity. Buyback of share from the public can also be done if promoters want to hike their stake in the company, sometimes to avoid any takeover threats.

Normally, companies that have surplus cash in their kitty, either plough it back into the business or pay out dividends to investors. However, given some tax anomalies, companies found it more attractive to do buybacks rather than distribute surplus profits to shareholders in the form of dividends.

The erstwhile finance minister, P Chidambaram, in Budget 1997, introduced dividend distribution tax (DDT) to reward companies investing in future growth. Dividends distributed are currently taxable at a little more than 20 per cent.

To escape dividend distribution tax, listed companies were resorting to buybacks, as they were more tax effective.

In fact, after FY16-17, buybacks became more popular as dividends amounting to more than ₹10 lakh were made taxable in the hands of shareholders (at the rate of 10 per cent).

Even after re-introducing long term capital gains tax on equity shares (on gains in excess of ₹1 lakh in a financial year) at 10 per cent in Budget 2018-19, buyback was a preferred option.

In 2018-19, as per official data, 60-plus companies went in for buybacks, including large IT companies such as TCS, HCL Tech, Tech Mahindra, besides ONGC, BHEL, Oil India, Coal India and NMDC.

To plug the differential tax treatment between buybacks and dividend payouts, the Budget has introduced tax on buybacks for listed companies as well. The 20 per cent tax will be levied on the difference between the issue price and the buyback price of the share.

Buybacks can be done either through the tender route or via open market purchases. In the former, the company fixes a buyback price and accepts shares on a proportionate basis during the buyback period.

Hence the ‘acceptance ratio’ plays a role in deciding how much of your holdings you can actually sell. This implies that you may not be able to participate fully in buybacks. Hence dividend payouts are a better deal for investors, as the surplus is paid out to all shareholders based on their holdings.

But given that buybacks were a more tax-efficient choice for companies over dividend payments, there was a spurt in buybacks in recent years. Dividend payout thus reduced substantially, hurting investors.

Introduction of buyback tax is expected to increase the dividend payouts from listed companies, particularly from those that have been resorting to buybacks to avoid tax incidence. If you are a long term-investor, higher dividend payouts can prove to be more beneficial to you.

In the coming year, you can expect more dividend payouts than buybacks.

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