A buyback is a scheme by which a company purchases back some amount of its outstanding shares and then extinguishes them. This reduction in the shares helps in better earnings per share for continuing shareholders and increase the return on equity.
Buyback of shares can also be done from the public if promoters are keen to raise their stake in the company, especially to avoid any takeover threats.
Usually, companies that have surplus cash, either route it back into the business or payout dividends to investors. However, given some tax anomalies, companies have preferred to do buybacks rather than distribute surplus profits to shareholders in the form of dividends.
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Finance Minister, P. Chidambaram, in 1997, introduced dividend distribution tax (DDT) in his budget presentation to reward companies investing in future growth. To escape this tax, companies began resorting to buybacks. so, buybacks became more popular. Buyback remained the preferred option even after long-term capital gains tax on equity shares (on gains in excess of ` 1 lakh in a financial year) was re-introduced at 10 per cent in Budget 2018–19. In 2018–19, more than 60 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 stop the differential tax treatment between buybacks and dividend payments, Finance Minister Nirmala Sitharaman, in her maiden Budget, in 2019, proposed to levy a tax of 20 per cent on buybacks by listed companies as well. This tax would be levied on the difference between the issue price and the buyback price of the share. This may lead companies to pay out surpluses through dividends rather than resort to buybacks, which has been the norm in recent years. The reason, as stated, was that buybacks were a more tax-efficient choice for companies over dividend payments. Dividend payout, thus, reduced substantially, and this affected investors.
Importance of Buybacks for Investors
Buybacks can be done through the tender route as well as via open market purchases. In the case of the trader, the company fixes a buyback price and accepts shares on a proportionate basis during the buyback period. The ‘acceptance ratio’ plays a role in deciding how much of one’s holdings can be actually sold. This implies that one 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.
The introduction of buyback tax is expected to increase the dividend payouts from listed companies, especially those that have been resorting to buybacks to avoid tax incidence. For long-term investors, higher dividend payouts can be more beneficial. So, though the investors may be happy, the companies are not.