Buybacks seem to be in vogue in 2016, with biggies like Wipro, Bharti Airtel, Bharti Infratel, Nalco and Novartis having made announcements for buyback of shares for whopping amounts in the range of INR 2,000 to 3,000 crores.  What has suddenly changed in the recent past, due to which companies have started using this route to reward the shareholders?

Traditionally, buyback was used as a restructuring strategy by listed companies for various reasons such as using surplus cash, boosting Earning per Share (EPS), increasing Return on Equity (RoE), increasing the promoters’ shareholding (through buyback of shares held by public), etc.. However, due to amendments in the buyback regulations by SEBI, this route has developed traction with India Inc.

Before April 2015, listed companies could buy back shares in 2 ways:

Firstly, through market purchases, wherein listed companies bought shares which would get directly cancelled.  Promoters were not allowed to participate in such process; and

Secondly, through the tender offer route, wherein the promoters could participate, condition being that such a fact should be disclosed in the offer document.  Such route being off-market, the capital gains were subject to tax at 10 per cent (excluding surcharge and cess) if shares were held for more than 12 months, and at 30per cent (excluding surcharge and cess) in other cases.  This was construed as a deterrent for public shareholders from participatingin the buyback process as, if the shareholder sold shares on market, lower tax rates applied, since Securities Transaction Tax (STT) would be paid on such transaction. In such cases, there would be no tax on capital gains if shares sold had been held for more than 12 months; else tax would be attracted at 15 per cent (excluding surcharge and cess).

Considering the above, the SEBI amended the buyback regulations in April 2015.  As an outcome of such amendment, buyback through tender offer can now take place through the stock exchange mechanism, which means that STT would be paid on such transaction. Further, promoters are also allowed to participate in such tender offer route.

The amendment in Finance Act, 2016 taxing dividend at the rate of 10 per cent in the hands of individuals, HUFs and firms has turned out to be a catalyst for buybacks. On declaration of dividends, companies have to pay dividend distribution tax at the rate of 17.647 percent (excluding surcharge and cess). Further, the shareholders (individuals, HUFs and firms) receiving dividend would also have to pay tax at 10 percent (excluding surcharge and cess).

As per the Income tax Act, buyback is not considered as dividend if it is in accordance with the provisions of the Companies Act.  Accordingly, amount paid by the company to its shareholders in buyback would not attract dividend distribution tax.  The gains on buyback would be generally regarded as capital gains in the hands of the shareholders. Since STT would have been paid on such buyback of listed shares, depending upon the period of holding, the capital gains may either be exempt from tax (if shares held for more than 12 months) or chargeable at 15per cent (excluding surcharge and cess).  In a nutshell, there are savings in the hands of companies on account of saved dividend distribution tax and investors could potentially benefit upto 10per cent (excluding surcharge and cess).

This strategy comes with a caution.  In case the buyback price is not attractive enough for the public to tender the shares, the promoters may end up diluting their stake in the listed entity. The dilution would be a function of the number of shares tendered and the existing promoter holding.

Further, if the listed company has corporate shareholders, such corporate shareholders may have exposure on account of the tax on book profits arising from the said buyback (Minimum Alternate Tax). Upstreaming of funds from unlisted corporate shareholders to the ultimate shareholder by way of buyback or dividend distribution may still be subject to tax in the hands of company / shareholder, as the case may be.

Overall, buyback seems to be an effective way from the company’s standpoint to reward shareholders due to the absence of dividend distribution tax, and from long term investors’/ shareholders’ perspective, it provides access to company’s cash (instead of dividend). This would have to sync with the dividend policies of the company, specifically considering that SEBI is introducing a mandatory dividend policy for the top 500 companies.However, due to benefits of such corporate strategy, the shareholders / investors can expect India Inc. to announce more buyback offers.