Dividends, Buy backs & all the buzz about tax rules
The buzz of “Dividend v/s Buybacks” is back in the market, thanks to cash rich IT companies with no foreseeable investment opportunities especially after Trump’s not so IT friendly regime. Further, a recent change in tax rules made in last year’s budget has added the icing on the cake. We are again back to the age old debate of Dividend v/s Buybacks.
So, lets decode the issue step by step:
First, let us understand what is buy back of shares?
Buy-Back is a corporate action in which a company buys back its shares from the existing shareholders usually at a price higher than market price. When it buys back, the number of shares outstanding in the market reduces.
A buyback allows companies to invest in themselves. By reducing the number of shares outstanding on the market, buybacks increase the proportion of shares a company owns.
Buybacks can be carried out in two ways:
- Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all of their shares within a certain time frame and at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding on to them.
- Companies buy back shares on the open market over an extended period of time.
Also, the company has to comply with legal formalities associated with buy back as specified in Companies Act and rules made thereunder.
The reasons for buy-back:
- To improve earnings per share;
- To improve return on capital, return on net worth and to enhance the long-term shareholder value; (as capital reduces)
- To provide an additional exit route to shareholders;
- To enhance consolidation of stake in the company;
- To prevent unwelcome takeover bids;
- To return surplus cash to shareholders;
- To achieve optimum capital structure;
- To support share price during periods of sluggish market conditions (buy backs reduce the no. of shares int the market and as supply reduces w.r.t demand share price improves);
- To service the equity more efficiently.
Comparing buy-backs with dividend
A company with surplus profits wishing to distribute them to its shareholders has two options i.e. either it can buy-back the shares or distribute the surplus as dividends.
Let us look at benefits of both:
Buy-backs are advantageous for the companies for all the reasons listed above. Shareholders get an opportunity to liquidate their investment at a higher than market price.
The most obvious benefit of dividends is income. Dividends allow shareholders to gain money even without liquidating their investments, which is a big perk for people who rely on their investments to help pay living expenses.
Furthermore, dividends give investors the option to use the distributed profits as they see fit. If they feel the stock is attractively valued, they can use their dividends to buy more shares, Or, if they would rather invest their profits elsewhere, they are free to do that as well.
Also, the dividends are tax free in hands of shareholder (upto 10 lacs w.e.f. 1/4/2016), while buy back gains may get taxed as short term capital gain or long term capital gain (if not through stock exchange.)
Twist in the tax rules and tilt towards buy-backs
Of late, companies are increasingly resorting to buybacks over dividends, reason being tax efficiency of buy backs over dividends. With effect from April 1, 2016, dividends will be subject to additional 10 percent tax if it exceeds Rs 10 lakh in the hand of the shareholder in a year. This is in addition to dividend distribution tax.
Buybacks are subject to securities transaction tax of 0.125 percent in the hands of the investor, if done through the stock market route. As a result of this, long-term capital gains became tax-free and short-term gains became subject to a tax of 15 per cent (excluding surcharge and cess).
This made buybacks a tax-efficient choice over dividend payments, especially for promoters who are usually among the large shareholders.
About 70 per cent of the buyback offers in fiscal years 2016 and 2017 have been through the tender offer route.
Though, the final decision w.r.t. mode of distribution of profits would be of Company, nevertheless, the tax twist has tilted the balance in favour of buy-backs.
Compiled by Commerce for IAS