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Tax rules tilt scales in favour of buybacks versus dividends
May, 05th 2016

Some listed companies have announced consideration of buyback of shares in April 2016. Buyback of shares has not been a common phenomenon till now. So, what is it that has prompted these companies to come out with offers for buyback of shares? It is purely the tax advantage of share buybacks, as against taxation of dividends, that has triggered this preference for buybacks.

The recent Budget has changed the taxation of dividends. Besides the dividend distribution tax (DDT) of 20.90% payable on dividends by the company distributing them, the individual shareholder receiving dividends in excess of Rs.10 lakh will also have to pay a tax on such excess dividends at 11.85% (10% plus surcharge and cess, if the income exceeds Rs.1 crore). The dividends would, therefore, attract tax of almost 32.75%, which is about the same rate as any other income.

On the other hand, buybacks of shares can now be effected through the stock exchange route. Such buybacks are routed through share brokers on the stock exchange, and are, therefore, subject to securities transaction tax (STT). In case of listed companies, buyback of shares is subject to capital gains tax in the hands of the shareholder. Long-term capital gains on transfer of equity shares, on which STT is paid, where the equity shares have been held for more than 12 months, is exempt from tax. Similarly, short-term capital gains arising on transfer of equity shares, on which STT is paid, is subjected to tax at 15% (effectively 17.77%). The company does not pay any tax on such buyback of shares.

It is evident that the scales have been significantly tilted in favour of buyback of shares by listed companies, as against payment of dividends, on account of the recent changes in the tax laws.

Commercially, both buybacks and dividends involve a cash outflow for the company. The only restrictions are from a company law perspective. It cannot do a buyback of more than 25% of the shares, or 25% of its net worth. It cannot issue any shares for a period of six months after the buyback. The debt-equity ratio cannot exceed 2:1 after the buyback, and other such rules. Apart from this, there has to be a period of at least 12 months between two buybacks by the company.

The shareholder is significantly benefited by a buyback of shares, as opposed to a dividend. The only problem is that of the shareholder having to fill up the offer form for buyback to exercise the option to tender her shares, as against a situation in which the dividend is automatically credited to her bank account without any action required from her.

Further, in a buyback offer, one is not certain whether all the shares offered will be accepted in the buyback offer, since normally, a proportionate acceptance is the norm when the shares tendered by shareholders are more than the total number of shares being bought back.

Obviously, listed companies would prefer to resort to buybacks rather than pay out dividends, which involve higher taxes. For unlisted companies, buybacks attract a buyback distribution tax at 20% (effectively 23.69%) payable by the company on the excess of redemption price over the issue price, with no taxation in the hands of the shareholders. Therefore, buybacks are also now more tax efficient than dividends for unlisted companies, though not as tax efficient as in the case of listed companies.

This is a clear case of how tax provisions significantly impact commercial decisions by companies and taxpayers. Consider the manner of taxation of dividends.

Till 2003, dividends were taxable in the hands of shareholders. In 2003, they were granted exemption, with introduction of DDT of 7.5%, which as per the explanation at that time, approximated and substituted the total tax on dividends being paid by shareholders. The DDT rate has crept up over the years to its current level of 20.90%. Now, in an about turn, the shareholder is also being subjected to tax on dividends over Rs.10 lakh.

Frequent changes in tax laws are accompanied by frequent changes in the manner in which companies function, and, therefore, such amendments in tax laws need to be carried out with caution, and only if absolutely necessary.

Consistency in tax policy has unfortunately not been a quality that the government has demonstrated over the years. This lack of consistency is highly disruptive to the functioning of businesses, which have to constantly adapt to changes. They spend much more time and effort in rejigging their systems and practices, the cost of which is unfortunately not factored in while making amendments to tax laws. One hopes that the government formulates a long-term approach to our tax laws—that will indeed increase the ease of doing business.

 
 
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