In addition to tax-arbitrage, buybacks helped promoters in other ways as well
Union Budget 2019 has proposed to tax buyback of shares by companies at 20 percent. It was felt that many companies were avoiding dividend payouts because of the dividend distribution tax. Instead, the companies were returning cash to shareholders through share buybacks. The proposed tax on share buybacks is aimed at plugging this loophole.
Moneycontrol tries to decode the move by answering some commonly-asked questions.
Q: What is the rate of tax payable by companies when they give dividends to shareholders?
A: The dividend distribution tax (DDT) was introduced in Union Budget 2007. Investors who receive the dividend do not have to pay tax, but the companies giving the dividend have to pay DDT to the government. The rate of DDT is 15 percent. Inclusive of cess and surcharge, the figure is about 20 percent. For investors to get Rs 100 in dividends, the company has to shell out around Rs 120 – Rs 100 cash payout to shareholders and Rs 20 as DDT to the government.
It does not end here. Investors with total dividends receipt in excess of Rs 10 lakh are expected to pay tax at the rate of 10 percent (plus surcharge and cess) from April 1, 2017. Most promoters hold large stakes in the company and their dividend income exceeds Rs 10 lakh. So for the promoter, dividend receipts are taxed twice.
The promoter may not need cash in a given year, to the extent of the dividends announced. But because the company has announced the dividend, the payout reaches him and he has to pay the tax.
Q: Can this tax impact be avoided?
A: Prior to Union Budget 2019, this was possible. A company could opt for buyback of its shares instead of paying dividends. Investors looking for cash may want to tender their shares and get paid in cash. The promoter may choose not to participate in the buyback or tender shares to the extent of his requirement of cash. The gains on shares accepted in the buyback are taxed at the rate of 10 percent if the investors have held the shares for more than one year. If the shares are held for less than one year then the gains are taxed at 15 percent. The tax rate is higher after factoring in cess and surcharge. But still, that is lower than the DDT and tax of dividend payable.
Q: So don’t promoters lose out if they don’t participate in buybacks?
A: On paper, yes. But in reality, they do benefit. A promoter cannot be seen participating in a buyback because that would send out a negative signal to shareholders. But most promoters hold shares of their companies through fronts. This does not show up in the promoter holding disclosed to stock exchanges. During buyback, these front companies too tender the shares held by them.
Q: Do buybacks have more benefits?
A: In addition to the tax-arbitrage, buybacks help in many ways. First, it helps the company to give cash only to the shareholders who want it. No mass distribution of cash. When a few shareholders tender their shares and those are accepted, the company extinguishes those shares. That means the percentage of non-promoter shareholding goes down and the promoter’s stake in the company in percentage term goes up. In effect, promoters can raise stake through company funds.
As the number of shares outstanding goes down, other things remaining the same, the profit per share of the company (or earning per share – EPS) goes up. That means if the company continues to enjoy the same valuation (price to earnings multiple) then the price of the share climbs up. Promoters see their net-worth going up without much action on their part and more important in a tax-efficient manner.
Q: But why the government does not like this?
A: Instead of declaring dividends the promoters were using the buyback route to enhance their wealth and effectively increasing their shareholding in the company. In this process, the government, however, was a loser. It was not getting paid the DDT, tax on dividends where a single investor was pocketing more than Rs 10 lakh.To overcome this, Union Budget 2019 brought in buyback tax at 20 percent. That would plug the loophole and promoters now have to pay tax whichever way they go – be it dividend payout or the buyback.