Defining buy-back
When a company procures its own outstanding shares i.e. quantum of stock in the open market along with shares held by institutional investors and restricted shares held by insiders and company officers, to reduce the number of shares available for General Public.
Reasons for buy back
Buy back of shares is undertaken for numerous reasons, like to strengthen the value of remaining shares available by cutting the supply or preventing other stakeholders from taking a controlling share. Few reasons for companies buying back their shares are discussed as follows:
- Preserving stock price: Company operates with the intention of maximizing shareholder’s wealth which in turn is related to the quantum of dividend supplied to them. But the increasing stream of dividends is difficult to maintain during recession. If the economy slows or dips into recession, there are chances of cutting down on the volume of dividends to preserve cash, leading to shareholders selling off their stocks. Instead, if buy back of fewer shares is considered, the stock price will likely take less of a hit. Share buy backs can be modified according to the conditions prevailing in the market, thus, preserving the stock price.
- Undervalued stock: Due to investor’s inability to see beyond a business’ short lived presentations, bearish performance and lurid news statements, undervaluation of stock of a company is common. In such a situation, company might repurchase a part of its shares at reduced price and then re-issue the same once the market gains momentum, thereby raising its equity capital without issuing any additional shares.
- Instant anchor to financial statements: Declining number of outstanding shares results in increasing Earning Per Share (EPS) of a company as the net income is now divided by reduced number of outstanding shares; this in turn lures small investors looking for quick money to invest in that company. This rapid influx of investors artificially leads to inflation in the stock price. All this leads to appreciation in the financial health of the company, thus, stemming the total inflows enjoyed by the company.
Buyback implementation
Buybacks are carried out by following two methods:-
- Tender offer: It refers to a process whereby shareholders might be conferred with a tender offer and given the option to tender or submit all or a portion of their shares within a given time period at a premium to the current market price. The premium given compensates investors for advancing their shares rather than holding onto them.
- Open market purchase: Companies buy back their shares on the open market over an extended frame of time and may even organize an outlined share repurchase program that purchases shares at certain times or at regular intervals.
Dividend v/s Buyback: Contrasting taxes
The mode of attaining satisfied shareholders is by rewarding them with a steady stream of dividends. But now dividends are being taxed at three different levels, namely:
- Being post tax appropriations, dividends are distributed after taxes are paid to the government on the total revenue influx, leading to multiple tax imposition on same amount.
- Payment of Dividend Distribution Tax (DDT) on dividends, paid by the company declaring dividends.
- Dividends exceeding INR 10 lakhs earned in a year will pay an additional tax at 10%.
On the other hand, tax criteria in case of buybacks is different for listed as well as unlisted companies, the same is discussed as under:
- For listed companies: Buyback can be executed via following two channels:-
- Buyback directly from the shareholders: If gain from buyback is Long-Term Capital Gain (LTCG), the tax will be payable on the lower of two amounts, which are, 20% with indexation or 10% without indexation. No Security Transaction Tax (STT) is paid by the shareholders. Hence, LTCG on buyback is taxable.
- Buyback through Stock Exchange: Buying back of shares through stock exchange leads to payment of STT on transaction. Since STT is already paid in this case, LTCG will be entirely exempt.
- For unlisted companies: No tax imposition on the person who benefits from the buyback of shares irrespective of whether the gain from the buyback is short-term or long-term.
As compared to dividends, buybacks has emanated as a smart instrument for large investors and companies. Though, the introduction of tax on LTCG without benefit of indexation lead to diminishing advantages of buyback, it still has an upper hand with its implications comparatively serviceable than those of dividends.
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