What is a Buyback of Shares?
A buyback of shares refers to a corporate strategy where a company repurchases its own shares from existing shareholders. This process typically occurs at the current market price or a premium. By executing a buyback, the company reduces the number of shares available in the market, which can lead to increased ownership concentration and provide a mechanism for returning capital to shareholders.
Why Do Companies Buy Back Shares?
Companies engage in buybacks for several strategic reasons:
- Consolidated Ownership: A significant portion of ownership can lead to higher costs and administrative burdens for a company. Buybacks help consolidate ownership, creating a more streamlined capital structure and potentially reducing expenses related to public reporting and shareholder management.
- Share Price Adjustment: If a company believes its shares are undervalued due to market fluctuations or external factors, a buyback can help rectify this situation. By reducing supply, the company aims to boost demand and enhance its stock price, signaling confidence in its value to investors.
- Enhanced Financial Appeal: Reducing the total number of outstanding shares can lead to an increase in Earnings Per Share (EPS). A higher EPS often makes a company more appealing to investors, enhancing its market valuation and potentially leading to an increase in stock price.
- Promoter Stake Increase: When company promoters wish to increase their stake in the company, buybacks provide a method to acquire shares without impacting the share price negatively. This can also signal to the market that the promoters are confident in the company’s future.
Why is Buyback Tax Levied on Companies?
Initially, the taxation landscape for companies was different. When companies distributed dividends, they were subject to Dividend Distribution Tax (DDT). However, when they opted for buybacks, the tax liability shifted to shareholders, often in the form of capital gains. This setup created a tax advantage for companies, particularly unlisted ones, as capital gains tax rates are generally lower and not all shareholders exceed the exemption limit.
Certain foreign companies exploited this discrepancy, utilizing tax treaties to avoid capital gains taxes. By promoting buybacks over dividends, they benefited from tax-free capital gains. To mitigate such tax avoidance strategies, the Indian government introduced Section 115QA of the Income Tax Act in 2013, initially targeting unlisted companies, and later expanding it to include listed companies in July 2019.
Income Tax Provisions Under Section 115QA of the Income Tax Act 1961
Under Section 115QA, both listed and unlisted companies are mandated to pay an additional income tax on the distributed income resulting from share buybacks. Key provisions include:
- Tax Liability: This tax is imposed regardless of whether the company has other income tax obligations.
- Tax Rate: The rate is set at 20% of the buyback amount, plus a 12% surcharge and applicable cess, making the effective tax rate considerably higher.
- Payment Timeline: Companies must remit this tax within 14 days of making payments to shareholders during the buyback. Failure to comply results in interest charges of 1% per month on the unpaid tax amount.
- Final Settlement: This tax payment is considered a final settlement; no tax credits are available for the company or shareholders, relieving shareholders of any further tax obligations related to the buyback.
Budget 2024 – Changes in Buyback Taxation
In the 2024 budget, significant changes to buyback taxation were announced. The current tax framework requires companies to pay tax on the difference between the buyback price and the issue price of shares. This was aligned with the previous Dividend Distribution Tax (DDT) structure.
However, in the Finance Act of 2020, DDT was abolished, shifting tax obligations to the shareholders. To streamline buyback taxation in line with the revised dividend tax regime, the government proposed to eliminate the buyback tax for companies starting October 1, 2024.
From this date, companies will no longer be liable for tax on buybacks. Instead, shareholders will be taxed on the total amount received from the buyback as a deemed dividend under the new provisions of Section 2(22)(f). It’s important to note that the cost of acquisition of the shares will not be deductible against this dividend income. Instead, it will be carried forward as a deemed capital loss, which can be offset against future capital gains from the sale of other shares.
Illustrative Scenarios
To clarify the impact of these changes, let’s explore two scenarios:
Before October 1, 2024:
D Ltd repurchases 500 shares in August 2024 at a market price of Rs. 650, with an issue price of Rs. 50.
- The company must pay a buyback tax of 20% on the distributed income of Rs. 600 (i.e., Rs. 650 – Rs. 50).
- Shareholders are not liable for any taxes on this transaction.
After October 1, 2024:
D Ltd repurchases 500 shares in November 2024 at the same market price.
- The company will incur no tax liabilities for the buyback.
- However, shareholders will be taxed on the total amount received (Rs. 650 per share) as deemed dividends, based on their applicable income tax slab rates.
Conclusion
The overhaul of buyback taxation represents a positive shift for investors, ensuring that buybacks are conducted primarily to signal the company’s belief that its shares are undervalued. Such actions can enhance market confidence and promote more efficient pricing mechanisms.
The forthcoming tax implications effective October 1, 2024, will require investors participating in buybacks to pay tax based on their respective slab rates on the full amount received. Furthermore, the cost of shares tendered during the buyback will be recognized as a capital loss, providing a tax-efficient mechanism for offsetting future capital gains.
In essence, these changes are designed to encourage transparency and align the interests of companies with those of their shareholders, fostering long-term value creation in the financial markets.
