Dividend vs Buyback

access_time 2019-12-02T08:25:52.382Z face Jassprit S Johar Blog

Dividend payouts and Buy Back of Shares are both modes to pay shareholders that are being employed by companies that have surplus funds. Both dividend payouts and buybacks are indicative that a company want to release surplus funds available in their books and enhance shareholder value. In recent times, we've seen a surge in announcement of buybacks wherein many big companies like TCS, HCL and Wipro have announced buybacks.

It is not a hidden fact that the trend towards buy back has increased after the Union Budget 2016. So, why is it that large number of companies are preferring buying back their own shares rather than dividend? In this article, we will analyze both the situations sequentially.

What are Dividends?

Dividend simply means, division of profits. It is a sum of money out of its profits paid by a company to its shareholders from time to time, be it annually or after any other duration. However, it cannot be said that dividends are guaranteed. Even for a profit-making company, the board of directors may decide not to declare any dividend or reduce the quantum from earlier one for investing in future growth of the company.

What are Buybacks?

Buy-Back is a corporate action in which a company buys back its shares from the existing shareholders usually at a price slightly higher than market price. This premium is a company's way of rewarding its shareholders, which incentivizes them to take part in the buyback process. When a company buys back, the number of its shares outstanding in the market reduces. Buybacks can be carried out in two ways:

 

Equity and Preference Shareholders are given an offer to submit a portion of shareholding 0r all shareholding within a time limit and that too at a premium of current FMV. The premium amount will compensate shareholder for submitting their shareholding rather than holding such shares with them.

 

Companies generally buy back shares at FMV over a particular period of time.

There are many reasons for companies to opt for buy back. Some of them have been listed hereunder:

 

To improve earnings per share;

 

To improve return on capital, return on net worth and to enhance the long-term shareholder value;

 

To provide an additional exit route to shareholders when shares are under-valued or are thinly traded;

 

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;

 

To service the equity more efficiently.

When a company is in the decision-making process regarding whether to go for buy-back of shares or pay dividend, taxation of both the transactions plays a major role.

Tax implications of Dividend Payout:

In India, dividends are subject to taxation at three levels:

1.

 

Dividend is not treated as an expense for the companies rather it is treated as an appropriation from net profit after tax of a company. Therefore, there is no tax saving to the companies on distribution of dividend. Company is required to discharge its income tax liability on entire profits before payment of dividend. (First Stage Tax)

2.

 

Section 115-O of the Income Tax Act, 1961 (hereinafter referred to as "The Act") levies a Dividend Distribution Tax (DDT) at the rate of 15% on the dividend declared, distributed or paid by the company. This second stage tax further eats out the profits available for appropriation and thus, reduces the dividend payable to the shareholders. (Second Stage Tax)

3.

 

Finance Act, 2016 has introduced a section 115BBDA in the act which seeks to levy a tax at the rate of 10% on all shareholders who receives dividend in excess of Rs. 10 Lakh in a financial year. (Third stage tax)

Dividends having attracted tax at three stages have become quite inefficient both for the companies as well as the shareholders from tax planning perspective.

Tax implications of Buyback:

Tax implications of buy back can be analyzed by categorizing the related provisions into two main categories:

 

Tax implications on buy back of listed shares; and

 

Tax implications on buy back of unlisted shares.

Now, let us look at the two categories in detail.

Buy Back of Listed Shares:

Listed shares are the shares issued by a company listed on a recognized stock exchange. In the event of a company buying back its own listed shares, the transaction is exempt from income tax in the hands of the companies. This means that the burden of taxability is shifted on to the shareholders. The manner of taxability of shareholders further depends upon two aspects:

 

Buyback directly from the shareholders:

 

 

This means that the securities transaction tax shall not be applicable on the same. The capital gains shall be taxable as short-term capital gains, if the period of holding is less than 12 months. In this case, the rate of tax shall be the slab rate applicable on the assessee. On the other hand, Long-term capital gain (if the holding period is more than 12 months), shall be taxable under Section 112 of Income Tax Act, at the rate, 20% of capital gain after indexation

 

Buyback through Recognized Stock Exchange:

 

 

In such a scenario, short-term capital gain shall be taxable at a flat rate of 15% under Section 111A as this transaction is chargeable to securities transaction tax (STT) whereas long-term capital gain on such transaction shall be chargeable @ 10% for LTCG exceeding Rs.1 Lac.

Buy Back of Unlisted Shares:

In the event of a company buying back its own unlisted shares, the same is taxable under Section 115QA of the Act at a flat rate of 20% on the 'distributed income'. Distributed income means the consideration paid by the company on buyback of shares as reduced by the amount which was received by the company for the issuance of such shares. This is an additional tax which will be over and above the tax chargeable in respect of total income of the unlisted company notwithstanding that no income tax is payable by the company under the provision of Income Tax Act. Rule 40BB of Income Tax Rules 1962 laid down the complete procedure for calculation of Distributed Income in various cases. On the other hand, shareholders shall be exempt from tax as per section 10(34A) of the Act.

Why prefer buyback over dividend?

In recent time, buybacks have been preferred by companies over dividend due to following reasons:

 

Double Taxation of Dividend:

 

 

Union Budget 2016 made dividend receipts above Rs. 10 lakh taxable at 10 per cent in the hands of investors. When a company declares a dividend, there is already a dividend distribution tax (DDT) on the payout. Besides, the dividend is paid out from the net profit, which in itself is arrived at after paying corporate taxes. So, Budget 2016 imposed additionally a tax on dividends (above Rs. 10 lakh) for high net worth investors and, therefore, made dividend payments unattractive.

 

Improved EPS Valuation:

 

 

Dividend is distributed by companies from the net profit in the form of cash payouts, and to that extent it reduces the addition to the net worth of the company and thus, its market value. However, as buyback is a reduction of the outstanding capital, it improves the earnings per share (EPS) of the company and thus, valuation.

 

Buyback acts as price stabilizer:

 

 

When a company indicates that it is willing to buy back the stock at a certain price, it generally gives a signal to the market of a fair price for the stock. However, this need not contain declines as there are instances too, of stock prices falling below the buyback price.

In view of above factors, companies have been preferring the buyback route as it is tax efficient to the extent of 9% in terms of tax incidence.