The Finance Ministry of the government has recently expressed its intent to examine the possibility of imposing a 20% tax, as proposed in the budget for 2019-20, on the ongoing share buybacks by companies that are publicly listed. A thorough understanding of what share buybacks are and why they are done is essential to grasp the implications of this potential tax.
In essence, a buyback is a financial scheme where a company repurchases a specified quantity of its outstanding shares from the market. These repurchased shares are subsequently extinguished or cancelled by the company, thus reducing the number of shares in circulation.
Reasons Behind Share Buybacks
Companies may resort to buybacks for a variety of reasons, two of which are particularly noteworthy. One reason is to ameliorate their earnings per share (EPS), a key metric of profitability, for the shareholders who retain their holdings. This is because by diminishing the number of shares on the market, the EPS for remaining shares increases.
Alternatively, the promoters of the company may instigate a buyback if they wish to augment their stake in the company. This strategy is sometimes employed to thwart potential takeover threats.
Evasion of Dividend Distribution Tax
It’s important to note another strategic utilization of buybacks, especially by listed companies. They often employ share buybacks as a means to evade the Dividend Distribution Tax (DDT). A dividend is essentially a return given by a company to its shareholders from the profits it earned in a specific year. It’s like a reward to its shareholders for their investment. The DDT is a tax that is levied on the company that pays these dividends. As per the current structure, the effective rate stands at 20.3576%.
Table: Difference Between Buybacks and Dividends
| Aspect | Buybacks | Dividends |
|---|---|---|
| Tax implication | Potentially taxed at 20% | Currently taxed at 20.3576% |
| Impact on company ownership | Can change the shareholding pattern | Does not influence the shareholding pattern |
| Impact on earnings per share | Can increase EPS | Has no direct impact on EPS |
New Tax Proposal for Share Buybacks
To address the ongoing differential tax treatment between buybacks and dividend payouts, the government has recently put forth a proposal to impose a 20% tax on buybacks. This proposed tax is planned to be imposed on the difference between the issue price and the buyback price of the share.