Share Buyback – A Double-edged Sword?

An increasing number of companies are choosing buybacks to replace dividends and avoid tax payments, rather than to increase shareholder value

Share buybacks have been around for several years and are not a recent phenomenon. Companies have taken this route in the past as an efficient way to increase the value of their shares. There are several benefits of a buyback. By reducing the number of shares in the market, the earnings per share ( EPS) get a boost. When a company buys its stock, the cash assets on its balance sheets reduce. This increases the RoE (return on equity). Shareholders who sell their stocks in the repurchase programme earn the market value plus a premium (if offered). The residual value for the remaining shareholders also goes up. Of course, it helps to up the promoter’s stake in the company, assuming non-participation by promoters.

A company may choose to do a buyback through a tender offer or through the open market. In a tender offer, the company makes an offer to buy a certain number of shares at a specific price, directly from shareholders. In the open market option, the company buys up to a certain number of shares (no compulsion to buy the whole announced quantity); a maximum price is fixed and the buyback can be done upto or below that particular price, not beyond. An open market buyback offer can generally go on for a year, whereas a tender offer gets executed in a shorter period of time. It can be interpreted that the intention behind a buyback through open market option is to buy as many shares as possible (within the overall limit fixed) at as low a price as possible; thus, trying to

increase remaining shareholders’ value to the maximum (without too much consideration to value received by selling shareholder). In case of a fixed price buyback, the intention is to give a reasonable price to selling shareholders, along with creating longer term value for remaining shareholders.

Of late, the number of companies taking the buyback route seems to have increased. A look at some of the recent buybacks, ( see Buyback Offers So Far in FY17) shows that most of the buybacks are at a fixed price, which indicates that the main purpose could have been to return a fixed amount of money to the selling shareholders.

As can be seen in the table above, the total buyback amount is a very minuscule part of the market cap of the company. In such a case, the intention is unlikely to be of doing a genuine buyback to increase the shareholder value. Then, what could possibly be the intention? It can further be seen that the buyback amount is almost equal to the dividend paid out by these companies in the last two years. So, are companies trying to pay out dividend through the buyback route instead of direct dividends?

Possibly, yes! And this could be because of the change in taxation law towards dividend payment. The Union Budget 2016/17 introduced an additional 10 per cent tax for those earning an annual dividend income of more than `10 lakh, over and above the 15 per cent DDT (dividend distribution tax) paid by companies. This new tax came into effect on April 1, 2016. This seems to have made dividend distribution ‘tax-unfriendly’ and, therefore, companies might be opting for the ‘tax-efficient’ buyback route. Buybacks are subject to securities transaction tax ( STT), which entails a tax outgo of 0.1 per cent. Long-term capital gains on transfer of shares, on which STT is paid, where stocks have been held for more than a year, are exempt from tax. Similarly, short-term capital gains arising on transfer of shares, on which STT is paid, is subject to tax at 15 per cent (excluding surcharge and cess). The company does not pay any tax on such buyback of shares. This has led to a surge in companies announcing buyback offers.

Most of the buybacks done in FY17 so far seem to have been for tax advantages. Bharti Infratel, which paid a dividend of `2,082 crore in FY ’ 15, paid a dividend of `571 crore in FY ’ 16, and has used the buyback route for paying back investors `2,000 crore. Similarly, Sobha Ltd, which paid a dividend of `69 crore in FY ’ 15, paid a dividend of `20 crore in FY ’ 16, and paid a larger chunk of `75 crore to shareholders through buyback. Most offers where the buyback has been done for tax reduction have been done through the Fixed Price Tender Offer route. But, if we consider Dr. Reddy’s open market buyback, the reason seems to be different. The pharma major paid a total dividend of `341 crore in FY ’ 15; in FY ’ 16, too, it paid `341 crore. Over and above that, it did a buyback worth `1,569 crore. The buyback could have been an attempt to support the stock, which fell 36 per cent between November 2015 and January 2016. The buyback announcement was made on February 17, 2016, and then the stock moved up 17 per cent within 15

THE NEW TAXATION LAW, INTRODUCED ON APRIL 1, SEEMS TO HAVE MADE DIVIDEND DISTRIBUTION ‘TAXUNFRIENDLY’

days of the announcement.

Who benefits from such buybacks? Minority shareholders are unlikely to benefit from such buybacks.

In most cases, small shareholders do not come in the tax bracket of annual dividend income of more than `10 lakh, so they are not liable to pay tax. Also, minority investors may not want to participate in these buybacks as they may have bought the shares for longer term capital returns. Obviously, the ‘promoter’ shareholders (with significant stake) would tend to benefit from such buybacks. Their dividend income will certainly be more than ` 10 lakh and, therefore, they would prefer to avoid taxation by opting for buyback instead of dividend. Of course, assuming a proportionate buyback, their shareholding will continue to remain the same post buyback. In fact, depending on minority shareholders’ participation in the buyback, some promoter shareholders might use this exercise for their benefit, either by letting their shares tendered in higher quantities or by using this route to increase shareholding in the company, without investing their personal money. In such cases, minority shareholders stand to lose because of government’s action.

To understand this further, let us look at some more numbers from past buybacks ( before the taxation change). Past buyback offers show how the buyback size as a percentage of market cap used to be much higher than what it is these days. ( See Past Buybacks.) Piramal Healthcare’s buyback size in 2011 was 26 per cent of its market cap, Indiabulls Real Estate, in 2012, was 9 per cent, Bayer CropScience, in 2013, was 7 per cent and governmentowned NHPC’S offer was over 10 per cent. But the buyback size as a percentage of market cap for recent offers has been in the 2-3 per cent range. This again reflects that the recent buybacks are done more with an objective to replace dividends and with an intention to avoid tax payments. This is in contrast to past buybacks, which were done with an intention to put cash to good use and to genuinely increase shareholder value.

This may just be the beginning. Other cash-rich companies, like Infosys and TCS, HUL and ITC, Bajaj Auto and Eicher Motors, could also consider the buyback route soon.

The jury is still out on whether the government will be able to achieve its objective of collecting higher tax from dividend payouts, if most of the companies start using the buyback route instead of dividend payouts. Not only will the government not benefit, it will be a clear loss for the minority shareholders as well. Of course, the rich promoters would continue to reduce their tax outgo by using the buyback route instead of the dividend route. This move is probably worth a relook by the government. ~

RICH PROMOTERS WOULD CONTINUE TO REDUCE THEIR

TAX OUTGO BY USING THE BUYBACK ROUTE