When a domestic company buys its shares back from the public, it has to pay a tax of 23.296 percent on the distributed income.
Imagine you’re at a restaurant for lunch. After finishing, you are told to pay a portion of the bill for other guests eating at the restaurant. This is an unexpected and unfair situation, and you would likely choose not to return to that restaurant and instead seek out one with more reasonable practices. This analogy can explain the disadvantage to shareholders when a company announces a buyback of shares and pays tax on the distributed income.
When a domestic company buys its shares back from the public, it has to pay a tax of 23.296 percent on the distributed income. The distributed income is the difference between the amount paid by the company to buy back the shares and the amount it received when the shares were originally issued.
Although a lower number of shareholders tender their shares and take exit (partially or fully) from the company, it adversely impacts the interest of other shareholders. The company will have to use its own funds to pay taxes on the distributed income, reducing the overall value of the remaining shareholders’ investments.
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When a company conducts a buyback, it can improve its future earnings per share (EPS) by reducing the number of shares outstanding. However, if the company is required to pay taxes on the distributed income, it will have less funds available to reinvest. As a result, the EPS may not reach the same level if the shareholders had paid the taxes on the distributed income.
Take an example. A company has 1 million shares and a net income of Rs 1 crore, which translates to an EPS of Rs 10 per share. The company does a buyback of 250,000 shares. Assuming no change in net income, the EPS would now be Rs 13.33 per share. If the company pays a tax of Rs 10 lakh on the distributed income, this would leave the company with Rs 90 lakh in net income and an EPS of Rs 12 per share.
It shows that the continuing shareholders collectively bear the tax burden payable by the company on the buyback. It will be rational if the incidence of tax is shifted to the shareholders. In November 2022, the Securities and Exchange Board of India (SEBI) released a consultation paper on the Review of SEBI (Buyback of Securities) Regulations, 2018, whereby it proposed various changes in existing buyback norms. One such change was shifting the incidence of tax on buyback from the company into the hands of shareholders.
SEBI proposed the change in the buyback regulations based on an analysis of buybacks conducted by 68 listed companies during the 2020 fiscal year. In 19 of these companies, promoters tendered more shares than their pre-buyback holdings. As a result, these companies paid buyback taxes not only on the shares tendered by the promoters from their pre-buyback holdings but also on the additional shares tendered by them. In these 19 companies, the total tax paid by the companies amounted to Rs 2,988.79 crore, of which Rs 2,734.35 crore was taxes paid on shares tendered by the promoters. These taxes were paid from the company’s free reserves on behalf of the existing shareholders and promoters at the expense of continuing shareholders. Based on this analysis, SEBI proposed shifting the tax responsibility for buybacks from the company to the shareholders.
A company can take the route of buybacks or dividends distribution to distribute surplus cash to shareholders. As the incidence of tax in dividends is shifted to the recipients, a realignment of tax incidence on buyback with that of dividends is desirable.
This change would not only address the tax burden issue but also make the tax treatment of buyback more fair and equitable. Shareholders would see a reduction in the tax rate on long-term holdings, which would be half of the current buyback tax rate, and a decrease in the tax rate on short-term holdings. In addition, shareholders would be able to claim a loss if the buyback price is lower than the issue price, which is currently not allowed.
It’s important to note that when a foreign company repurchases shares from its Indian shareholders, the shareholders are currently liable to pay taxes on the capital gains resulting from such buyback. The capital gains in this situation are calculated according to Section 46A of Income-tax Act.
