Companies can return money to you in two ways – by paying dividends and by buying back their shares. In case of dividends, you have no role to pay. You simply passively receive the dividend and then decide whether you want to reinvest the money in the same company by buying more shares or invest it elsewhere. However, in case of buybacks you have an active choice to make – to participate or not to participate. In this article, we will give you a framework on how to make this decision.
Why companies buy their shares back
There can be a number of reasons for this. The company may have surplus cash and not enough scope in its business to deploy the cash. It might simply have no ideas to deploy the cash in its operations or expansion. In such a scenario, the company can return the cash to shareholders through buybacks. Shareholders who do not sell their shares to the company do not automatically lose out. A buyback reduces the number of outstanding shares of the company and hence increases the value of each share.
Second, the main alternative to share buybacks – paying dividends, has become highly tax inefficient. The company pays dividend distribution tax (DDT) at 15% when it pays out dividends. In addition, shareholders who get more than Rs 10 lakh per annum as stock dividends have to pay a tax of 10%. This creates a major disadvantage for large shareholders of companies including promoters. To protect their interest, companies are increasingly resorting to share buybacks rather than dividends
Third, the company may think that its own shares are undervalued. A buyback may be a signal to the market that the company’s management thinks that the market has undervalued the stock in question and it ought price them higher. However this can also be a signal used by a failing company, wishing to prop up its share prices. You have to look at the company’s current and historical cash flows before interpreting a buyback in this way.
Tax Implications of Share Buybacks
If the company is buying back shares through the stock exchange, the tax treatment is the same as selling shares to a third-party. You pay a 15% capital gains tax if you sell the shares back to the company within 1 year of purchase (short term capital gains tax) and 10% if you sell them after 1 year of purchase (long term capital gains tax). You get an annual exemption of Rs 1 lakh on such long term capital gains. If the company is buying the shares through an off-market route, the tax treatment is different. You pay short term capital gains tax at your slab rate if you are selling your shares back to the company within 1 year of purchase. If you are selling your shares after 1 year, you pay long term capital gains at 20% with indexation or at a 10% rate without indexation. Indexation takes the effect of inflation into account while calculating your taxable gains and reduces your tax burden accordingly.
Should you participate in a share buyback?
The answer to this question depends on why the company is doing the buyback and whether you need the money. If the buyback is merely a tax manoeuvre to pass cash efficiently to promoters, you can by and large, sit out the buyback. If the buy-back is a sign that the company has no ideas to deploy the cash, consider selling out and putting your money in a more growth oriented company. If the company is signalling that its shares are undervalued, you might want to hang on to your shares for future gains. All this will only become apparent when you study the overall business and financial position of the company in question. Also, check if you actually need the money. If you do not have any major financial goal or expenditure at hand, you might do better do simply wait it out. Participating in the buyback may unnecessarily create a tax liability on you.
But there could be arbitrage opportunities as well. You can buy the shares of a company which has announced buy back and sell it back to the company at the buy back price. This depends on the difference between the buy back price and your purchase price, the acceptance rate of the shares in buy back and so on. Also have a look at the short term capital gains tax on the gains. You can see an upcoming opportunity in Mphasis share buy back here.