Buybacks in the time of coronavirus

March 18, 2020 6:45 AM

Being denied the legitimate tool of OMOs for buyback of shares due to double-taxation caused by administrative realities is a cross that India Inc can't bear, certainly not at a time of crisis like this.

rbi, reserve bank of indiahe US Fed cut its rates to zero; other central banks worldwide followed suit to pump in liquidity, but RBI, after the conference on March 16, is yet to do so.

By Siddarth Pai and TV Mohandas Pai

Due apologies to Gabriel García Márquez, but the markets’ tryst with the novel coronavirus mirrors the fate of Urbino from the novel; a life cut short by an incident entirely out of the left field. The coronavirus’s effect on humanity is truly ubiquitous as no aspect of life is left untouched by this. The immediate effects are palpable in the rising death count and falling stock market. As one trader wryly put it, during Holi, the festival of colours, the only colour that investors could see was red; and the only black in their lives is the litres of ink spilt by journalists and pundits about the crash.

At times like these, sound policy becomes paramount. The US Fed cut its rates to zero; other central banks worldwide followed suit to pump in liquidity, but RBI, after the conference on March 16, is yet to do so. Sebi, in a bid to arrest the downslide, is mooting the suspension of short-selling as well. All the regulators worldwide are looking to bring back confidence and prevent a rout from destroying value. At such critical stages, companies announce buybacks through market purchases to stem the decline in stock prices and stabilise them. Flexibility in the management of capital created by the boards of companies also plays a crucial role in such situations. Price stabilisation in the form of buybacks sends a strong signal to the market, boosts sentiment and allays fears. But India’s tax policy penalises the ability of firms to buy back their stocks at times of grave crisis through open market operations (OMOs)!

Modern financial management speaks about the ills of wrongful capitalisation and the contrivances available to achieve optimal capital. Buybacks emerge as a powerful tool to help normalise the stock price when it doesn’t reflect the inherent value of the shares, due to market forces of firm-specific issues. Buybacks can happen through two channels: a tender offer from existing shareholders on a proportionate basis, or OMOs, where the company acts as a buyer of their shares at a certain price. India’s history of buyback taxation has also evolved. During force majeure events such as the coronavirus sell-off, buybacks via open-market are a show of confidence by the board to stabilise the stock price and help return cash and liquidity to the market. But our adverse tax policies prevent this.

Governments the world over have realised the need for this, and created systems to allow for such operations, with shareholder and regulatory approvals. In India, Sebi has also created frameworks for the same. But here, as it is with many policies in India, tax plays an inordinate role in the determination of capital decisions.

In the eternal tussle between the taxman and businesses, where capital marker decisions like buybacks or dividends are increasingly looked at with suspicion, it is important to analyse the provenance of India’s Buy Back Tax (BBT) and Dividend Distribution Tax (DDT) framework. Before April 1, 2013, DDT was at 16.5%, whereas BBT didn’t exist for companies; the Long-Term Capital Gains (LTCG) rate for listed shares was also 0, with buybacks being taxed in the hands of the shareholders. Due to the divergence between the two frameworks, buybacks via proportionate tender offers began to be used as a means of returning capital to shareholders instead of dividends. Slowly, the tax administration began to change the tax structures by taxing long-term capital gains in listed shares and dividends above certain thresholds. This led to the absurdity of triple taxation of dividends, which was previously written about by the authors—wherein dividends paid out of post-tax profits (Tax #1), had DDT levied on them (Tax #2) and were further taxed in the hands of shareholders above `10 lakh (Tax #3).

Similar to how constant tinkering led to the absurdity of dividend taxation, buybacks are now burdened owing to restructuring. Before July 5, 2019, there was no BBT on listed companies and shareholders had to pay tax (LTCG) the same way they did on any regular transfers. But since the fateful July 5, 2019 budget, a buyback tax of effectively 23.3% (with surcharge and cess) has been introduced. Buybacks, in theory, were supposed to be exempt in the hands of shareholders (under section 10(34A) of the Income Tax Act, 1961) (see graphic).

But as the famous Yogi Berra once remarked, “In theory, there is no difference between theory and practice; in practice, there is.”

The BBT makes sense when it comes to proportionate tender offers to shareholders since the shareholder details and number of shares is determined and, thus, the tax-exempt status afforded to the shareholder, to prevent double taxation, can come into play. But, in open market operations, the traceability of the buyer can’t be made, leading to a distortion wherein the company pays a BBT of 23.3%, and the shareholder pays LTCG of 10% on the same share. Although Sebi’s Buyback Regulations, 2018, state that the company’s name should appear as a purchaser for OMO, the systems to administer this remain wanting. In the interim, to exacerbate matters, the company pays tax on the difference between its historic issue price and the buyback price, whereas shareholder pay tax on the difference between the sale and purchase price. Thus, the taxman collects tax from the shareholders on every single transfer since the initial issue, and from the company as well on the final difference between the issue and buyback price. The spectre of double taxation returns (see graphic). This also penalises buybacks to stabilise stock prices at times of stock market crashes!

The government and tax officials often speak about rewarding and respecting the honest taxpayer and improving ease of doing business, but such distortions due to insufficient thought damage India’s business-friendly brand worldwide. The buyback tax announced on July 5, 2019, was defended by the then finance secretary at a CII event where he said that the stated purpose of the tax was to disincentivise buybacks and encourage investments. But, finance practitioners will attest that buybacks and dividends are a means of returning money to investors and shareholders when the company can’t locate any viable investments for the money so accumulated and in times of such precipitous falls. This will prevent investment adventurisms with shareholder funds or forays into ventures wherein the company doesn’t have any expertise. Investments can’t be forced; they need to be nurtured and using tax-disincentives as a tool to spur investments is value- and sentiment-destructive.

As for the tax terpsichorean trysts between DDT and BBT, the arbitrage still exists due to the selective application of the “super-rich surcharge” amongst investors. The taxation of dividends at the slab rates for individuals leads to an absurd 42.7% tax for individuals and family trusts whereas the BBT remains at 23.3%, inclusive of all surcharges. FPIs, for whom the “super-rich surcharge” is waived on incomes including dividends, have protection under their DTAAs and enjoy a lower rate on dividends as compared to buybacks.

Indian taxpayers deserve well-thought-out and well-articulated tax policies which don’t require a litany of clarifications and circulars and amendments to rectify the unintended but inevitable consequences of badly-drafted policies. Being denied the legitimate tool of OMOs for buybacks due to double-taxation caused by administrative realities is a cross that India Inc can’t bear, not at a time of crisis like this. Sebi, in its wisdom, also barred promoters from participating in OMOs. Thus, it cannot be claimed that such operations are a means of tax avoidance by promoters. Such operations will instil confidence into the company and serve as a vote of confidence from the board. At this critical time, with huge fall in stock prices and increased volatility, taxing buybacks from OMO, which can stabilise stock prices, is deeply detrimental to the financial markets.
At such volatile times, reason should prevail and well-thought-out policy, to quote Márquez, “was a lone voice in the middle of the ocean, but it was heard at great depth and great distance”. The call to afford listed companies a way out through OMO buybacks must not fall on deaf ears.

Siddarth is founding partner, 3one4 Capital and Mohandas Pai, chairman, Aarin Capital

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