Buyback of shares refers to the activity in which the company uses its reserves to buy back its own shares. This can be done in two ways:
1. Open Market purchase: In this case the company buys from the open market up to a maximum price fixed by it. Promoters are not allowed to participate in this buyback.
2. Open Tender offer: All shareholders including promoters are allowed to take part in this type of buyback scheme. Shareholders have the option of tendering the shares back to the company during the buyback period at the price fixed by the company.
Buyback is a very effective way of using the reserves of the company to enhance shareholder wealth. It is normally used when the management feels that the share price is trading below its fair value or when the promoters want to increase their stake in the company. It can also be used to thwart a takeover bid on the company. Buyback is also a very effective way of rewarding shareholders and many companies routinely use this method to increase returns of their shareholders and win their loyalty.
Advantages to the company are manifold. To begin with it increases the return on shareholders’ capital which in the long run helps the company achieve an investor friendly tag. It is a very effective way of rewarding shareholders and unlike other methods like bonus issue or dividend, here they get a choice to either stay invested or exit at a premium to the market price. Buyback is also the only way a company can extinguish capital without regulatory approval. Whenever the company has reserves and does not have any foreseeable utility of these funds, a buyback offer is the best way of using the idle money available. It increases return on capital employed, improves investor confidence and can result in raising of promoter’s stake in the company.
From shareholder’s perspective, it is usually better than a bonus or a dividend issue as they get to chose between different options to maximise their benefits. Investors who do not wish to stay invested in the stock can use the buyback offer to exit as usually it is at a significant premium to the market price. Since buyback is normally not through the exchange mechanism, hence short-term capital gains will be added to your income while long-term capital gains are taxed at 10% or 20% – indexation. Now before February 2017, long-term capital gains was exempt on shares when they were sold on the exchange and, therefore, a big deterrent to shareholders to offer their shares in the buyback scheme was taxation on shares held for more than 12 months.
Now since long-term capital gains on shares have come back, this is no longer a deterrent. In fact, for shares held for very long periods of time, taxation at 20% minus indexation may turn out to be less than the 10% taxation which investors would have to pay if they sold the shares in the exchange. However, for short-term investors, taxation on buy back will usually be higher as the gains are added to your income versus a 10% tax in case of sale through the exchange. Either way the tax aspect has to be carefully considered for deciding whether to take advantage of the premium offered in the buy back offer.
As a general rule, buyback of shares help in augmenting return on share capital and are, therefore, useful in increasing returns to the equity investors. Hence unless you really need money or are bearish on the future prospects of the company, it is better to stay invested and not get tempted by the premium offered by the buyback offer.
(By Ashish Kapur, CEO, Invest Shoppe India Ltd)