Things you need to know on share buybacks

Unlike dividends, income from buybacks is exempt from tax.

Larsen & Toubro (L&T) announced its first-ever buyback of shares worth Rs 10,000 crore a few months ago, under which it would buy back 3.13 crore shares or 2.40% of its equity at Rs 3,000 per share. The buyback price was later revised upwards to Rs 3,200. Wipro announced a buyback in June of this year. TCS has also announced a share buyback at Rs 4,150 per share at a premium of 15% to the closing price on the day of announcement, amounting to Rs 17,000 crores. What is a share buyback? And why do companies resort to buybacks when the better tax-efficient option would be to declare dividends? For the record, companies spent Rs 22,000 crores on buybacks during FY-22-23, while the total amount spent on dividend payout was Rs 4 lakh crores. Do shareholders gain when they tender the shares? How are gains taxed? Here are some answers:

What is a share buyback?

A share buyback is a corporate action in which a company buys back its own shares from its shareholders. The shares bought are extinguished or cancelled in the books of the company resulting in a reduction of capital. In short, share buybacks are the reverse of initial public offering (IPO). In an IPO a company raises funds from the public leading to an increase in equity capital. In a buyback, the company returns the money to them by buying out their shares. It is a way for companies to return capital to their shareholders, and it can also be used to improve the company’s financial ratios, such as earnings per share (EPS).

Companies buy back their shares through a tender offer or the open market route. However, it is not mandatory for the shareholders to participate in the share buyback. If they accept the offer, they can tender either a part or all their shares during the buyback window. For the buyback to succeed the buyback price should be significantly higher than the market price so that the investors will have an incentive to tender the shares rather than holding on to them.

Companies can also buy back shares in the open market from existing shareholders. Unlike a tender offer where the price is fixed, the company usually fixes a ceiling on the price up to which they are willing to buy. They may buy shares even at the market price. Also, the entire process in an open market may extend to many months, unlike a tender offer where the duration is less than ten days.

Why companies buyback their shares

Companies having high cash reserves or retained earnings dip into reserves to declare bonuses or take over rivals to consolidate their position in the industry When both these options look not so appealing, companies may resort to buybacks. As mentioned earlier the buyback will result in a reduction of shares and increase the earnings per share or EPS of the company. A smaller number of shareholders also means less nuisance for the company during shareholder meetings. Buybacks may also be used to ward off hostile takeovers. Many companies use buybacks for sheer optics - to signal to the outside world that they are upbeat about the future prospects of the company.

Benefits for shareholders

Buybacks can provide shareholders with a way to sell their shares at a premium to the market price. There can be arbitrage opportunities for retail investors. Incidentally, retail investors are those whose value of holding is less than Rs 2 lakhs.  

Taxability of buybacks 

While the dividends received by shareholders are taxed in their hands, income received on the buyback of shares is exempt from tax under Section 10(34A) of the Income Tax Act, 1961. The company, on the other hand, is liable to pay a tax of 20% on the amount of the buyback. The company pays the tax on the difference between the issue price & buyback price. For example, if the issue price is Rs 500 & the buyback price is Rs1200, the company must pay the tax of 20% on Rs 700.

(The writer is a CFA, former banker and presently teaches at Manipal Academy of Higher Education)