There are multiple ways by which companies can restructure their capital.
Each process has its own advantages and disadvantages. The various benefits
that buy-back of shares provide led to the Government introducing it as a concept
of the year 1998. Some of them are listed below:
(a) Buy-back of
shares helps a firm be more flexible in reversing decisions or split the
buy-back through longer periods, unlike cash dividends paid by a company
(b) Cash dividends require
continuous payments in future, but buy-back of shares is a one-time payment.
Naturally, a firm holding excess cash deposits with no viable way of
re-investing may consider repurchasing its shares in place of paying cash
dividends
(c) Buy-back of
shares increases the controlling capacity of the firm, as the number of shares
publically available is reduced
(d) Buy-back helps
shareholders in need of cash and who are willing to sell their shares to
accommodate the same. On a similar note, shareholders who do not require immediate
cash may hold on to it for the future
In short, buy-back
of shares helps firms provide cash to the desired shareholders and also provides
flexibility in the time period of holding for existing shareholders.
In addendum to the reasons above, the following benefits are why
buy-back would be preferred over regular cash dividends:
(a) Nature of Cash Flows:
When cash flows are
in a stable condition, cash dividends would be preferred over buy-back of shares.
However, in situations when cash flow timings are unstable, it is better to
re-purchase shares than to give out cash dividends
(b) Under-valuation
of Shares:
Buy-back of shares
is appropriate particularly when the market value of a share is less than its
face value, i.e. when the shares are undervalued. If that is the case, the firm
may achieve two goals:
(i) If the shares
are undervalued, the existing or remaining shareholders will enjoy some benefits
if the firm purchases shares at a lower value
(ii) News of this re-purchase
will reach capital markets and lead to them reacting upon hearing so
(c) Uncertainty of
Further Investment:
Buy-back of shares can
be treated as an investment of surplus cash, which , provides maximum benefit
to the remaining shareholders as investments. When share prices are undervalued,
the management should consider re-purchasing its own share at a reduced price
(d) As a
financing decision
Buy-back of shares
increases the financial leverage of a firm. It does so by reducing the amount
of paid-up capital having the same amount of debt financing. A firm may change
its capital structure after repurchasing of shares and issuing debt after ascertaining
the capital mix between debt and equity. Thus, buy-back of shares is a valid
approach towards changing the capital structure or financial leverage of a
company.
Based on the advantages
stated above, it can be easily concluded that buy-back is a mutually beneficial
process for the company, existing shareholders, and for shareholders exiting.
Furthermore, any gains earned by shareholders were taxable in the hands of the shareholders
alone. For unlisted shares, these gains were taxed as short term capital
gain or long term capital gain depending on the period they were held for by
the exiting shareholders. For listed shares, since Securities Transaction Tax
was being paid, the long term capital gain was exempt till March 2018, after
which they also become taxable in the hands of shareholders. Hence buy-back
is also advantageous for the government as they are getting tax on profits
earned by the shareholders.
In recent times,
the Government considered buy-back as a tool to evade dividend distribution tax
and accordingly introduced section 115QA as a remedy. After which, buy-back was
first made applicable on unlisted shares and then on listed shares.
Accordingly, now in case of buy-back, shareholders are not required to pay tax
on their gains. Instead, companies are now required to pay tax on the
difference between the issue and buy-back prices. Thus, due to the introduction
of buy-back tax, the tax incidence of shareholders has been shifted to
companies initiating the buy-back, making the process more expensive and
complicated.
The buy-back tax
cost could discourage companies from opting for the buy-back process and missing
out on the advantages listed above. Earlier, the Government could receive their
revenue from the shareholders and now they’re collecting it from the companies instead.
As such, there is no significant benefit other than reducing the tax collected from
N shareholders, by collecting it directly from the company.
The Government may
have eased the tax collection process for the buy-back process, but they now risk
alienating companies from initiating it. It would be advisable for them to
reconsider this approach.
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