Under such a scenario, XYZ Ltd uses its cash reserve of Rs 15,000 to buy back 100 shares. The likely impact on XYZ Ltd would be:

These factors should lead to an increase in the share price in one to two years. Boots PLC in the UK has successfully adopted the buyback financial strategy.With the amendment to the companies act permitting buyback, one can see a spate of buybacks from the domestic corporate sector during the next one to 10 years.

The successful implementation of buyback depends upon two critical factors. First, the cost of buyback, that is, the market price of XYZ Ltd's shares. For example, HLL Ltd, with its cash reserves could do a buyback but with the current market price hovering around Rs 1,700, this could be expensive.

Second, the impact of buyback on the company's average cost of capital. Ideally, a buyback should drive down the average cost of capital. This may be possible only for companies with high credit rating, high cash flow interest cover and a reputed management team, which could then counter the impact of higher gearing. Contrary to common perception, buybacks may not be suitable for excessively geared companies.

Only under appropriate conditions a company could borrow money and then buy back its shares - a debt for equity swap. For example XYZ Ltd used topaying 40 per cent dividend could swap equity (cost 40 per cent) for debt (cost 20 per cent) and still be a market outperformer with a gearing of 100 per cent. But it is not a solution for underperforming to boost its share price.

For example, EFG Ltd is such a company, which usually pays dividend of 15 per cent but borrows at 22 per cent owing to high debt and several other factors. If such a company buys back its shares, the earnings stream will be adversely affected due to higher proportions of debt, which is costlier than equity by 7 per cent. The market should and will further downgrade such shares to act as a deterrent to companies willing to jump on the bandwagon for superficial reasons.

Thus buybacks are now imminent, but there seems to be lot of confusion as to the tax implications and the buyback code and regulations. The minsitry of finance has not yet clarified the position, but the likely tax consequences could be derived from first principles. Let's go bak to our example and assume that XYZLtd's company rate of income tax is 35 per cent and the capital-gains tax rate is 20 per cent.

As to the impact on XYZ Ltd, there are three alternatives - to treat it as a revenue expense or capital expense or as a distribution. If XYZ Ltd is able to deduct Rs 15,000 as revenue expense, it saves tax @ 35 per cent of Rs 5,250, thus reducing the effective cost of buyback to Rs 9,250. This would make a buyback significantly cheaper with an equivalent loss of revenue to the exchequer. But this expense though wholly and exclusively for business would not qualify as "necessarily" for business. Secondly, in substance, it remains an equity transaction with owners of the company, for example, the ABC group, and not an expense for conducting the business of XYZ Ltd.

Alternatively, XYZ Ltd could treat it as capital loss of Rs 50 per share - purchase price of Rs 150 less Rs 100 face value. XYZ Ltd could then offset such losses against other gains. This is far-fetched as XYZ Ltd has not sold any asset whether fixed orcurrent nor extinguished any liability. Again, it looks like an equity transaction with the owners, which is distinct from buying or selling an asset.

The third option is to treat it as a special dividend. This amount of Rs 15,000 represents excess accumulated return on capital over the past years, which has now been paid out in one instalment. XYZ Ltd will then have to pay tax of 10 per cent on Rs 15,000 as it would for any interim or final dividend. Therefore, XYZ Ltd bears the tax burden for distributing its net assets of Rs 15,000 to its owners ABC. This is the treatment adopted worldwide. Thus the special dividend treatment reflects the substance of a buyback, which is distribution of excess profits. The buyback code could then require a transfer of Rs 15,000 from distributable reserves of XYZ Ltd to undistributable reserves to protect the creditor's buffer and ensure consistency with dividend treatment.

As to the impact on XYZ Ltd's shareholders, there are two alternatives. ABC can treat Rs 15,000as capital receipt or dividend receipt. Under section 2 (47) (ii) of the Income Tax Act, shares are deemed to have been sold if there has been a change in shareholders' right to vote or right to receive dividend or right to receive excess capital on liquidation.

In our example, though ABC now owns only 900 shares, ABC can still exercise the same proportion of votes, that is, 100 per cent and has the right to receive 100 per cent of XYZ Ltd's dividend. Therefore, Rs 15,000 in such circumstances is likely to be treated as divident receipt. As dividends are tax-free, the net receipt to ABC is Rs 15,000, which is only fair if XYZ Ltd has already borne the tax burden. This will be so when XYZ Ltd treats Rs 15,000 as dividend payment and not as revenue or capital expense.

Thus shareholders should also treat most of the buybacks as dividend receipts, assuming that the company makes a proportionate offer of buyback to all shareholders in the same class. This would be a legal necessity under the buyback ofpreference shares. Say XYZ Ltd wants to buy back all its 100 15 per cent voting preference sharea at Rs 150 each (face value of Rs 100).

Here the preference shareholders have lost the right to cast those 100 votes and the right to receive Rs 15 of annual dividend. Therefore, they will be deemed to have sold the shares and the net gain of Rs 5,000 will become taxable (Rs 15,000 proceeds less Rs 10,000 cost). This net gain will be taxable at the rate of 20 per cent, reducing the net receipt to Rs 14,000. This capital receipt treatment will be relevant only in such exceptional circumstances of a buyback.

Thus the accounting principles dictate that companies and shareholders treat buybacks as a special dividend payment. If buybacks are treated as a revenue or capital expense, then this would result in significant inconsistency between Indian business standards and tax practices and those of rest of the world. More importantly, the revenue or capital treatment would lead to government tax subsidies on buybackpayments made by profitable companies to their enriched shareholders.

Even capitalist countries like the US and UK do not subsidize such distributions and, therefore, to subsidize such transactions in a country like India would lead to a unfair and unjust taxation system. Minority shareholders also need to be protected and, therefore, the buyback code should incorporate two safeguards: The buyback offer should be made to all shareholders and it cannot be priced below the market price.

Copyright © 1998 Indian Express Newspapers (Bombay) Ltd.

Net Express

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