Whether it’s a dividend payment or a buyback of shares, at core, both involve returning shareholders’ money back to them. If the company does not have use for that cash, it is better off returning it to shareholders rather than keeping it idle in its balance sheet or making a wrong capital allocation that negatively impacts return on equity.

The difference between the two, though, is that in a buyback, cash is returned only to a few shareholders while in the case of dividend, cash is returned to all shareholders. So, what makes one better than the other?

A point can be made that investors who do not participate in a buyback have their ownership levels increase in the company. And if it is a company that has excellent long-term prospects, they will gain from this. But this advantage in buybacks can be nullified by reinvesting dividends. Investors can increase their ownership by re-investing the dividend money they receive in shares of the same company. So, as such, under normal conditions, from a pure arithmetical analysis, one is not better than the other, except under one condition.

Under that one condition, which is when shares are undervalued or widely perceived to be undervalued, buybacks come with a message from the management/board of the company that they too perceive the shares to be mispriced. Such buybacks (assuming they are large in size) serve as a confidence booster and can support more efficient pricing of the shares.

In the real world

However, in the real world, there is another factor that gives advantage to buybacks over dividends —  differential tax treatments. While dividends were taxed at the shareholders’ end at their slab rate, buybacks were taxed at the company end (@20 per cent), and investors participating in the buybacks did not have to pay capital gains tax (short or long term). This always worked out cheaper in terms of tax payments for investors at the upper end of tax slab.

Thus, in corporate India, in quite a few instances, buybacks were a preferred way of returning cash to shareholders, especially in companies where promoter stake was high. This, combined with SEBI rules mandating 15 per cent of the buyback amount being reserved for small shareholders (investors holding up to ₹2 lakh worth of shares in the company), resulted in speculators jumping into the fray to capitalise on arbitrage opportunities whenever buybacks were announced. The net impact of this was distortion in share prices, and this was unwarranted.

In substance and spirit

In this context, the new proposal to tax buybacks at the hands of the shareholders who participate in the buybacks, at their respective slab rates, is a very welcome move. This will ensure that company managements/boards will choose a buyback to return money to shareholders only if they also want to send a message that they view the shares as undervalued. This would ensure that buybacks are done only for the purposes for which they were originally conceived in the financial world — long-term shareholder value creation, in substance and in spirit.

The new buyback proposal will be effective from October 1, 2024. Investors who participate in the buybacks will have to pay tax according to their applicable slab rate on the full value they received. The cost on the shares they tender will be treated as capital loss and can be adjusted against capital gains.