Why the concept of buyback tax is fundamentally flawed
When KPR Mills cancelled its proposed buyback last week, it was the first signal that Indian companies and investors were unhappy with the buyback tax imposed in the Budget 2019.
Why the buyback tax?
In the last 3 fiscal years, the average annual buyback value was Rs.48,000 crore. That is a 10 fold increase after the 10% tax on dividends in the hands of shareholders was introduced for large shareholders in Budget 2016. This had led to a big shift towards companies opting for buybacks as an option to return money to shareholders. The government felt that tax-free buyback was distorting the scene and providing an arbitrage to shareholders, especially the promoters. It is to curb arbitrage that the budget introduced this tax.
A flawed concept
The concept of tax on buybacks is flawed for a number of reasons. Firstly, unlike what the government believes, discouraging buy-backs will not encourage investments. That depends on risk and ROI. Buybacks offered a profitable exit to minority shareholders and that route has also been blocked. Thirdly, the idea of taxing buybacks at 20% of difference between buyback price and issue price ignores the cost of acquisition of the investor and puts an unnecessary burden. Lastly, capital decisions are best left to the boards.
Taxing equity unfairly
While buyback tax may have removed the arbitrage, what it has underlined is that equity continues to be taxed at exorbitant rates in India. Consider the case of dividends. Firstly, it is a post tax appropriation and secondly, there is a DDT incidence of more than 20% on payouts. In addition, the dividends above Rs.1 million are taxed in the hands of the shareholder at 10%. Now, buybacks are no different. Firstly, the introduction of LTCG automatically implies that any gain made on buybacks will be taxed at 10% above Rs.1 lakh per annum. Now there will be an additional 20% tax on buybacks based on a formula (buyback price – issue price), that is flawed to begin with. This move has made equity the most steeply taxed instrument in India!
Killing the golden goose
Buybacks may have benefited promoters but it has also benefited scores of small shareholders who got an attractive exit. This tax virtually shuts the doors on that avenue. But more importantly, it makes equity more expensive in India and that raises the cost of equity. Now investors will expect 20% higher returns in pre-tax terms and that would be negative for valuations. For a government looking to nurture the equity cult in India and create a robust capital market, the buyback tax goes against the grain. It is best scrapped at the earliest!
