Dividend V. Buyback – Which is more beneficial?

Many a times, profitable companies end up in a situation of generating more cash than they can reasonably reinvest in their business at attractive returns on capital. As cash holdings on a company’s balance sheet increases, there is increased pressure from shareholders to return some of this excess cash to them. There are two ways in which companies offer rewards to their investors — dividends and share buy-backs.

Recently, Tata Consultancy Services (TCS), India’s largest IT services firm’s share buyback programme of up to ₹16,000 crore is open. Last month, TCS shareholders had approved a proposal to buy back up to 5.3 crore shares of the company, having a face value of Re 1 each at ₹3,000 per share.

Dividend

Paying dividend regularly at a pre-defined payout ratio will help to improve investor sentiment towards the company. However, Dividend Distribution Tax (DDT) and its associated compliances burden on the companies leads to many criticism from the corporates. DDT had to be paid by the company at an effective rate of 20.5% and any dividend received by the shareholders were exempted on their hands up to Rs.10 lakhs and anything above Rs.10 lakhs required shareholders to pay 10% income tax. So, it leads to double taxation on the same income.

Union Budget 2020 scrapped the DDT payable by the companies and from 1^st April, 2020 onwards shareholders have to pay tax on the entire amount of dividend received. Hence, the burden of tax has been shifted from the company to the shareholders. A small retail investor who are into lower tax bracket has positive impact of these amendment and those who are in higher tax bracket has to pay more tax.

Dividend can be distributed from the following resources:

• Out of the profits of the Company of that financial year; or
• Out of the profits of the Company earned in previous year or years; or
• Out of both of the above;
• Out of money provided by the state government or central government for payment of dividend in pursuance of a guarantee given by that government.

However, if company want to declare dividend out of the profits of the previous years, there are certain additional conditions which needs to be kept in mind.

Procedural aspects of dividend declaration

> The company may before declaration of dividend in any financial year transfer such part of its profits for that financial year to reserves and surplus as the Board of Directors thinks appropriate. There is no fix amount to be transferred to the reserves and surplus as required under the old Companies Act, 1956. Board may transfer any reasonable amount before declaring a dividend.

> It must be approved by the Board of Directors and Shareholders. However, shareholders have no right to increase the rate of dividend. They can propose reduced rate of divided.

> The amount of the dividend, including interim dividend, shall be deposited in a scheduled bank in a separate bank account within 5 days from the date of declaration of such dividend.

> No dividend shall be paid by a company in respect of any share therein except to the registered shareholder of such share or to his order or to his banker and shall not be payable except in cash. Here, payment in cash means payment by cheque or warrant or in any electronic mode.

Where a dividend has been declared by a company but has not been paid or the warrant in respect thereof has not been posted within 30 days from the date of declaration to any shareholder entitled to the payment of the dividend, every director of the company shall, if he is knowingly a party to the default, be punishable with imprisonment which may extend to 2 years and with fine which shall not be less than Rs.1000 for every day during which such default continues and the company shall be liable to pay simple interest at the rate of 18% per annum during the period for which such default continues.

Buyback

Buyback of shares is the repurchase of its outstanding shares by a company. Companies generally buyback shares in order to reorganize its capital structure, maintain debt equity ratio, return cash to shareholders and enhance overall shareholders’ value. Buyback leads to reduction in outstanding number of equity shares, which may lead to improvement in earnings per equity share and enhance return on net worth.

Regulatory framework governing buy-back

• Companies Act, 2013
• Companies (Share Capital and Debentures) Rules, 2014
• SEBI (Buy-Back of Securities) Regulations, 2018 (in case of listed company)

Section 68 of the Companies Act, 2013:

A company may purchase its own shares or other specified securities (hereinafter referred to as buy-back) out of—

(a) its free reserves;

(b) the securities premium account; or

(c) the proceeds of the issue of any shares or other specified securities:

Provided that no buy-back of any kind of shares or other specified securities shall be made out of the proceeds of an earlier issue of the same kind of shares or same kind of other specified securities.

Hence, companies can buy back shares from the above mentioned sources only. They can’t simply borrow the funds to buy back the shares.

Pre-conditions for buy back of shares

The following are the pre-conditions of buy-back:

> the buy-back must be authorized by its articles of association;

> the buy-back must be approved by the board of directors of the company;

> the buy-back must be approved by the members of the company by way of a special resolution if it exceeds from 10% of the total paid-up equity capital and free reserves of the company;

> the maximum buy-back is 25% or less of the aggregate of paid-up capital and free reserves of the company: Provided that in respect of the buy-back of equity shares in any financial year, the reference to twenty-five per cent in this clause shall be construed with respect to its total paid-up equity capital in that financial year;

> the ratio of the aggregate of secured and unsecured debts owed by the company after buy-back is not more than twice the paid-up capital and its free reserves;

> all the shares or other specified securities for buy-back are fully paid-up;

> the buy-back of the shares or other specified securities listed on any recognized stock exchange is in accordance with the regulations made by the Securities and Exchange Board in this behalf.

Other pre-conditions for a listed company

> A company  may  buy-back  its  shares  or  other  specified  securities  by  any one of the following methods:

• from the existing shareholders  or  other  specified securities holders on a proportionate basis through the tender offer;
• from the open market either through book-building process or through stock exchange;
• from odd-lot holders.

Provided that the buyback from open market shall be less than 15%  of  the  paid  up  capital  and  free  reserves  of  the company,  based  on  both  standalone  and  consolidated  financial statements of the company.

> A company shall not buy-back its shares or other specified securities so as to delist its shares or other specified securities from the stock exchange.

> A company shall not buy-back its shares or other specified securities from any person through negotiated deals, whether on or off the stock exchange or through spot transactions or through any private arrangement.

> No company  shall  directly  or  indirectly  purchase  its  own  shares  or  other specified securities:

• through any  subsidiary  company  including  its  own  subsidiary companies;
• through any   investment   company   or   group   of   investment companies; or
• if a  default is made by the company in the repayment of deposits accepted either before or after the commencement of the Companies Act, interest payment thereon, redemption of debentures or preference shares or payment of dividend to any shareholder, or repayment of any  term  loan  or  interest  payable thereon to any financial institution or banking company.

Income tax provisions for buy-back

The provisions of Income Tax with regard to buy-back of shares are covered under Section 115QA of the Finance Act, 2013 which originally applied to only unlisted companies which warranted a tax of 20% on the distributed income. The rationale for the introduction of the provision was that unlisted companies resorted to buyback of shares in order to avoid dividend distribution tax. The Union Budget 2019 announced the said section to be applicable to the listed companies as well. The amendment is effective for all buybacks post July 5^th, 2019, vide Finance Act 2019. Now onwards listed company making buy-back are liable to pay tax at the rate of 20% on the difference between buy-back price and issue price and shareholders are not liable for the capital gain tax.

For e.g:

Abc Ltd being a listed company repurchases 1000 shares in December, 2020, with a market price of Rs. 500 with an issue price of Rs.10. The company is now liable for a buyback tax of 20% on the distributed income that is Rs. 490, the difference between market price and issue price (500-10) and the individual shareholders are no longer liable to pay any taxes.

Which option is better – dividend or buy-back?

A company which declares dividend is considered to be cash rich and it also helps in sending a message that the company is making good money. Share buyback is positive for the company as the number of outstanding shares goes down and hence the earnings per share increases. If one is looking to build wealth over time, then share buyback could be a better option than dividend payouts, because earnings per share tenders to rise when the floating share count falls. Nevertheless, both are efficient ways of rewarding shareholders where a company can choose the method that is best suited for its shareholders and itself.