Buyback and dividends are two ways a company pays their shareholders when they have surplus funds. Through these methods, a company makes the optimum use of available funds to enhance the value of the shareholders.
In this blog, we will cover what are Dividends and Buybacks; which is a better choice for shareholders?
What are Dividend Shares?
Dividends are the profits that a company wants to share with its shareholders. The dividend is a sum of money a company earns through profit over some time.
The process of distributing dividends to its shareholders is decided by the company itself. Some companies pay a dividend to their shareholders on an annual basis while some companies pay a quarterly dividend.
It should be noted that dividends payouts are never guaranteed by any company as they are the profit a company earns over some time.
The board of directors of the company have all the rights to decide if the company is going to pay out any dividends or not. Even if the company makes a profit, it does not need to pay a dividend to the shareholders.
Some companies invested their profit in the growth and expansion of the company. Excessive dividends of the company may be subjected to TDS at 10% in the hands of receivers effective from April 1, 2020.
How Dividend is Declared?
The distribution of the dividend completely depends on the company. Before the company declares its dividend, the company transfers a part of its profits to the current financial year along with the reserve and surplus. According to the old companies act 1956, there is no fixed amount of money to be declared as a dividend.
The dividend must be approved by the board of directors and other members of the company. However, shareholders don't have the right to increase the rate of the dividend.
No dividend shall be paid by a company concerning any share therein except to the registered shareholder of such share or to his order and shall not be payable except in cash.
What are BuyBack Shares?
Buy-Back of shares or share repurchase happens when a company buys back its shares via investors or stakeholders. Companies seek buyback as an efficient way to return money to their stakeholders.
What is the Need for BuyBack Shares?
Companies declare their shares buyback if they want to increase the demand in the market. Through them, the companies minimize the number of shares in circulation, which can increase their share value and EPS (Earnings per share).
Hence, buying back shares help the company to reorganize its capital structure, maintain the debt to equity ratio, and improve the overall shareholders’ value.
Regulatory framework for Buyback:
- Companies Act 2013
- Companies Share Capital and Debenture Rules
- Buyback of Security Regulation, 2018
As per the Section 68 of the Companies Act, 2013;
A company may purchase its shares or other specified securities out of -
Its free reserves;
The security premium account
The proceeds of a previous offering of the same kind of shares or other specified securities may not be used to buy back the same kind of shares or other specified securities.
As a result, firms can only purchase back shares from the sources listed above. They can't just borrow the money to buy the shares back.
Conditions for the BuyBack of Shares
The following are the pre-condition for Buyback:
The buyback of shares should be approved by the board of directors of the company.
Buyback of shares should be authorized by its article of association.
The buyback must be approved only if it exceeds 10% of the total paid-up equity capital reserves of the company.
The limit of the maximum buyback is 25%, which is also an aggregate of paid-up capital and free reserves of the company.
After the buyback, the ratio of secured and unsecured debt is not more than twice the paid-up equity capital and free reserves.
The buyback of shares or other specified securities listed on NSE, or BSE is in accordance with the regulations made by SEBI.
Income Tax Provisions for BuyBack
Section 115QA of the Finance Act, 2013, covers the regulations of Revenue Tax in relation to share buybacks, which is applicable only for unlisted firms and requires a tax of 20% on dispersed income.
The regulation was enacted in response to the fact that unlisted corporations used share buybacks to avoid paying dividend distribution tax. The above-mentioned section will be applicable to listed enterprises as well, according to the Union Budget 2019.
Finance Act 2019 makes the modification applicable for all buybacks made after July 5, 2019. From now on, listed companies that buy back stock must pay a 20% tax on the difference between the buy-back price and the issue price, while shareholders are exempt.
Dividend Vs Share BuyBack - Which is a Better Choice?
Several parameters are required to compare the profit of buyback shares and dividends.
Tax Implications
This is the fundamental step to compare the buyback of shares with the dividend. In the case of dividends, there is a dividend distribution tax (DDT) which means dividends are taxed at 10% above Rs 1 million in the hands of the investors.
Let’s not forget that dividends are a post-tax appropriation which in turn makes it a 3 level of taxation on dividends.
In terms of the market mechanism, the buybacks will be treated as LTCG which means if a 10% tax is applicable on LTCG, it will be more economical than paying the cash as dividends.
In Terms of Valuation
When a company needs to buyback stock at a certain price, it will be treated as a base below which the price will not fall. In the case of dividends, there is no such signal coming out of the announcement, although at an overall market level, dividend yield does act as price support for the index.
Takeaway
Dividends and Buybacks are ways of rewarding the shareholders. As we found that buybacks are more tax efficient as compared to dividends, there are some governance issues that need to be taken care of. For more details regarding dividends and buyback, give us a call at 0120-4400777.
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