In the world of investing, stock buybacks often spark curiosity and debate.

But what exactly is a buyback, and why do companies choose this route?

More importantly, how does it impact you as an investor when it comes to taxes?

In this first episode of our Stock Market Decoded series, we’ll explore what stock buybacks are, why companies engage in them, and the tax implications for shareholders involved in buybacks.

By the end, you’ll have a clearer understanding of how buybacks work and how they might impact shareholders.

What is a Buyback?

A buyback refers to the process where a company repurchases its own shares from the market or directly from shareholders.

When a company initiates a buyback, the total number of outstanding shares in the market reduces, often leading to a potential increase in the value of the remaining shares.

For example, in 2022, Tata Consultancy Services (TCS) conducted a buyback worth Rs. 18,000 crore.

Through this buyback, TCS repurchased shares from its shareholders, thereby reducing the number of publicly available shares.

Why Do Companies Engage in Buybacks?

Companies may choose to repurchase shares for various reasons, which generally benefit the company and its shareholders in different ways:

1. Consolidating Ownership: By reducing the number of outstanding shares, the company can consolidate ownership and reduce the dilution of earnings per share (EPS).
2. Undervalued Stock: If a company believes its shares are undervalued, a buyback can be a way to invest in itself and signal confidence in its future growth.
3. Returning Excess Cash: Companies with excess cash, particularly those that don’t see viable options for investing in expansion or other projects, might opt for buybacks to return value to shareholders.

Which Companies Typically Engage in Buybacks?

Cash-rich companies, particularly those in sectors like technology, often engage in buybacks.

For example, IT companies tend to hold significant amounts of cash on their balance sheets and frequently use buybacks as a way to deploy this excess cash.

On the other hand, companies that carry high levels of debt generally avoid buybacks due to the financial burden it could impose.

Types of Buybacks

There are two common methods through which companies conduct buybacks:

1. Tender offer
2. Open Market buyback

Tender Offer Buyback

A tender offer occurs when a company invites its shareholders to submit their shares for purchase at a specified price.

Typically, the price offered by the company is higher than the current market price (CMP), incentivizing shareholders to sell their shares back to the company.

For instance, in March 2022, TCS initiated a tender offer buyback at Rs. 4500 per share, which was higher than its CMP at the time, encouraging shareholders to tender their shares.

Open Market Buyback

In this method, a company buys back shares directly from the open market over a prolonged period.

The process can take time as the company acquires a significant number of shares.

For example, Infosys executed an open market buyback at a price not exceeding Rs. 1750 per share.

Unlike a tender offer, shareholders are not directly involved, and the repurchase is gradual.

A key difference between these methods is timing: while a tender offer allows shareholders to monetize their shares quickly, an open market buyback usually takes longer.

Taxation of Buybacks

The tax treatment of buybacks is changing.

Starting from October 2024, buybacks will no longer be taxed at the company level.

Instead, the responsibility for taxes will fall on shareholders who sell their shares through a buyback.

The buyback amount will be treated as a deemed dividend, subject to tax under Section 2(22)(f) of the Income Tax Act.

Conclusion

Buybacks are a common practice for companies seeking to consolidate ownership, return excess cash to shareholders, or repurchase undervalued stock.

While buybacks can have positive effects on share prices, it’s important to consider the different methods through which they are conducted whether through a tender offer or open market purchase and the tax implications that could arise.

As buyback taxation rules change in October 2024, shareholders need to stay informed about the potential financial impact of participating in buybacks.

*Disclaimer – This is for information purposes only and not investment advice. Data credit to the rightful source.