What to do during a share buyback?

Investors can sell shares in the open market if the price is good, to take advantage of the tax arbitrage

The past few months have seen a number of companies offering to buy back their equity through either open-market purchases or tender offers. Companies have announced Rs 7,800 crore worth of buybacks in six months. For shareholders, the big question is: Should one sell holdings in the market to benefit from a buyback?

Buyback announcements often drive stock prices higher if the market price is lower than the price at which the buyback is announced. There are various circumstances under which managements might announce a share buyback. If a management feels that its share price is undervalued, or when the company has surplus cash and lower capital expenditure plans, managements may announce a buyback. The company then extinguishes the shares bought back, reduces outstanding share capital, helping boost its return ratios such as earnings per share.

Says Daljeet Kohli, head of research, India Nivesh Securities: “Buybacks support the stock price if it has fallen too much. If a company has surplus cash and does not need it for capital expenditure, it might utilise the cash to make a buyback. This helps boost return on equity.” As buybacks are open for a limited period, it can get a little tricky to decide whether to sell a stock. Often stock prices tend to dip after the buyback period is over. Hence, experts advice it’s better to evaluate the merits of each separately.

For example, companies might announce a buyback despite having huge debt on the books. Investors  should evaluate whether the company ought to be paying off its debt (with its surplus cash) instead of going for a buyback. “One should evaluate the circumstances and then decide whether to hold one’s shares. If it’s value-accretive, one should see how much benefit the company could derive from a buyback and how much its return ratios are likely to improve,” says Kohli.

Experts also say one should keep in mind the nature of the buyback and  whether such transactions are conducted through the open market or a tender route. The tax treatment for each is different.

Buybacks conducted through the open-market route are done in the stock market. Investors selling during this period pay a securities transaction tax (STT). The sale works like any other stock-market transaction. Therefore, the capital gains tax on this will be lower; that is, short-term capital gains will be taxed at 15 per cent, while long-term capital gains are exempt from taxes.

A buyback conducted through a tender is an off-market transaction and not subject to STT. Like other open offers or de-listing offers,  a buyback through this is subject to tax as in any other capital asset. That is, long-term gains will be taxed at 10 per cent without indexation, or 20 per cent with indexation whichever is lower. Short-term gains are taxed at normal slab rates. Says Mehraboon Irani, head, private client group, Nirmal Bang: “Buybacks can be beneficial to shareholders but one should consider the net benefit after taxes. If the buyback price is good, one can consider selling shares in the open market at a discount of two to three per cent, rather than through the fixed tender route.”