Govt’s new buyback tax set to hit MF investors, shareholders alike

“This is because IT companies are cash rich," said a fund manager of a leading asset management company (AMC), on the condition of anonymity. “Their operating cash flow is almost the same as their net profit, which means they can distribute almost their entire profit. Many companies have stated policies of distributing 50% of their earnings to shareholders as dividends or buybacks," he added.

These distributions may well have been for fundamental economic reasons, but the switch from dividends to buybacks reduced the effective tax burden on corporate investors.

Taking cognizance of this trend, Budget 2019 has proposed to tax buybacks at the same rate. The memorandum to Budget 2019 noted, “Taxpayers preferred it (buybacks) for tax avoidance, since the tax rate for capital gains is lower than the rate of dividend distribution." The government has proposed the closure of the buyback loophole from 5 July 2019, effectively.

So what will IT companies do now with their surplus cash? Some experts have suggested mergers and acquisitions. “IT companies are likely to make acquisitions outside India rather than distribute their surplus cash," said Vinit Bolinjkar, head of research at Ventura Securities Ltd, a brokerage. “This will make foreign companies the unintended beneficiaries of India’s buyback tax," he added.

What it means for you

For shareholders of companies, the buyback tax is, of course, bad news. But even for mutual fund investors, the buyback and dividend taxes have consequences. First, like other investors, mutual funds were beneficiaries of tax-efficient buybacks and this is set to come to an end. Second, the consequential effect on corporate behaviour—investing rather than distributing money—to save tax can take a toll on returns. Hoarding cash can drive down return on equity (RoE) and investing in avenues which don’t add value can’t be good for the company.

Mutual fund investors are already at a disadvantage. They have to endure an additional layer of taxation if they opt for dividend options of funds at 10% of the dividend distributed. Those who choose the growth option have to pay a 15% short-term capital gains tax and a 10% long-term gains tax depending on how long the unit is held. The new buyback tax adds heavily to their woes.

A consequence of India’s tax policy is that the effective tax rate for a dividend paying company is higher than that of a company that retains the earnings to re-invest, wrote Rajeev Thakkar, chief investment officer, PPFAS Asset Management Co. Ltd, in a post on 3 July on the AMC’s blog The Tortoise Speaks. Adding a footnote after Budget 2019, he wrote, “Post the amendment in the Income-tax Act, dividends and share buybacks will be at par. However, the point relating to preferring companies which can deploy surplus cash in their own business or create value by reinvesting capital in other businesses remains valid."

Aashish Somaiyya, chief executive offiver, Motilal Oswal Asset Management Co. Ltd, spelt out the problem in plainer terms. “Buyback tax coupled with dividend tax will lower the expected payoff from equity and its multiples. Such high level of taxation will lead to companies retaining more of their earnings which has potential risk of driving down RoE and can also lead to sub-optimal reinvestment in the business or unrelated/loosely related diversification and increase governance risks."

A chief investment officer at a private AMC, speaking on the condition of anonymity, added that he would have to revise his calculations about equity returns if the buyback tax is retained.

Investors should keep an eye on how companies and fund managers react to this tax when it comes to investing in other companies.