Why hike in share buyback tax announced in the Budget hurts investors

Companies reward shareholders by way of dividend payment or share buybacks. Both are done from tax-paid reserves and company profits. Such payments are also used as tools of wealth distribution and efficient allocation of capital.

For example, a company that’s in a mature business may not find viable opportunities to deploy all its cash earnings and may decide to return them to shareholders, who can then allocate these funds in better investments.

When slab taxation for dividends was introduced, it was met with feeble protests from the industry and investor community. Slab taxation of dividends means that for every ₹100 earned and distributed by a company, the company first pays ₹25 as corporate tax, and the shareholder pays an additional tax of anywhere between 10% and 37.5% on the taxed distributed profit. A clear case of double taxation.

For those in the highest tax bracket, effective taxation could be as high as 53.125%.

A handful of taxation experts did call out this double taxation and were hoping for a rationalisation of the same in the Budget 2024. Instead, it was a double whammy as finance minister Nirmala Sitharaman introduced tax on buyback proceeds in Budget.

Buyback proceeds will be deemed dividends and fully taxed in the hands of investors with no deductions, including the cost of the acquisition of shares.

Also Read: Mint Explainer: The budget, buybacks, and Esop taxation

Consider these examples:
 

Due to the disproportionately high tax on buybacks, retail shareholders will skip these issues if corporates still choose to have them. Only institutional investors like mutual funds, who pay no taxes or near zero tax, will participate. A promoter stake sale will attract capital gains for the promoter, but the triggered buyback will result in slab-rate tax for retail shareholders. The unfairness is palpable.

Another side effect of these taxes is that companies with mature business will prefer to hoard cash despite having no avenues to deploy, thereby resulting in suboptimal capital decisions.

Many family-owned and small and medium business enterprises choose the corporate structure for compliance and business compulsions. Banks and overseas customers insist on signing contracts with corporate entities only, and therefore even smaller business owners have no choice but to move to this structure.

Also, small business owners put large amounts of their personal assets into company capital and often need to draw out profits for personal expenses. Imagine their plight if they were unable to withdraw accumulated profits from their own businesses without paying the government twice over in taxes. Compared to them, shareholders of listed companies will at least have an exit option in the form of selling shares on the exchanges.

Clearly, new-age entrepreneurs who aren’t into the game of stake sale will prefer the LLP structure, which allows for a lot more flexibility in capital allocation. However, those stuck in a company structure will find the going very tough. This is far removed from fair tax and ease of business.

The finance ministry must urgently rationalise the double taxation of dividend and buyback taxes. Eliminating dividend tax, and tax buybacks like any other equity sale would be a step in the right direction.

Kavitha Menon is RIA and founder of Probitus Wealth.