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Tax On Buyback, Is Fundamentally Flawed?

Posted on 12-Jul-2019 Comments  0

Buyback Tax

Why the concept of buyback tax is fundamentally flawed

When KPR Mills cancelled its proposed buyback last week, it was the first signal that Indian companies and investors were unhappy with the buyback tax imposed in the Budget 2019.

Why the buyback tax?

In the last 3 fiscal years, the average annual buyback value was Rs.48,000 crore. That is a 10 fold increase after the 10% tax on dividends in the hands of shareholders was introduced for large shareholders in Budget 2016. This had led to a big shift towards companies opting for buybacks as an option to return money to shareholders. The government felt that tax-free buyback was distorting the scene and providing an arbitrage to shareholders, especially the promoters. It is to curb arbitrage that the budget introduced this tax.

A flawed concept

The concept of tax on buybacks is flawed for a number of reasons. Firstly, unlike what the government believes, discouraging buy-backs will not encourage investments. That depends on risk and ROI. Buybacks offered a profitable exit to minority shareholders and that route has also been blocked. Thirdly, the idea of taxing buybacks at 20% of difference between buyback price and issue price ignores the cost of acquisition of the investor and puts an unnecessary burden. Lastly, capital decisions are best left to the boards.
Taxing equity unfairly

While buyback tax may have removed the arbitrage, what it has underlined is that equity continues to be taxed at exorbitant rates in India. Consider the case of dividends. Firstly, it is a post tax appropriation and secondly, there is a DDT incidence of more than 20% on payouts. In addition, the dividends above Rs.1 million are taxed in the hands of the shareholder at 10%. Now, buybacks are no different. Firstly, the introduction of LTCG automatically implies that any gain made on buybacks will be taxed at 10% above Rs.1 lakh per annum. Now there will be an additional 20% tax on buybacks based on a formula (buyback price – issue price), that is flawed to begin with. This move has made equity the most steeply taxed instrument in India!

Killing the golden goose

Buybacks may have benefited promoters but it has also benefited scores of small shareholders who got an attractive exit. This tax virtually shuts the doors on that avenue. But more importantly, it makes equity more expensive in India and that raises the cost of equity. Now investors will expect 20% higher returns in pre-tax terms and that would be negative for valuations. For a government looking to nurture the equity cult in India and create a robust capital market, the buyback tax goes against the grain. It is best scrapped at the earliest!

Investment Lessons

Key investment lessons from India’s ICC World Cup exit

While there is a general feeling of gloom at India exiting the ICC World Cup in the Semi-Finals, there is an undoubted sense of irony in the situation. It was supposed to be an Australia versus India final but neither of the teams has really qualified for the finals. For an investor, there are a lot of critical lessons in the semi-final losses that India and Australia had to go through. Here are a few!

Avoid over-dependence

Both in the case of India and Australia, the big problem was the over-reliance on the top order batsmen. In fact, in both the case, the middle order was extremely brittle which got tested in the semi-finals when their top order failed. This applies to your investments too. Avoid a situation where the returns of your portfolio are too dependent on a handful of stocks or a handful of factors. Diversification can be a force multiplier in most investment cases.

Play to the conditions

This was starkly revealed in the India versus NZ match. Kane Williamson and Taylor curbed their natural strokes and adapted to the conditions and grafted their innings. In the end, they managed a decent winning total. That applies to your investments too. You can’t go around with a fit-all strategy. Work with a Plan-B. Above all, have a strategy that is flexible enough to change with the changing market and macro conditions.

Winning the key moments

As Kohli put it eloquently in the post-match conference, they lost the game in the 45 critical minutes. India lost those key moments when they allowed NZ to build a partnership and when the top order failed. This applies to investments too. Your losses and profits are never consistent but depend on a few moments of good or bad markets. Be prepared to ensure that you capture these key winning moments in your investment plan. That is what makes the difference to your returns.

Never let things drift

Be it cricket or your money, never let things drift. Take corrective action immediately. Unlike India, Williamson never let up on the pressure and kept setting attacking fields. This forced errors. It always pays to be in full control of the situation.

Learn to move on 

Well you have bad days in cricket and you also have bad days in the market. For Indian cricket, they will have to wait for another 4 years for their next attempt at the World Cup. It is really not so bad when it comes to your investments. But, the key lesson is that you have to move on. Let your current setbacks not impact future strategy. That is perhaps the most important take-away from the ICC World Cup!

Inflation & Growth 

How the CPI and IIP data point towards a likely rate cut by RBI

The Ministry of Statistics and Program Implementation (MOSPI) announced the CPI inflation and IIP growth during the week. While the CPI inflation came in slightly above expectations, the IIP growth continued to disappoint. What are the highlights of these macro numbers and what do they portend for the RBI decision on repo rates when the MPC meets up August?

Inflation edges higher

CPI inflation for June 2019 came in at 3.18% nearly 14 bps higher than the inflation reported in the month of May. The retail inflation has been on a steady uptrend over the last 5 months, though it still remains well within the RBI comfort level of 4%. For the month of June, the rise in CPI inflation came from a sharp rise in food inflation from 1.83% in May to 2.17%. This has been a consistent trend and is partially explained by the better MSP for farmers and partially by the base effect of last year. However, the good news is that the core inflation continues to trend lower. The big worry for the CPI inflation in the coming months is that the Union Budget has increased the excise duty on petrol and diesel and has also imposed infrastructure cess of 1%. This had led to an immediate increase in fuel prices. With the tensions in the Middle East on a boil, the oil inflation remains the big risk to the overall price levels. The food inflation trajectory will also depend on the monsoons!

IIP growth falters again

The index of industrial production (IIP) for the month of May 2019 came in at 3.1%. This is lower than the growth recorded in the month of April and also the corresponding period last year. The IIP growth saw pressure on mining and manufacturing front. As manufacturing accounts for 77% of the IIP basket, the correlation is almost direct. Weakness in manufacturing is largely due to low capacity utilization, weak global and domestic demand and liquidity stress across key sectors like auto and FMCG. The impact on the consumer sector demand clearly underlines the reasons for the sharp fall in the IIP. This needs to be tracked closely as the IIP also has a primary and secondary impact on the overall GDP growth next quarter.

What does the RBI do now?

Markets are rife with expectations of another rate cut by the RBI in August. In June the RBI had cut rates by 25 bps to 5.75% and that just about implied an effective rate cut of 25 bps in the last one year. The rate cuts of February and April were neutralized by the two rate hikes last year. The RBI needs to cut rates to bring real rates of interest down and to help reduce the cost of funds for borrowers. With the Fed also giving a dovish outlook, the RBI may not have much to worry on the maintenance of yield spreads. The RBI language may matter more than the rate action!





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