Share buyback can achieve various investment goals

The term “buyback of shares” is per se not defined in Indian laws. Nevertheless, the concept of buyback is dealt with under section 77A of India’s Companies Act, 1956, and is generally used when a company repurchases its own shares which are issued and subsisting.

Buyback has been used as a tool to achieve diverse commercial goals in mergers and acquisitions and private equity (PE) transactions in India. Some of these goals are elaborated below.

Resisting hostile takeover

Listed companies in India can use buyback as a counter-strategy to hostile takeover bids since a buyback effectively decreases the floating shares in the market and can increase the acquisition cost on an immediate basis. These factors can act as a surprise element and cause fluctuations in the pre-determined plan of the party intending to do a hostile takeover.

In this regard, it is pertinent to note that hostile takeovers of listed entities having low promoter shareholdings or low market capitalization have become easier since the introduction of the new Takeover Code in India. Therefore, the use of buyback as an anti-hostile takeover mechanism could gain further practical importance in the future.

Squeezing out minority

There have been instances in the past where promoters of Indian companies have used “forced” or “selective” buybacks as a tool to dilute the stake of minority shareholders in their company, and this has become an issue of concern for PE investors holding small stakes without any major rights in companies.

Buyback in the normal course is a voluntary process and pre-supposes that one cannot forcibly buy back the shares of a shareholder. However, since buyback technically is also a reduction of capital, Indian companies have tried to avoid the restrictions on buyback envisaged under the Companies Act and applicable regulations of the Securities and Exchange Board of India by preparing schemes under section 100/101 and/or under sections 391 to 394 of the act, and have tried to force buyback through the sanction of a high court by way of such “selective buyback schemes”.

Such a scheme provides that shares of selected persons, say, public shareholders, would be bought back at a price specified by the company. If sanctioned by the court, the shares of such public shareholders would be bought back by the company without the express consent of the shareholders.

Tax-efficient cash distribution

Companies also consider buyback as a tax-efficient way to distribute cash among shareholders as companies do not per se incur any tax liability on buyback. Buyback proceeds are taxed as capital gains in the hands of the shareholders while dividends distributed are taxed at about 16% in the hands of the company.

If the shareholders are residents of tax-friendly jurisdictions where no tax is imposed on capital gains, such as Mauritius, the entire buyback transaction can go untaxed. The Authority for Advance Rulings (AAR) ruled in March that this constituted a “colourable transaction” to avoid divided distribution tax but this ruling can be said to be more of an exception than a norm, owing to the specific circumstances of the case.

Exit route

Buyback has also been popular among PE investors as a route to exit their investee companies as a buyback exit option could provide an assured return to the investor, irrespective of the prevailing market conditions. But the popularity of the buyback exit option has consistently decreased due to regulatory uncertainty over assured-return exit options (such as buyback exit options, put and call options).

The uncertainty arose after the Department of Industrial Policy and Promotion (DIPP) issued Circular 2 of 2011, dated 30 September 2011. Paragraph 3.3.2.1 of the circular stated that any equity instrument issued or transferred to non-residents having in-built options or supported by options sold by third parties would lose its equity character and would have to comply with the external commercial borrowing guidelines. This paragraph was quickly withdrawn in October 2011 by a subsequent order issued by DIPP after stiff resistance from the investor community.

In light of regulatory uncertainty on critical investment issues and the general environment of “policy paralysis” created by the government, the minimum expectation of the investor community from the regulatory authorities in India is to not create additional confusion and to be proactive in providing much-needed clarity on critical investment issues by accepting the universal truth that “where there is an entry, there has to be an exit”. It would only be rational on the part of a financial investor to expect a minimum assured return on its investment.

Kalpataru Tripathy is a partner and Varun Bajaj is an associate at Amarchand & Mangaldas & Suresh A Shroff & Co. The views expressed in this article are those of the authors and do not reflect the position of the firm.