Buy back of shares

Amit Gupta
Cash on the balance sheet
always used to be king, until
recently when cash on some
large companies’ balance sheets
ballooned to such a point that
their boards felt serious pressure
from analysts and activist
shareholders on its utilization.
Thus, a number of IT majors as
well as large PSUs have been
queuing up to buy back their own
shares and release the perceived
excess cash holdings back to
the investors.
What exactly is a
buy-back?
Buy-back is a procedure that
enables a company to purchase
its shares from its existing
shareholders, usually at a price
near to or higher than the
prevailing market price. When a
company buys back, it reduces its
outstanding shares in the market,
which increases the percentage
shareholding for the remaining
shareholders.
In a buy-back, the company
generally offers its shareholders
an option to tender a portion
of their shares within a certain
time frame and at a specified
price (maybe at a premium to the
current market price). This price
compensates the shareholders for
tendering their shares rather than
holding on to them. Sometimes,
companies buy back shares on the
open market over an extended
period of time.
We move to our
next question: Why
buy back?
The reasons for buy-back are
obvious — they improve the
earnings per share and long-
term shareholder value, provide
an exit route to shareholders
when shares are undervalued or
are thinly traded, help achieve
optimum capital structure and, of,
course, help return surplus cash to
the shareholders.
Another reason why this mode of
capital reduction is preferred by
Indian corporates is that it does
not require any approval of the
court or the National Company
Law Tribunal (NCLT).
Share buy-back is also considered
more tax-efficient than dividends
to distribute a company’s
earnings: While companies have to
pay dividend distribution tax (DDT)
on the total amount distributed
and dividends above INR10 lakh
are taxable in the hands of the
shareholders, listed companies
are exempt from buy-back tax
(BBT) and there is no capital gains
tax in the hands of, even large,
shareholders in case shares are
held for more than one year and
the buy-back is routed through a
stock exchange where Securities
Transaction Tax has been paid.
Further, in case of unlisted
companies, BBT is chargeable
in the hands of the company on
the “net amount distributed”
(i.e., after reducing the amount
received by the company for the
issue of such shares), while the
amount received is exempt in
hands of the shareholders. So,
there is a clear tax benefit to the
extent of the amount received
by the unlisted company from its
shareholders (including securities
premium), as it is not subject
to BBT.
This raises the question: If buy-
backs are so advantageous, why
does every company not follow
this path instead of dividend
distribution? Well, nothing comes
easy in this world or without
its own riders. The process of
buy-back can be undertaken only
subject to the satisfaction of
conditions as prescribed under
Sections 68, 69 and 70 of the
Companies Act, 2013, Rules 17
of the Companies (Share capital
and Debenture) Rules 2014
and relevant SEBI regulations
in respect of buy-back, which,
for instance, restrict companies’
ability to raise further capital for
a period of six months from the
closure of buy-back, except by way
of bonus shares or in discharge of
subsisting obligations.
Key considerations
under corporate
laws
Source of buy-back
• Buy-back should be funded
from free reserves, securities
premium, proceeds from any
shares or other specified
 securities (not of the kind to be
bought back).
Recipients of buy-back
• Buy-back can be from existing
shareholders/security holders
on a proportionate basis or from
open market or purchase of
shares issued to employees
under ESOP.
Quantum of buy-back
• The buy-back should not exceed
25% of the aggregate of the
paid-up capital and free reserves
held by the company, subject
to authorization by a special
resolution in the general meeting.
In case of equity shares, the
reference to 25% should be
construed with respect to its
total paid-up equity capital in that
financial year.
• However, in case the buy-back
does not exceed 10% of the
total paid-up equity capital and
free reserves of the company,
there is no requirement of a
special resolution in the general
meeting; authorization by a board
resolution will suffice.
An interesting question that
often comes up relates to the
interpretation of Section 68(2)(c)
of the Companies Act, 2013 and
its proviso, which states as under:
“68. No company shall purchase
its own shares or other specified
securities…..unless –
“(c) the buy-back is twenty-five
per cent or less of the aggregate
of paid-up capital and free
reserves of the company:
“Provided that in respect of the
buy-back of equity shares in any
financial year, the reference to
twenty-five per cent in this clause
shall be construed with respect
to its total paid-up equity capital
in that financial year;”
Based on a plain reading of
this Section along with the
proviso thereto, the following
could be some possible legal
interpretations:
1. The limit for buy-back of
shares (other than equity
shares, i.e., preference
shares etc.) is 25% of paid-
up capital + free reserves,
while for buy-back of equity
shares the limit is 25% of
paid-up equity capital only,
i.e., free reserves cannot be
considered for buy-back of
equity shares.
2. The limit for buy-back of
all shares is 25% of paid-up
capital + free reserves (in
terms of amount/value),
while as per the proviso, in
case of buy-back of equity
shares, the number of equity
shares is limited to 25% of
total number of equity shares
in that financial year.
3. The limit for buy-back of
all shares is 25% of paid-up
capital + free reserves, while
for equity shares it is 25% of
paid-up equity capital + free
reserves
4. The limit for buy-back of
all shares is 25% of paid-up
capital + free reserves, while
for equity shares it is 25% of
paid-up equity capital in the
said financial year only, i.e.,
any equity capital issued
in earlier financial years
cannot be considered.
For example, an interpretation
of bullet 1 above could be that
in case of buy-back of equity
shares, the formula of 25%
of total paid-up capital + free
reserves is to be replaced by
25% of paid-up equity capital.
In such a scenario, there would
be no incentive for companies
to undertake buy-back of
equity shares, as without free
reserves, the quantum of
permissible buy-back would
reduce significantly. Thus, a
better interpretation could
be that in case of buy-back of
equity shares, 25% of paid-up
capital + free reserves should
be replaced by 25% of paid-up
equity capital + free reserves.
Another possible interpretation
of the proviso could be that
a company can buy back
only up to 25% of its total
number of equity shares in the
equity share capital, as under
Explanation II to Section 68 for
the purpose of buy-back, “free
reserves” includes securities
premium.
However, the above matter is
subject to legal interpretation
and companies are well advised
to consult their legal advisors
before concluding on the limits
of possible buy-back of equity
shares.
Other conditions
• The buy-back needs to be
authorized by the articles of
association.
• After buy- back, the debt- equity
ratio of the company should not
be more than 2:1.
No offer of buy-back should be
•
made by a company within a
period of one year from the date
of the closure of the preceding
offer of buy-back.
• The buy-back should be
completed within a period of one
year from the date of passing of
the special resolution or board
resolution, as the case may be
Moving on to the accounting
aspect, Section 68(7) of the
Companies Act, 2013 specifies
that a company should extinguish
and physically destroy shares
bought back within 7 days of
completion of the buy-back.
Even though Indian regulations
prohibit companies holding their
own shares acquired under buy-
back, Ind-AS has the concept of
treasury shares, which are the
shares issued by an entity that
are held by the entity. Treasury
shares may arise not only in
buy-back, but in consolidated
financial statements they would
include shares issued by any group
entity that are held by that entity
or by any other members of the
consolidated group. They will also
include shares held by an employee
benefit trust that is consolidated
or treated as an extension of the
reporting entity. Treasury shares
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July 2017
do not include shares in a group
entity held by associate or joint
ventures.
If an entity reacquires its own
equity instruments, those
instruments (“treasury shares”)
should be deducted from
equity. No gain or loss should
be recognized in profit or loss
on the purchase, sale, issue or
cancellation of an entity’s own
equity instruments. Consideration
paid or received should be
recognized directly in equity.
Let us take an example of Bank
X, which holds its own equity
shares (which are owned by the
borrowers) as a pledge on certain
loans granted. Should such shares
be deducted by Bank X from its
equity?
As explained under para AG
36 to Ind-AS 32, an entity’s
own equity instruments are not
recognized as a financial asset
regardless of the reason for which
they are reacquired. An entity
that reacquires its own equity
instruments needs to deduct
those equity instruments from
equity. However, when an entity
holds its own equity on behalf of
others, e.g., a bank holding its
own equity on behalf of a client
who has pledged it to the bank,
there is an agency relationship
and as a result those holdings are
not included in the bank’s balance
sheet.
Thus, in the given case Bank X
will not deduct the shares held as
pledge from its equity. Rather, the
shares held are a security and will
not be recorded in the financial
statements of Bank X. However,
if Bank X appropriates those
shares as per contractual terms
on default by the borrower, the
shares acquired will be reduced
from equity. Additional guidance
can be found in the section on the
principles of “de-recognition of
financial asset” under Ind-AS 109.
How are treasury
shares disclosed?
Ind-AS 1 requires the amount of
treasury shares to be disclosed
separately either on the face
of the balance sheet within the
equity caption or in the notes.
In addition, Ind-AS 24 Related
party Disclosures requires an
entity to make disclosures where
it reacquires its own equity
instruments from related parties.
There is a similar requirement in
Ind-AS 107.
Conclusion
Any company that does
not need capital for
growth and is sitting on a
significant cash pile may
resort to buy-back of its
shares, considering the tax
efficiency and other benefits
discussed above. However,
finding a balance between
short-term buoyancy from
shareholders versus the
long-term priorities for
growth is the ongoing
challenge for companies,
requiring significant
judgement and careful
oversight.