The day the Union Budget is presented is always eventful for the stock markets. This proved to be true this time as well. The Nifty and Sensex recorded their worst intraday decline in over 2 years two days post the budget. This could be attributed to the absence of anticipated announcements like measures to boost consumption, to revive the slowing auto industry, increase basic tax exemption limit, etc.
There were a host of other unanticipated announcements as well such as hike in import duty on gold, increase in cess and excise duty on petroleum products, tax on buyback of shares, and surcharge on the mega rich.
Though these factors cumulatively led to the slump in Nifty, some specific issues alarmed investors.
Following are the three factors that led to Nifty plummeting post Union Budget 2019:
Proposal to increase minimum pubic shareholding limit to 35% from 25%
The government's proposal to raise the public shareholding threshold to 35% caught the equity markets off-guard. A simplistic way of looking at this proposition is that there will be more shares for market participants. But in reality, this is much more complicated and has the tendency to alter the course of the market at least in the short run. As many as 1,174 companies out of over 4,700 listed companies will have to sell shares to reduce the promoter shareholding to 65%, which could total upto Rs3.87 lakh cr.
The proposal, if and when implemented, will cause a deluge of shares in the equity markets, thus, limiting the upside in these shares. Many companies, especially multinational ones, which have very high promoter holdings will have to adopt the FPO, QIP route among other options to bring down their holdings to comply with these rules. This may cause many MNCs to delist rather than face the procedural and logistic challenges that will ensue if the rule is implemented. Some of the companies with high promoter holdings include Tata Consultancy Services, Avenue Supermarkets, Dabur , and Pidilite Industries.
This is not the first time that such a proposal was made. Capital markets regulator SEBI had first introduced the concept of minimum public shareholding in 2010, and allowed 3 years to all publicly traded companies, barring state-owned firms, to attain a minimum 25% public shareholding. This rule was made mandatory to state-owned firms in 2014. During that time, shares worth at least Rs6,800cr were offloaded in the stock markets.
Nevertheless, the proposition as such is a positive for minority shareholders. It not only makes many companies accessible and available to retail investors, but also improves market depth. One can also expect wider institutional participation, higher inflows from foreign investors and better governance.
However, all this hinges on how the proposal is structured and implemented and whether or not sufficient time is given for the transition.
Tax on buyback of shares
In Union Budget 2019, FM Sitharaman proposed an additional tax of 20% on the buyback of shares by listed companies. This was aimed at discouraging publicly owned companies from bypassing payment of dividend distribution tax. Typically, companies have to pay a tax on declaring dividends. Therefore, companies increasingly prefer to reward shareholders through buybacks over dividends. Taxing buybacks will close a loophole to avoid DDT.
The 20% tax net with surcharge and cess comes into effect immediately. No clarification has been provided for companies already in process of buyback. Moreover, as companies now cannot reverse the process, it can be assumed that the burden of such tax has to be borne by the companies, which could not have been factored at the time of initiating the process.
Market regulator SEBI had allowed buyback transactions as regular stock market sale-purchase deals; these were exempt from capital gains tax from 2015 onwards. Since then, the value of buybacks went up from Rs1,724cr in 2015 to Rs39,246cr in 2018. Cash surplus companies, especially software firms, routinely resorted to buy back as a means of sharing additional income/profit with shareholders.
Post buyback tax, companies would be reluctant to adopt this route to transfer wealth to shareholders as it would mean adjusting the buyback price for tax. This would lower the buyback price in comparison to the prevailing market price, which would make it unprofitable for shareholders. This proposal already found its first victim in KPR Mills, which withdrew its Rs263.31cr buyback proposal last week citing “increase in amount of buyback obligation” due to the tax.
Surcharge on the super-rich
The Budget for 2019 announced a new surcharge for people with annual income of more than Rs2cr at 3% and income above Rs5cr at 7%. In her speech in Parliament, the FM said the higher surcharge rates would apply to individuals. However, a deeper read of the Budget document relayed that this surcharge had implications for over 2,000 foreign funds that are legally equivalent to associations of persons (AOP). Nearly 70% of foreign portfolio investors (FPIs) in India are registered as non-corporates. Most of the FPIs are structured either as trusts or AOP and would be impacted by the new surcharges.
The tax outgo for a large number of FPIs, domestic and foreign individuals and companies, would jump to 14.25% in terms of the long term capital gains tax (LTCG) and the peak of 21.37% in terms of short term capital gains tax (STCG). In this month till date, FPIs have pulled out over Rs4,120cr worth of funds from the equity markets.
The impact would be significant on FPIs that trade actively in the F&O markets. Profit from derivatives is considered as business income for tax purposes and is subject to income tax. The threshold of Rs5cr is too miniscule for FPIs and they are known for taking large positions in the Indian markets.
FPIs that were hoping for some clarification or tweak in the surcharge were in for disappointment, as FM Sitharaman reiterated that FPIs registered as trusts will have to pay up higher surcharge. The only way they could avoid the surcharge is by structuring themselves as companies. Overseas funds, more specifically mutual funds prefer to be registered as AOPs or trusts to avoid paying Minimum Alternative Tax (MAT).