Comment: Why the buy-back fashion is bad for Britain

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The Independent Online
Another day, another share buy-back, special dividend or some such other ploy for giving out vast amounts of supposedly surplus cash to shareholders. The propensity of British industry and commerce to say, "We cannot find any decent use for this money, maybe you, the shareholders, can," and then with a flutter of pounds 50 notes to dole it out, seems to know no bounds. In the past three months alone, more than pounds 4bn has been returned to shareholders in the form of special dividends, share buy-backs and the like. The total for the three years over which these schemes have been fashionable must be well into double figures. This is over and above ordinary dividends, which are themselves rising strongly.

Encouraged by the big City fund management groups, many of which are able to get significant tax breaks on corporate distributions of this type, companies as diverse as Boots, Guinness, Reuters, Barclays and National Power have all climbed aboard the bandwagon. It is a phenomenon which in part helps explain the present buoyancy in the stock market, for all that money has got to be reinvested in some way or other.

Why is it happening, and is it a good thing? To the latter of these two questions, I have to confess a sneaking suspicion that it is not. The backdrop is the focus in modern management techniques on cost-cutting and efficient use of capital. Cost-cutting has transformed many companies into highly cash-generative machines. This has combined with a period in which corporate cash resources have been building, anyway, because of relatively sluggish levels of economic activity.

In the old days it would have been thought acceptable for managements to find a home for such surpluses in diversification and general reinvestment. Not now, where after some truly disastrous experiences in corporate diversification the demand is for companies to focus on their core expertise and functions, and to hone what investment they do make into carefully costed projects and enterprises. Institutional shareholders have tried to encourage managements to think of capital as a scarce resource, and to treat it with the reverence it deserves.

As a consequence, a great many companies have found themselves with more money than they actually need, or certainly know what to do with. This is especially the case with the utilities, which with the benefit of hindsight, were plainly over-capitalised when they were first privatised.

Take the case of British Telecom. It has no cash mountain as such, but it has a balance sheet of such size and strength that arguably it could afford a couple of billion pounds' worth of equity cancellation and barely notice the difference. The fact that it hasn't yet done so perhaps tells you more about BT's need to avoid the avenging hand of the regulator and the politicians than its ability or otherwise to undertake such an exercise. Certainly, BT is under a lot of pressure from the City to follow others with what would amount to the mother of all buy-backs. In the end, however, anything on this scale may be just too politically sensitive for Sir Iain Vallance and his colleagues on the BT board to contemplate.

It might also finally prompt the Government into action on the tax front, for whatever the commercial pros and cons of these schemes, there can be little doubt that they are also powerfully motivated by tax considerations.

The mechanics of these considerations are perhaps too complicated to explore in any detail in a column of this length; suffice it to say that the Inland Revenue is losing out quite seriously and that the public purse is the poorer as a consequence.

This is because a share buy-back or special lump sum payment is treated for tax purposes as if it were a dividend distribution. Tax on such dividends is paid directly by the company to the Inland Revenue in the form of advanced corporation tax, which in most cases can be offset against mainstream corporation tax. Tax-exempt shareholders such as pension funds and charities can then reclaim those tax credits from the Revenue. In a share buy-back, therefore, a pension fund gets not just the market value of its shares, but a 20 per cent tax credit on top. Since the cost of this, in most cases, is being offset against mainstream corporation tax, the Inland Revenue loses out accordingly. The tax credit is paid for out of money that would otherwise go to the Treasury.

Why the Revenue has allowed this process to continue largely unchallenged for so long is a bit of mystery for it can readily be seen that it is the public purse which is funding the bonanza element in these schemes. It is not all one way, of course. A big corporate distribution means a larger tax take from those who do pay tax. But since that tax, too, can be offset by companies against mainstream corporation tax, the effect here is neutral. There's no two ways about it, the Treasury is losing out. That the money is going largely into people's pensions obviously mitigates what's happening from a public policy perspective, but it does not excuse it.

Tax is one thing; there is also a rather wider concern about these schemes. Plainly it makes sense for a company when it cannot find a decent use or return for its money to give it back to the capital markets. If the markets work as they should, the effect is to redistribute capital from those who don't need it to those who do. It may not always work this way in practice, but that's the theory. The trouble is that the pressures on companies to follow fashion are now so intense that there is a real danger of over-indulgence in something which in moderation is probably not a bad thing.

With interest rates at their present level, it can actually make sense to borrow money for a buy-back - quite a few do - for the effect is earnings- enhancing. To the purpose of tax efficiency should therefore be added that of financial engineering. It is hard to generalise, but it may be that some companies are doing something which in the next business downturn, with interest rates higher once more, they will live to regret.

Any business run for cash is also one which is highly likely to be under- investing for the future. I'm not saying here that we are heading for a full-blown repeat of Michael Milken's 1980s junk bond revolution, with its quite disastrous consequences for large swathes of US industry. But there are parallels and we may be seeing in mild form the beginnings of something similar. Shareholders should think long and hard before forcing managements into such schemes, for it is they who will be bailing these companies out if it transpires that the process has gone too far.

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