Tax implications on share buy-backs have undergone significant changes pursuant to the amendments introduced in the Finance Act (No. 2), 2024 (the "Finance Act").
Background
Buy-back of shares is a corporate action pursuant to which a company purchases its own outstanding shares from existing shareholders. Buy-back provides an exit option to the shareholders and is also often used as a method by Indian companies for repatriation of surplus funds to their shareholders.
Existing provisions
The tax implications on the buy-back of shares in India are currently governed by Section 115QA of the Income-tax Act, 1961 (the "Act").
An Indian company undertaking a buy-back is required to pay income tax on the amount of "distributed income" (i.e., the difference between the consideration paid to the shareholder in the buy-back and the amount received by the company for the issuance of such shares) at an effective tax rate of 23.30% (inclusive of applicable surcharge and cess).
Additionally, the Act provides that the consideration received by the shareholders towards the buy-back from the company will be exempt from tax in the hands of the shareholders under Section 10(34A) of the Act. Consequently, the shareholders are not eligible to claim credit for the income tax paid by the company on the "distributed income".
Amendments
The Finance Act seeks to amend certain provisions of the Act which will change the manner in which buy-backs are taxed. Pursuant to such amendments, the revised taxation regime for buy-backs that are undertaken on or after October 1, 2024 will be as under:
- Section 115QA of the Act (the current provision of the Act that governs taxation of buy-backs) will no longer apply to buy-backs;
- Consideration received pursuant to a buy-back will be treated as dividends within the definition of "dividends" under Section 2(22)(f) of the Act and accordingly, taxed in the hands of the shareholders as 'income from other sources';
- Shareholders will not be able to claim any deduction for expenses against the buy-back consideration;
- The company undertaking the buy-back will be required to deduct tax at source ("TDS") at the rate of 10% in case of resident shareholders; and in case of non-resident shareholders, at the rates in force (subject to the rates provided under the applicable tax treaty);
- Consideration received by the shareholders pursuant to the buy-back will be deemed as 'NIL' for the purpose of capital gains computation, leading to a 'capital loss' for the shareholders. Therefore, the amount of 'capital loss' would be equal to the cost of acquisition of the shares that are bought back;
- Such 'capital loss' will be available to be carried forward for eight (8) subsequent financial years and eligible for set-off against any other capital gains, subject to applicable set-off provisions.
Interplay with the Companies Act, 2013
Section 68 of the Companies Act, 2013 outlines various conditions in relation to buy-back of shares and provides that buy-back can be financed out of free reserves, securities premium, or proceeds from issue of any shares, provided that no buy-back of any kind of shares or other specified securities shall be made out of the proceeds of an earlier issue of the same kind of shares or specified securities.
It is important to highlight that the language used in Section 2(22)(f) of the Act does not use the phrase "accumulated profits, whether capitalised or not", which implies that the intention of the legislature is to cover within its ambit all kinds of buy-back referred to in section 68 of the Companies Act, 2013 – whether financed out of free reserves, securities premium, or proceeds from issue of any different kind of shares or securities. Accordingly, consideration paid by a company pursuant to buy-back under Section 68 of the Companies Act, 2013 would be deemed as 'dividend' for the shareholders regardless of whether or not the company undertaking the buy-back has accumulated profits.
Impact on non-resident shareholders and interplay with the tax treaties
To assess the impact of the amendments under the Finance Act on non-resident shareholders, it is important to evaluate the tax implications under the relevant tax treaties between India and the country of residence of the relevant shareholder. The tax liability on buy-back consideration received by non-resident shareholders would depend on the characterization of the income under the relevant tax treaty and there could be different interpretations depending on the language used in the relevant tax treaty:
- Article on Dividend Income: If the buy-back consideration is treated as dividend under the relevant tax treaty, it may be subject to TDS at the rate specified in the tax treaty.
- Article on Capital Gains: If the buy-back consideration is classified as capital gains, the tax treatment will depend on whether the tax treaty provides relief or exemption for such gains. The computation mechanism for determination of capital gains and the consequent tax liability would need to be evaluated.
- Article on Business Profits: If the non-resident shareholder is holding shares that are bought back as 'stock-in-trade', the buy-back consideration could be considered as 'business profits'. The taxability of business profits is subject to the presence of Permanent Establishment (PE) of such non-resident shareholder under the provisions of the relevant tax treaty.
- Article on Other Income: If the buy-back consideration does not fall under any of the above categories, it may be treated as 'Other Income'. Taxation of "Other Income" would depend on the language used in the relevant tax treaty, which might allow either country to tax such income.
In view of the above, a thorough examination of the relevant tax treaty relevant to the facts of the buy-back transaction will be necessary to determine the appropriate tax treatment for non-resident shareholders.
Impact of the Amendments on Restructuring Transactions
Currently, Section 115QA of the Act which governs taxation of buy-back applies to a purchase of shares undertaken by a company under any provision of the Companies Act, 2013 which has the effect of distribution of income by a company to its shareholders.
In the case of Anarkali Sarabhai vs. Commissioner of Income Tax (CIT),1 the Supreme Court of India observed that even a reduction of capital involves 'purchase' of shares (or rights therein) by a company from its shareholders. Accordingly, there is a view that the provisions of Section 115QA of the Act are applicable to any scheme of reduction of share capital involving cancellation / redemption of shares.
Consequently, the amendments under the Finance Act to the taxation regime for buy-backs may also impact restructuring transactions. For example:
- Reduction of share capital by way of cancellation of shares: Unlike buy-back of shares provided under Section 68 of the Companies Act, 2013, reduction of share capital is governed by Section 66 of the Companies Act, 2013. An application needs to be filed before the jurisdictional bench of the National Company Law Tribunal ("NCLT") by the company seeking such reduction in share capital and consent is required from the shareholders and creditors. In a reduction of share capital, the company may, at its own discretion, choose an "Appointed Date" for undertaking such reduction of share capital.
- It is unclear if the provisions of Section 115QA of the Act would apply in case of reduction of share capital (by way of cancellation of shares) where the Appointed Date is a date prior to October 1, 2024, but the reduction of share capital becomes effective on or after October 1, 2024.
- Redemption of Redeemable Preference Shares ("RPS"): Redemption of RPS by a company would fall within the ambit of Section 2(47) of the Act and would construe to be a 'transfer' in the hands of the shareholder. Therefore, premium (if any) received by the shareholder on redemption of RPS will now be taxable as 'income from capital gains' in their hands. The non-resident shareholders may claim exemption under the relevant tax treaty, if available.
The Finance Act proposes a pivotal shift in the tax treatment of buy-backs for resident and non-resident shareholders. In light of the amendments, companies and investors will need to reconsider their approach for exits and repatriation of surplus funds.
Footnote
1. Anarkali Sarabhai vs. CIT [1997] 224 ITR 422 (Supreme Court)
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