Background
The power of the company to purchase its own securities is known as “buy-back”. A company resorts to buy-back for varied reasons such as (i) reduction of capital without reduction of control of the existing shareholders; (ii) distribution of profits to shareholders; (iii) reduction of number of shareholders; (iv) increasing earnings per share; (v) buying back ESOPs and providing liquidity to the employees etc.
Section 68 of the Companies Act, 2013 permits a company to buy-back its own securities out of (i) free reserves; or (ii) the securities premium account; or (iii) the proceeds of any shares or other specified securities.
History of buy-back taxation (prior to amendment)
Buy-back taxation, akin to taxation of dividends, has undergone numerous changes over the years from charging tax in the hands of company to shareholders and vice-versa.
A new section, namely, Section 46A of the Income Tax Act, 1961 (“IT Act”), was inserted vide Finance Act, 1999 to tax difference between the consideration received on buy-back and the cost of acquisition of the shares as capital gains in the hands of shareholders. Further, the definition of ‘dividend' under Section 2(22) of the IT Act was amended to exclude buy-back from the definition of dividend.
Subsequently, the government realised that buy-back method was used by companies mainly to distribute profits as the same was more beneficial from taxation perspective (as compared to declaring dividend and paying Dividend Distribution Tax). To plug this loophole, Finance Act, 2013 inserted a new Chapter XII-DA, wherein in the case of buy-back by unlisted companies, ‘distributed income' (i.e. buy-back price less amount received by a company in respect of the shares1) is taxed as per Section 115QA in the hands of an unlisted company at the rate of 20%2. Consequently, Section 10(34A) of the IT Act was also inserted to exempt any receipt by the shareholder under buy-back as referred to in Section 115QA of the IT Act.
Buy-back taxation was made applicable to listed companies as well vide Finance (No. 2) Act, 2019 and consequential income in the hands of shareholders was exempt under Section 10(34A) of the IT Act.
It is pertinent to note that Finance Act, 2020 abolished Dividend Distribution Tax in the hands of the company and dividend was made taxable in the hands of shareholders at applicable rates. However, buy-back tax was still payable by the company and buy-back proceeds were exempt ifor shareholders. Thus, buy-back was a preferred route for distribution of accumulated profits by company especially in cases where majority of the shareholders were high net worth individuals.
Buy-back taxation post amendment by Finance (No.2) Act, 2024
The government was of the view that both buy-back as well as dividends are methods for the company to distribute accumulated reserves and hence there should be parity in their taxation. Accordingly, the following amendments were made to the IT Act for shifting the taxability from companies to shareholders in case of buy-back in accordance with Section 68 of the Companies Act, 2013.
- Section 115QA of the IT Act shall not apply to buy-back of shares undertaken on or after October 1, 2024.
- Exemption under Section 10(34A) of the IT Act would not be available for buy-back of shares undertaken on or after October 1, 2024.
- Clause (f) has been inserted in Section 2(22) of the IT Act to include proceeds from buy-back in accordance with Section 68 of the Companies Act, 2013 within the ambit of deemed dividend. Consequently, specific exemption provided under Section 2(22)(iv) has been deleted. Further, Section 2(22)(f) has also been included within the ambit of Section 194 of the IT Act.
- No deduction can be claimed under Section 57 of the IT Act against proceeds of buy-back which are deemed as dividend under Section 2(22)(f) of the IT Act.
- While computing capital gains under Section 46A of the IT Act (capital gains on buy-back), consideration received shall be deemed to be ‘nil' in respect of buy-back of shares in accordance with Section 68 of the Companies Act, 2013.
Implications on account of the amended provisions in relation to buy-back on or after October 1, 2024
For companies undertaking buy-back
Companies are absolved from payment of buy-back distribution tax for buy-back undertaken on or after October 1, 2024. Thus, companies would have surplus funds at their disposal. However, they shall be liable to withhold taxes as per Section 194 / Section 195 of the IT Act as proceeds of buy-back are now taxable as dividend.
Dividend taxation in the hands of shareholders
The entire proceeds received by shareholders on buy-back of shares undertaken on or after October 1, 2024 will be taxable as dividend under the head ‘Income from Other Sources' (i.e. the amount of dividend will no longer be restricted to the amount of accumulated profits available with the company undertaking buy-back).
Generally, in case of normal dividends received by the shareholders, the shareholders are eligible to claim deduction in respect of interest expense, if any, up to 20% of the dividend income. However, in case of buy-back on or after October 1, 2024, no deduction can be claimed by the shareholders against buy-back proceeds which are taxed as deemed dividend.
Thus, under the IT Act, the dividend income will be taxable in the hands of the shareholders on gross basis (without any deduction) and the effective tax rate can go up to 35.88% (for taxpayers other than foreign companies) / 38.22% (for foreign companies)
Capital gains taxation in the hands of shareholders
In a buy-back, the shareholder surrenders the shares held by him to the company. Thus, surrender of shares in a buy-back is regarded as a transfer under Section 2(47) of the IT Act, and shareholder is liable to capital gains tax. For the purpose of computing capital gains in respect of buy-back under Section 46A of the IT Act, consideration received shall be deemed to be ‘nil' (as entire proceeds on buy-back is deemed to be dividend). Thus, capital loss (short-term / long-term depending upon the period of holding of the share) will be generated in the hands of shareholders to the extent of ‘cost of acquisition' of shares surrendered in a buy-back undertaken on or after October 1, 2024.
The capital loss so generated shall be eligible for set-off and carry forward for eight assessment years from the assessment year in which the capital loss is incurred. In case of set-off of capital loss (generated on buy-back of shares) with any other capital gains, the taxpayer may be able to save tax up to 14.95% (in case of long-term loss on buy-back) or up to 35.88% (in case of short-term loss on buy-back for taxpayers other than foreign companies) / 38.22% (in case of short-term loss on buy-back for foreign companies). However, capital loss arising on account of buy-back on or after October 1, 2024 might become a permanent cost to the shareholder if no capital gains are earned within the period of limitation (i.e. 8 years from the end of the relevant Assessment Year).
Key issues / challenges on account of the amendments made vide Finance (No.2) Act, 2024 in relation to buy-back taxation
- Section 68 of the Companies Act, 2013 permit buy-back out of free reserves or securities premium or proceed of any shares. As per the amended provisions, entire proceeds received by a shareholder on buy-back of shares will now be taxable as dividend irrespective of the fact whether the buy-back is out of accumulated profits or not.
- There may be genuine cases where the shareholder might have incurred certain expenses like commission / fees / interest in relation to shares which are bought back by the company. However, the amended provisions provide for gross basis of taxation as dividend without any deductions.
- In case of buy-back by listed entities on stock exchange, the benefit of grandfathered cost as per Section 55(2)(ac) of the IT may not be available (even if it is assumed that cost of acquisition is to be computed as per Section 55(2)(ac) of the IT Act) as Section 46A of the IT Act would deem the value of consideration of shares as ‘nil'. Thus, the shareholders would generate capital loss only to the extent of actual cost of acquisition and may lose out on step-up cost on account of grandfathering as per Section 55(2)(ac) of the IT Act.
- In case of non-resident shareholders, there is a need to evaluate whether buy-back of shares would be considered as Dividend or Capital Gains for the purpose Double Taxation Avoidance Agreement to avail treaty benefits (if any).
- A detailed evaluation would be required to determine whether an intermediate company, which receives buy-back proceeds from another company and correspondingly distributes dividends itself, would be eligible for deduction under section 80M of the IT Act.
Conclusion
In conclusion, while the legislative amendments aim to create parity in taxation between dividends and buy-backs, the practical implementation of the amended provisions may result in significant complexities. The higher tax rate on buy-back proceeds in the year of receipt and the associated capital loss set-offs against capital gains, if any, may diminish the attractiveness of buy-backs. The amended provisions may introduce additional challenges, particularly for non-resident shareholders. These unintended consequences highlight the need for a thorough re-evaluation and possible redesign of the buy-back tax provisions. Addressing these issues proactively will be crucial for maintaining a fair and efficient tax environment, ensuring that the legislative intent is fully realized without imposing undue / additional burden on the taxpayers.
Footnotes
1 Computed as per Rule 40BB of Income Tax Rules, 1962
2 Exclusive of surcharge and cess
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