India: Taxation of the buy back of shares
Sumeet Khurana of Lakshmikumaran & Sridharan looks at the proposed changes in Finance Bill 2013 to alter the entire tax regime for the buy back of shares and the negative consequences they will have for taxpayers.
The Indian legal system introduced the concept of buy back of shares in 1999, before which the Indian Company Law prohibited Indian companies from purchasing their own shares. The Working Group on Companies Act, 1956, reviewed the position in light of global developments and observed that buy-back returns surplus cash to the shareholders, increases the underlying share value, supports share prices during temporary weakness and maintains a target capital structure. The recommendations were accepted and Section 77A was introduced in Companies Act. Section 77A mandates that buy backs could only be made from the following sources:
Free reserves of the company;
Securities premium account; and
Proceeds of any shares or other specified securities.
The issue of whether buy back proceeds should be taxable as dividends or capital gains in the hands of recipient shareholders was also resolved by the Finance Act, 1999. Section 46A was introduced which mandates that the proceeds of buy back of shares will be taxable as capital gains in the hands of shareholders. Simultaneously, section 2(22) of the Income Tax Act was amended to state that the buy back proceeds will not be taxed as dividends.
Tax efficient utilisation of buy back provision under erstwhile regime
It is noteworthy that some of the double taxation avoidance agreements (DTAAs) entered into by India provide that the capital gains arising from alienation of shares in an Indian company will be taxable only in the country of residence of the recipient shareholder. In other words, since gains arising from buy back of shares were characterised as capital gains under Section 46A, the same were not taxable in India on account of beneficial provisions of DTAAs. Therefore, many foreign investors opted for buy back as a means of taking away profits earned by their Indian investee company.
The investors from countries with which India does not have such a DTAA also claimed tax exemption on the buy back proceeds by invoking Section 47(iv). Section 47(iv) provided that gains from the transfer of a capital asset to a wholly owned Indian subsidiary are not taxable as capital gains. In other words, foreign companies having wholly owned subsidiaries in India claimed that buy back of shares by an Indian subsidiary company is effectively a transfer of capital asset by such foreign parent to the wholly owned Indian subsidiary. Therefore, even in the absence of a DTAA the buy back proceeds were claimed as tax free in a large number of cases.
Proposed changes in Finance Bill 2013
Finance Bill 2013 has proposed to alter the entire regime relating to buy back of shares. The Bill proposes to introduce a new section 115QA which states that a company proposing to buy back its shares will be liable to tax at the rate of 20% (plus surcharge and cess thereby making the effective rate 22.66%) on the distributed income. The salient features of the new regime are summarised below:
The shares being bought back are not listed on any recognised stock exchange in India;
The tax shall be payable by the company executing buy back of its shares;
The additional tax is payable even if the company is not otherwise liable for any income tax;
The tax needs should be deposited within 14 days of payment to shareholders;
The shareholder is not required to pay any tax on the amount received on account of buy back;
The tax so paid is not liable for deduction in computing taxable income of the shareholder; and
The amount on which tax is to be paid by the company is arrived at by reducing from the amount payable to shareholders on buy back, the amount received on issue of such shares.
Impact of the proposed changes
As noted above, the new regime is only applicable to unlisted shares. Hence, the erstwhile provisions will continue to apply for listed shares. The listed shares, if held as a capital asset for more than 12 months, result in tax fee capital gains on transfer in view of statutory exemption vide section 10(38). Hence, the provisions of section 46A treating buy back as capital gains will only apply to listed shares held for less than 12 months before the date of their sale or transfer.
Further, the new regime does not elaborate on the computation mechanism of the taxable amount. Although the proposed changes state that the taxable amount is arrived at by reducing from the amount payable to shareholders on buy back, the amount received on the issue of such shares, it provides little guidance on the practical issues that may arise. For instance, if the shares were issued by a company in different tranches to the same or different investors at different premiums, then whether the average price of shares will be adopted for computing the taxable amount or whether the computation will be made according to the scrip number of the scrip being bought back. The problem will be acute if the shares are dematerialised and there is no identifiable correlation between shares issued and shares bought back.
The proposed regime also seeks to undo the benefit conferred on foreign investors by the respective DTAAs without renegotiating the treaty. The proposed changes are going to add fuel to the fire of unrest among the foreign investors after last year's retrospective amendments.
Lakshmikumaran & Sridharan
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Sumeet Khurana is joint director in Lakshmikumaran & Sridharan. He is a fellow member of the Institute of Chartered Accountants of India and has more than 12 years of extensive experience in direct tax litigation matters.
He has handled a variety of direct tax litigation matters of leading companies in different sectors such as telecommunications, software, financial and manufacturing. He has also helped clients with structuring options and advised on mergers and acquisitions. He has spoken at various forums on domestic and international tax issues and has also contributed articles to different publications on tax controversies.