BACKGROUND
A company
having distributable profits and reserves may choose one of two ways to return
profit to its shareholders – declare a dividend or buy-back its own shares. In
the former case, the company is liable to dividend distribution tax (DDT) u/s
115-O of the Income-tax Act, 1961 (IT Act), while in the latter case, the
taxability is in the hands of the shareholder on the capital gains as per
section 46A of the IT Act. Such capital gain on unlisted shares had been either
tax-free on account of the application of beneficial tax treaty provisions, or
the taxable amount used to be lower because of special tax treatment accorded
to capital gains under the IT Act (such as indexation benefit).
Unlisted
companies used to be under the spotlight as they opted for the buy-back route
instead of dividend declaration to avoid DDT liability and in such cases the
capital gains tax was lower than DDT due to the above-mentioned reasons. To
counter this practice, the Finance Act, 2013 introduced section 115QA in the IT
Act. This section created a charge on unlisted companies to pay additional
income tax at the rate of 20% on buy-back of shares from a shareholder. In such
cases, exemption was provided to income arising to the shareholder u/s 10(34A)
of the IT Act.
AMENDMENT BY
FINANCE (No. 2) ACT, 2019
The Memorandum
to the Finance Bill noted the instances of tax arbitrage even in case of listed
shares wherein companies resorted to buy-back of shares instead of payment of
dividend. The buy-back option was considered attractive on account of the
following:
(i) Taxability
in case of buy-back: The company did not have any liability and capital gain in
the hands of the shareholder was exempt u/s 10(38) of the IT Act. After
abolition of this exemption, section 112A of the IT Act caused a levy of 10%
tax on capital gain with effect from A.Y. 2019-20;
(ii) Taxability
in case of dividend declaration: The company was liable to DDT but the dividend
was exempt in the hands of the shareholder (except if it exceeded Rs. 10 lakhs
which was taxable at 10% as per section 115BBDA of the IT Act).
In the backdrop
of companies (including major IT companies) implementing buy-back schemes worth
Rs. 1.43 trillion in the past three years to return cash to shareholders, the
Finance Bill presented on 5th July, 2019 introduced an
anti-avoidance measure. Section 115QA of the IT Act – tax on distributed income
to shareholders that was hitherto applicable only to buy-back of shares not
listed on a recognised stock exchange – has been made applicable to all
buy-back of shares, including of listed shares.
By a parallel
amendment, exemption is provided in section 10(34A) of the IT Act for income
arising to the shareholder on account of such buy-back of shares.
The amendments
are effective from 5th July, 2019.
ANALYSIS
Calculation of buy-back tax
The company
shall be liable to additional income-tax (in addition to tax on its total
income – whether payable or not) at the rate of 20% on distributed income. As
per clause (ii) of Explanation to section 115QA(1) of the IT Act, the
distributed income means consideration paid on buy-back of shares, less amount
received by it for the issue of shares, determined as prescribed in Rule 40BB
of the Income tax Rules. The Rule describes various situations and
circumstances for determination of the amount received by the company. This
includes subscription-based issue, bonus issue, shares issued on conversion of
preference shares or debentures, shares issued as part of amalgamation,
demerger, etc.
For issue of
shares not covered by any of the specific methods prescribed in the Rule, the
face value of the share is deemed to be the amount received by the company as
per Rule 40BB(13). Applying this mechanism, if a shareholder has acquired
shares (face value Rs. 10) from an earlier shareholder at Rs. 100 and the
buy-back price is Rs. 500; the buy-back tax liability for the company will be
computed as Rs. 490 (500 less 10) and not on the gain of Rs. 400 (500 less 100)
in the hands of the shareholder.
In case of
buy-back of listed shares, provisions of Rule 40BB(12) will come into the
picture. This states that where the share being bought back is held in dematerialised
form and the same cannot be distinctly identified, the amount received by the
company in respect of such share shall be the amount received for the issue of
share determined in accordance with this rule on the basis of the
first-in-first-out method. If the shares have been dematerialised in different
tranches and in different orders, practical challenges will be faced in
computing buy-back tax.
Dividend or buy-back – what is more beneficial?
After this
amendment, a question arises as to whether a company is better off declaring
dividend rather than repurchasing its own shares? The pure comparison of the
rates of tax u/s 115-O of the IT Act: DDT at 20.56%, and u/s 115QA of the IT
Act: buy-back tax at 23.29%, suggest so. However, if one adds the taxation of
dividend income in the hands of the shareholder at the rate of 10% for dividend
in excess of Rs. 10 lakhs as per section 115BBDA of the IT Act, higher
surcharge of 25% / 37% on tax to the DDT tax liability, the overall outcome for
the company and the shareholder taken together gives a different perspective.
This is reflected in the following table:
The comparison
of total tax impact column shows tax arbitrage in case of the buy-back option.
Section 14A disallowance
As per section
14A of the IT Act, expenses incurred in relation to income that does not form
part of total income is not allowed as deduction. In the year of buy-back where
additional tax is paid by the company and exempt income is claimed by the
shareholder, section 14A of the IT Act may be triggered to make a disallowance
in the hands of the shareholder. One may draw reference to the Supreme Court
decision in the case of Godrej & Boyce Manufacturing Company Ltd.
(394 ITR 449). In the context of disallowance u/s 14A of the IT Act on
tax-free dividend income that was subjected to DDT u/s 115-O, the Supreme Court
had ruled in favour of making a disallowance. The underlying principle of the
decision may be extended to cases covered by section 10(34A) of the IT Act as
well in the year of buy-back to contend that although buy-back has suffered
additional tax in the hands of the company, the applicability of section 14A of
the IT Act persists in the hands of the shareholder.
Whether loss in the hands of the shareholder will be
available for set off?
If buy-back
price (say 500) is lower than the price at which the shareholder acquired the
shares from the secondary market (say 700), the shareholder will record a loss
of Rs. 200. Section 10(34A) of the IT Act provides that any ‘income’ arising to
a shareholder on account of buy-back as referred to in section 115QA of the IT
Act will not be included in total income. Therefore, whether ‘income’ will also
include loss of Rs. 200, and as such this amount is to be ignored and not
considered for carry forward and set off purposes.
The Kolkata
Tribunal in the case of United Investments [TS-379-ITAT-2019(Kol.)]
examined whether when gain derived from the sale of long-term listed shares was
exempt u/s 10(38) of the IT Act, as a corollary loss incurred therefrom was to
be ignored. The Tribunal opined that in a case where the source of income is
otherwise chargeable to tax but only a specific specie of income derived from
such source is granted exemption, then in such case the proposition that the
term ‘income’ includes loss will not be applicable. It remarked that it cannot
be said that the source, namely, transfer of long-term capital asset being
equity shares by itself is exempt from tax so as to say that any ‘income’ from
such source shall include ‘loss’ as well. The legislature could grant exemption
only where there was positive income and not where there was negative income.
Referring to CBDT Circular No. 7/2013 on section 10A, the Tribunal noted that
exemption was allowable where the income of an undertaking was positive; and
the Circular also provided that in case the undertaking incurs a loss, such
loss is not to be ignored but could be set off and / or carried forward.
Accepting the reliance on the Calcutta High Court ruling in Royal
Calcutta Turf Club (144 ITR 709), the Mumbai Tribunal in Raptakos
Brett & Co. Ltd. (69 SOT 383), allowed benefit of carry forward of
losses.
Applying the
principles of the above decision, it can be said that transfer of listed shares
in a buy-back scheme is a taxable event per se and it is only a positive
income arising to the shareholder on buy-back effected as referred to in
section 115QA of the IT Act that has been granted exemption by the legislature.
In case of loss resulting from the buy-back price being lower than the
acquisition cost, it may be considered for carry forward and set off provisions
as per the relevant provisions of the IT Act. However, litigation on this
aspect cannot be ruled out.
Re-characterisation still possible?
In the past and
now in the recent case of Cognizant Technology Solutions, the tax authorities
have sought to disregard the buy-back scheme and treat it as distribution of
dividend. The General Anti-Avoidance Rules (GAAR) effective from 1st
April, 2017 has empowered the tax department to disregard and re-characterise
arrangements if the main purpose is to obtain tax benefit and other conditions
are satisfied.
Now that
distribution out of profits by way of dividend declaration and buy-back of
shares is chargeable to tax in the hands of the company as additional income,
will the income tax department still question the choice and manner chosen by
the company under the GAAR provisions remains to be seen. If such an attempt is
made, it would seek to ignore the very form of the transaction. The taxpayers
have recourse to CBDT Circular No. 7/2017 wherein it was clarified that GAAR
will not interplay with the right of the taxpayer to select or choose the
method of implementing a transaction.
A buy-back
scheme undertaken by a company compliant with the provisions of the Companies
Act and other regulatory frameworks may be alleged as a colourable device to
evade payment of DDT and tax on dividend income in the hands of the recipient.
The action of the tax authorities can be refuted by placing reliance on the
decision of the Mumbai Tribunal in the case of Goldman Sachs (India)
Securities (P) Ltd. (70 taxmann.com 46) which laid down that merely
because a buy-back deal results in lesser payment of taxes it cannot be termed
as a colourable device.
CONCLUDING
REMARKS
With the
immediate applicability of buy-back tax from 5th July, 2019 and
considering that it is an additional tax outflow for the company, the buy-back
price offered by companies and the return on investment will be affected. To
save the tax, companies may use surplus funds for additional investments or
deploy them back again in business rather than distribution to shareholders.
One will have
to wait and see if the grandfathering clause is considered by the Finance
Minister to protect and safeguard listed companies whose buy-back was already
underway as on budget day i.e. 5th July, 2019. Besides, the current
buy-back rules may need to be revisited to provide for situations that are
relevant to shares of listed companies. The rules ought to factor in a
situation where shares are acquired on a stock exchange at a higher price than
the issue price received by the company. If the acquisition price is considered
in such an instance, the buy-back tax will essentially be computed on the gain
in the hands of the shareholder (buy-back price less acquisition price).
