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September 2019

FINANCE (NO. 2) ACT, 2019 – ANALYSIS OF BUY-BACK TAX ON LISTED SHARES

By Janhavi Pandit
Chartered Accountant
Reading Time 10 mins

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).

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