BACKGROUND
The tax treatment of buy-back of shares has been a focal point of legislative intervention since the concept’s inception. In a buy-back, a company purchases its own shares for cancellation and pays consideration to the shareholders. From a shareholder’s perspective, this transaction resembles the sale of shares, with the company itself acting as the buyer. However, from the standpoint of the Companies Act, a company purchasing its own shares cannot hold them as treasury stock, and the quantum of the buy-back is partially linked to reserves, aligning its treatment more closely with dividends. This distinction has significantly influenced the legislative framework governing the taxation of buy-backs.
Prior to the Finance Act of 2013, the law provided that any consideration received by a shareholder on a buy-back was not treated as ‘dividend’ due to a specific exemption under section 2(22)(iv). Such buy-back considerations were instead taxed as ‘capital gains’ under section 46A in the hands of shareholders. In the case of shareholders residing in Mauritius or Singapore, India did not have the right to tax capital gains, allowing the entire buy-back proceeds to be repatriated tax-free. Consequently, companies increasingly used buy-backs as an alternative to dividend payments, thereby avoiding the Dividend Distribution Tax (DDT).
This tax arbitrage was addressed by the Finance Act of 2013 through the introduction of section 115QA, which shifted the tax liability to the company executing the buy-back. The Memorandum to the Finance Bill 2013 highlighted the issue:
“Unlisted Companies, as part of tax avoidance schemes, are resorting to buy-backs of shares instead of paying dividends to avoid the payment of tax by way of DDT, particularly where the capital gains arising to the shareholders are either not chargeable to tax or are taxable at a lower rate.”
Following the amendment, the regime for buy-backs became analogous to that of dividends, with the company paying the tax, and the income being exempt in the hands of shareholders under section 10(34A). The Finance Act 2020 abolished DDT (i.e., section 115-O) and reverted to the classical method of taxation, wherein dividends are taxed in the hands of the shareholders. This change led to a shift from a flat DDT rate to variable tax rates for shareholders — 36 per cent for residents and 20 per cent for non-residents (potentially reduced under DTAA rates). However, section 115QA remained intact, with companies continuing to pay tax at a flat rate of 23.296 per cent (inclusive of surcharge and cess), while the shareholders’ income remained exempt under section 10(34A). This discrepancy once again created an opportunity for tax arbitrage. For resident individual shareholders, dividends were taxed at 36 per cent, whereas buy-backs were taxed at 23.296 per cent. Moreover, since the tax was borne by the company, a larger distributable amount remained with the shareholders, prompting unlisted companies to favour buy-backs over dividend declarations to exploit the tax advantage.
This practice was curtailed by the Finance Act (No. 2) of 2024, which introduced a classical, albeit unconventional, split in the tax treatment. The new law proposes to treat the consideration received on a buy-back as a dividend, while the extinguishment of shares by shareholders is treated as a capital gain. This hybrid treatment is the focus of the article’s analysis.
LAW PRIOR TO AMENDMENT
Section 115QA mandated a flat rate of taxation at 23.296 per cent on the company executing the buy-back, while the consideration received by the shareholder was exempt under section 10(34A). The law, as it stood, had several unique features:
- Tax Liability on the Company: The obligation to pay tax was placed on the company, allowing it to distribute the entire amount computed under section 68 of the Companies Act, 2013, to shareholders. The tax paid on the buy-back did not count towards the limits set by the law, enabling a higher payout to shareholders. Consequently, the effective tax rate, on a derivative basis, reduced to 18.89 per cent (calculated as 23.296/123.926*100).
- Tax on Distributed Income (DI): The tax was levied on the distributed income, which was defined as the amount received by the company upon the issuance of shares, minus the consideration paid on the buy-back. This definition excluded the cost to the shareholder in cases where shares were purchased through secondary transfers, resulting in tax being paid on a higher amount than the actual income generated.
- Challenges for Non-Resident Shareholders: Since the tax was paid by the company in addition to the corporate tax, non-resident shareholders faced difficulties in claiming tax credits in their home countries. This scenario often led to the possibility of double taxation.
- Exemption for Shareholders: With the income being exempt in the hands of shareholders and the tax borne by the company, listed companies frequently offered buy-back prices above market value to incentivize participation. Shareholders, seeing significant value appreciation, were thus motivated to tender their shares in the buy-back.
This tax arbitrage was addressed by the Finance Act (No. 2) of 2024, which introduced significant changes to the tax regime governing buy-backs.
AMENDMENT BY FINANCE (NO. 2) ACT 2024
Finance (No. 2) Act 2024 introduced series of amendment introducing novel method to tax buy back. Following are list of amendments:
i) Introduction of section 2(22)(f) in the ‘Act’ to state that any payment by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 68 of the Companies Act, 2013 is taxable as dividend. (Clause 3 of the Bill)
ii) Insertion of proviso to section 10(34A) of the Act to provide that this clause shall not apply with respect to any buy-back of shares by a company on or after the 1st October, 2024. (Clause 4 of the Bill).
iii) Insertion of a proviso to section 46A of the Act w.e.f. 1st October, 2024 to provide that where a shareholder receives any consideration of the nature referred to in sub-clause (f) of section 2(22) from any company, in respect of any buy-back of shares, then the value of consideration received by the shareholder shall be deemed to be “nil’. (Clause 18 of the Bill)
iv) Insertion of a new proviso to section 57 to provide that that no deduction shall be allowed in case of dividend income of the nature referred to in sub-clause (f) of clause (22) of section 2. (Clause 24 of the Bill)
v) Insertion of a further proviso to sub-section 115QA(1) of the Act whereby it would not apply in respect of any buy-back of shares that takes place on or after 1st October, 2024. (Clause 39 of the Bill)
vi) Amendment to section 194 of the Act on deduction of taxes at source @10 percent on payments of dividend, to make it applicable to sub-clause (f) of clause (22) of section 2. (Clause 52 of the Bill)
Provisions are effective from 1st October, 2024. In other words, buy back before cut-off date will be governed by section 115QA. It is advisable that buy back scheme is complete in all respects (including filing with ROC), to avoid transitionary issues.
IMPLICATIONS IN HANDS OF COMPANY
Previously, companies were required to pay buy-back tax under section 115QA. With the recent legislative changes, the law now treats the payment of consideration by the company as a dividend, making it taxable in the hands of the shareholder. Consequently, the company assumes the role of a tax deductor. It will be required to deduct tax under section 194 or section 195 of the Income Tax Act, depending on the specific circumstances. Following the deduction, the company must remit the tax and comply with the filing requirements for TDS (Tax Deducted at Source) and SFT (Statement of Financial Transactions) returns.
The treatment of buy-back proceeds as dividends remains consistent even in scenarios where the company does not have accumulated profits. The deliberate omission of the phrase “to the extent of accumulated profits,” which is present in other provisions of Section 2(22), underscores the intent to classify buy-back transactions as dividends irrespective of the company’s profit status. This is particularly relevant in cases where the buy-back is funded from the securities premium account. However, from an equity perspective, securities premium fundamentally represents a repayment of capital, and therefore, its characterization as a dividend raises questions. The underlying principle is that securities premium should not be treated as a dividend, as it does not constitute income in the traditional sense but rather a return of capital to shareholders.
An intriguing question arises regarding buy-backs conducted under sections 230 to 232 of the Companies Act, which require approval from the National Company Law Tribunal (NCLT). The query is whether such buy-backs will be treated as dividends. This ambiguity exists because section 2(22)(f) of the Income Tax Act specifically refers to the purchase of shares in accordance with the provisions of section 68 of the Companies Act, 2013. A similar situation emerged concerning section 115QA, where the definition of buy-back initially referred only to section 77A of the Companies Act, 1956. This definition was subsequently broadened by the Finance Act of 2016 to include the purchase of shares in accordance with the provisions of any law in force relating to companies. However, this amendment was applied prospectively.
In the absence of a similar broadening of the language in the current context, it can be argued that only buy-backs conducted in accordance with section 68 of the Companies Act, 2013, fall within the scope of the new definition of dividend. At the same time, care and caution needs to be exercised as Court / Tribunal in undernoted decision1 have recharacterised buy back as dividend.
On similar lines, redemption of preference shares is governed by section 55 of Companies Act 2013 and should be outside the purview of provisions.
TAX IMPLICATIONS IN THE HANDS OF RESIDENT SHAREHOLDERS
CHARACTERISATION OF BUY-BACK CONSIDERATION
Section 2(22) of the Income-tax Act defines “dividend,” and clause (f) within this section specifically includes payments made by a company for purchasing its own shares as dividends. This definition of dividend is applied consistently across the entire Act, meaning that the consideration received by shareholders during a buy-back transaction will be treated as dividend income. Consequently, this income must be reported under the head “Income from Other Sources” and taxed accordingly.
1 Cognizant Technology-Solutions India Pvt. Ltd., vs. ACIT [2023] 154 taxmann.com 309 (Chennai - Trib.); Capgemini India (P.) Ltd., In re [2016] 67 taxmann.com 1 (Bombay HC)
Section 57 of the Act prohibits any deductions against this income, implying that the entire buy-back consideration will be taxed on a gross basis, without allowing any deduction for the original cost of the shares. Shareholders must also account for this dividend income when calculating their advance tax obligations. However, interest obligations under Section 234C will only commence from the quarter in which the dividend is actually received.
The Act allows this dividend income to be set off only against losses under the heads “House Property” or “Business Loss.” The fiction of treating buy-back consideration as dividend is intended to be applied uniformly throughout the provisions of the Act. For shareholders that are domestic companies, the benefit of Section 80M should be available. In essence, buy-back consideration deemed as dividend can be considered by the company if it further declares dividends to its shareholders or engages in additional buy-backs, allowing the company to claim a deduction under Section 80M. As a result, tax will only be paid on the income exceeding the relief available under Section 80M. Additionally, an Indian company can claim a capital loss for the shares bought back and set it off against future capital gains, effectively allowing for a double benefit under the new regime.
TAX RATE ON DIVIDEND INCOME
Dividend income, classified as “Income from Other Sources,” is taxed according to the applicable income tax slab rates. The highest tax rate for a resident individual taxpayer is 36 per cent. It’s important to note that the surcharge on Buy-Back Tax (BBT) is capped at 12 per cent, compared to a 15 per cent surcharge on dividend income, potentially resulting in a higher overall tax burden on dividend income. On the other hand, if a shareholder’s income falls below the taxable slab limits, the entire dividend income may be tax-free, allowing the shareholder to carry forward the cost of acquisition as a capital loss.
SHARES HELD AS STOCK IN TRADE
The new scheme of taxation primarily addresses cases where shares are held as capital assets. However, an important issue arises when shares are held as stock-in-trade, which is particularly relevant because dividend income is generally required to be offered for tax under the head “Income from Other Sources” without any deductions.
In the author’s view, since these shares are held as business assets, the appropriate head of income for dividend income should be “Business Income” under Section 28 of the Income-tax Act2. This approach would allow for a more accurate reflection of the economic reality of holding shares as part of the business inventory. Accordingly, the cost of shares should be allowed as a deduction when computing the business income, ensuring that the income is taxed in a manner consistent with its treatment as part of the business operations3. This interpretation aligns with the principle of matching income with related expenses, thereby providing a fair and logical tax outcome for shares held as stock-in-trade.
2 Refer CIT v Coconada Radhaswami Bank Ltd (1965) 57 ITR 306 (SC)
3 Badridas Daga v CIT (1958) 34 ITR 10 (SC); Dr TA Quereshi v CIT (2006) 287 ITR 547 (SC)
COST OF ACQUISITION OF SHARES
From the shareholder’s perspective, the buy-back results in the extinguishment of shares. Under the law, the cost of acquisition of these shares is treated as a capital loss, which can then be set off against other capital gains. This treatment is facilitated by an amendment to Section 46A, a special provision introduced by the Finance Act of 1999. This section states that, subject to the provisions of Section 48, the difference between the consideration received on buy-back and the cost of acquisition is deemed to be capital gains for the shareholder.
The Finance Act (No. 2) 2024 adds a proviso to Section 46A, deeming the value of the consideration received by the shareholder as Nil. Since the consideration is deemed Nil, the cost of acquisition becomes a capital loss, which can be carried forward according to the provisions of the capital gains chapter. The law’s intention is to allow shareholders to offset this loss against future gains, thereby economically maintaining the status quo. The Memorandum to the Finance Bill provides detailed numerical examples illustrating this tax neutrality.
Because the consideration is deemed Nil, this treatment applies uniformly across all provisions of the Act. Notably, the provisions of Section 50D or Section 50CA cannot be used to notionally increase the consideration. This fiction of Nil consideration will also hold true in the context of transfer pricing provisions involving non-resident Associated Enterprises (AEs).
An interesting question arises regarding the determination of the cost of acquisition for the purposes of Section 46A. Shareholders may acquire shares through direct purchase, various modes specified in Section 47 read with Section 49, or by acquiring shares before 31st January, 2018, which would qualify for the grandfathering benefit under Section 55(2)(ac). Section 46A references the cost of acquisition and explicitly makes its provisions subject to Section 48, which outlines the mode of computation but does not define the cost of acquisition itself.
While Section 49 provides the cost of acquisition for specific modes of acquisition, Section 46A does not directly reference this section, nor does it explicitly refer to Section 55, which defines the cost of acquisition for the purposes of Sections 48 and 49. This creates ambiguity, as Section 46A does not provide a clear fallback to Sections 49 and 55 for determining the cost of acquisition.
There are two possible interpretations of this issue:
1. Strict Interpretation (Recourse Not Permissible): Some may argue that Section 46A, being a special provision, is intended to override the general provisions of Sections 45 and 47. If this interpretation is followed, it would imply that recourse to other provisions, such as those allowing for a step-up in cost under Sections 49 and 55, may not be permissible. This view treats Section 46A as a self-contained code, limiting the ability to refer to other sections for determining the cost of acquisition.
2. Contextual Interpretation (Recourse Permissible): On the other hand, it can be argued that this interpretation is too extreme. Section 46A is explicitly made subject to Section 48, and Section 55 provides the cost of acquisition for the purposes of Section 48. Therefore, it stands to reason that the cost step-up provisions, including those under the grandfathering rules in Section 55(2)(ac), should be available to shareholders. Additionally, the headnotes of Section 49 state that it pertains to the “cost with reference to certain modes of acquisition,” which suggests that it should be interpreted in a manner similar to Section 55. This interpretation aligns with the legislative intent to preserve the cost base for shareholders, ensuring that they are not disadvantaged by the lack of explicit reference in Section 46A.
In conclusion, while there is room for debate, the contextual interpretation that allows recourse to Sections 49 and 55 seems more consistent with the broader legislative intent and the structure of the Income-tax Act. This approach ensures that shareholders can benefit from the cost step-up provisions, thereby maintaining their cost base and achieving a fairer tax outcome.
The grandfathering provisions under Section 55(2)(ac) require a comparison of three key values: the cost of acquisition, the fair market value of the asset as on 31st January, 2018, and the full value of consideration received or accruing as a result of the transfer. Among these, the lowest value must be adopted as the cost base for computing capital gains.
However, the proviso to Section 46A introduces a significant twist by deeming the third limb—the full value of consideration received — to be Nil in the context of buy-back transactions. As a result, the benefit of the grandfathering provisions effectively becomes unavailable in these cases. Since the deemed consideration is Nil, the computed capital gains could potentially be much higher, negating the protective intent of the grandfathering rules.
Given this scenario, shareholders might find themselves better off by selling their shares in the open market and paying tax on the resultant long-term capital gains, rather than opting for a buy-back. This approach would allow them to fully utilise the grandfathering benefit, thereby reducing their tax liability. Consequently, this provision makes buy-back transactions less attractive compared to a straightforward market sale, especially for shares that have appreciated significantly since 31st January, 2018.
TREATMENT OF CAPITAL LOSS
The cost of acquisition treated as a capital loss in the hands of the shareholder falls under the head “Capital Gains” and is governed by Section 74. A short-term capital loss can be set off against either short-term or long-term capital gains, while a long-term capital loss can only be set off against long-term gains. Overall, capital losses can be carried forward for a period of eight years.
Capital loss from a buy-back may arise from both listed and unlisted shares and can be set off against capital gains from the sale of shares, immovable property, or any other capital asset. This broad spectrum of gains available for set-off provides flexibility to shareholders. There may be instances where capital loss may not be available for set off:
- If no future gains arise within the eight-year period, the capital loss becomes a dead cost.
- In cases where the transfer is exempt under the Income-tax Act, such as transfers between a holding company and its subsidiary, the capital loss from a buy-back may not be allowable for set-off. Although the buy-back would be fully taxed, the exemption on the transfer prevents the recognition of the capital loss, leading to double jeopardy for the holding company, which faces taxation without the benefit of loss offset.
- If shares were converted into stock-in-trade prior to 1st October, 2024, and the buy-back occurs after this date, the entire proceeds would be taxed as dividend income. Simultaneously, the suspended capital gains tax on the conversion would become taxable under Section 45(2) of the Income-tax Act. This situation again results in double jeopardy, as the shareholder faces dual taxation. However, in such cases, the fair market value of the stock-in-trade as on the date of conversion should be allowed as a business loss at the time of the buy-back, providing some relief to the tax payer. From an equity perspective, the consideration is taxed as a dividend at a rate of 36 per cent, while the set-off of capital loss is available against long-term gains taxed at 12.5 per cent or short-term gains at 20 per cent. This discrepancy results in higher taxable income, reducing the real gain in the hands of the shareholder. Additionally, shareholders must file a return of income to carry forward the loss in accordance with Section 80, even if they have no other income chargeable to tax.
For the company, capital loss is attached to the company itself. In cases of merger or demerger, there are no transitional provisions since Section 72A only addresses the transfer of business loss. Furthermore, shareholders of unlisted companies cannot carry forward and set off capital losses if there is a change in shareholding that triggers Section 79.
TAX IMPLICATIONS IN HANDS OF NON-RESIDENT SHAREHOLDER
TAX RATE
For non-resident shareholders, dividend income is taxed under Section 115A of the Income-tax Act at a flat rate of 20 per cent (plus applicable cess and surcharge). However, this rate can be reduced under the provisions of the Double Taxation Avoidance Agreement (DTAA) between India and the shareholder’s country of residence. Depending on the specific treaty, the tax rate may be reduced to 5 per cent4 or 10 per cent5 or 15 per cent6, provided the non-resident shareholder meets the treaty eligibility criteria, such as the Principal Purpose Test (PPT) or the Limitation of Benefits (LOB) clause.
4 Hongkong, Malaysia, Mauritius if shareholding in India Company is at least 15%
5 UK, Norway, Ireland, France
6 USA, Singapore
Regarding the cost of shares, it will be treated as a capital loss, which can be set off in the manner prescribed earlier. However, this brings into focus a potential tax disadvantage for Foreign Direct Investment (FDI) shareholders who do not have any other investments in India. The capital loss arising from the buy-back of shares can typically only be set off against capital gains from the sale of shares in the FDI company. In such cases, the conventional route of declaring dividends might be more tax-efficient for the non-resident shareholder, as it would allow for a more immediate and potentially beneficial tax treatment compared to the deferral and potential loss of the capital loss offset in the buy-back scenario.
DIVIDEND CHARACTERISATION UNDER DTAA
Shareholders have the option to choose between the provisions of the Double Taxation Avoidance Agreement (DTAA) and domestic law, depending on which is more beneficial to them. The Dividend Article under most DTAAs offers a concessional rate of taxation. However, an important consideration is whether the dividend defined under Section 2(22)(f) of the Income-tax Act qualifies as a dividend under the DTAA.
One approach is the “pick and choose” method, where the shareholder adopts the domestic law definition of “dividend” for characterisation purposes and then opts for the concessional DTAA rate. This approach has been supported by courts and tribunals in various cases7, allowing shareholders to leverage the more favourable aspects of both the domestic and treaty provisions.
7 ACIT vs. J. P. Morgan India Investment Company Mauritius Ltd [2022] 143 taxmann.com 82 (Mumbai - Trib.)
Alternatively, one might argue that the dividend under Section 2(22)(f) does not fall within the Dividend Article of the DTAA. If successful, this argument would imply that the consideration received during the buy-back is not taxable as a dividend under the DTAA. Instead, it would fall under the Capital Gains Article, with its computation governed by domestic law. Under Section 46A, the consideration is deemed to be Nil, and this fiction remains absolute, irrespective of the taxability of the consideration in the hands of the shareholder. The “Other Income” Article in the DTAA would only apply if the income is not addressed by any other specific Article.
For this discussion, let’s consider the Dividend Article as defined in the OECD Model Convention (MC) and the UN Model Convention (MC). The definition of “dividend” under these conventions comprises three parts:
1. Income from shares;
2. Income from other rights, not being debt-claims, participating in profits; and
3. Income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the Contracting State of which the company making the distribution is a resident.
These parts are interconnected, particularly through the use of “other” in the second and third parts, which serves as a linking element. While the first two parts are intended to be autonomous, the third part is complementary, including income from other corporate rights, provided it is subject to the same tax treatment as income from shares under the laws of the source State. However, this does not automatically imply that all income treated domestically as dividend would fall within this definition.
Arguments Supporting that Dividend under Section 2(22)(f) Does Not Fall Within the Definition of Dividend under the DTAA:
- For income to fall under any of the three limbs of the Dividend definition, it must originate “from” shares, other rights, participation in profits, or corporate rights. The term “from” implies a direct relationship between the income and the asset. The asset must exist at the time the income arises, which is a crucial aspect of the definition.
- All three limbs require the asset to continue existing after the income is realised. This is consistent with the Supreme Court’s decision in Vania Silk Mills, where it was held that the charge under the capital gains article fails if the asset no longer exists after the transaction.
- The Dividend Article should be interpreted from the shareholder’s perspective, not the company’s. Section 2(22)(f) is specific to the company, as indicated by the words “any payment by a company on purchase of its own shares from a shareholder.” From the shareholder’s perspective, this payment is the consideration received for selling shares, and the tax consequences should not differ merely because the shares are purchased by the company itself.
- In cases involving buy-backs, there is a conflict between the Capital Gains Article and the Dividend Article. From the shareholder’s perspective, the transaction results in the extinguishment of rights in the company. This is acknowledged by the Memorandum to the Finance Bill, and the amendment to Section 46A, which deems the consideration to be Nil, indicates that the transaction is governed by capital gains provisions. The characterization of the transaction under the treaty should remain consistent, even if domestic law prescribes a different method of taxing the consideration.
- The first limb of the Dividend definition deals with “income from shares.” If this were interpreted to include income from the alienation of shares, it would render the Capital Gains Article redundant.
- The references to “other rights” or “other corporate rights” should be understood as rights arising from shareholding, not from the sale of shares. Klaus Vogel supports this interpretation, noting that “corporate rights” are meant to distinguish from “contractual rights” and should stem from a member’s rights within the company, not from a creditor’s right based on a contract or statute.
““With respect to the second element, income will stem from ‘corporate rights’ if it flows to the recipient because of a right held in the company, rather than against the company which implies a direct deviation from a member right as opposed to the right of a creditor based on any other contractual or statutory relationship.”
- The OECD Commentary on Articles 10 also suggests that payments reducing membership rights, such as buy-backs, do not fall within the definition of dividends. Following are relevant extracts:
“The reliefs provided in the Article apply so long as the State of which the paying company is a resident taxes such benefits as dividends. It is immaterial whether any such benefits are paid out of current profits made by the company or are derived, for example, from reserves, i.e., profits of previous financial years. Normally, distributions by a company which have the effect of reducing the membership rights, for instance, payments constituting a reimbursement of capital in any form whatever, are not regarded as dividends.”
Arguments Supporting that Dividend under Section 2(22)(f) Does Fall Within the Definition of Dividend under the DTAA:
- The DTAA does not exhaustively define “dividend,” leaving it to the contracting states to provide definitions. As such, Section 2(22)(f) could fall within the scope of the DTAA’s definition.
- Characterising capital gains transactions as dividends is not unprecedented. For instance, Section 2(22)(c), which deals with capital reduction, treats payments as deemed dividends to the extent of accumulated profits.
- The Mumbai Tribunal in KIIC Investment Company vs. DCIT8 sdealt with whether deemed dividends under Section 2(22)(e) fall within the Dividend Article of the India-Mauritius DTAA. The Tribunal held that, given the explicit reference to domestic law in the third limb of the definition, deemed dividends under Section 2(22)(e) should be considered dividends under the DTAA. Following are relevant extract:
“We have considered the aforesaid plea of the assessee, but do not find it acceptable. The India-Mauritius Tax Treaty prescribes that dividend paid by a company which is resident of a contracting state to a resident of other contracting state may be taxed in that other state. Article 10(4) of the Treaty explains the term “dividend” as used in the Article. Essentially, the expression ‘dividend’ seeks to cover three different facets of income; firstly, income from shares, i.e., dividend per se; secondly, income from other rights, not being debt claims, participating in profits; and, thirdly, income from corporate rights which is subjected to same taxation treatment as income from shares by the laws of contracting state of which the company making the distribution is a resident. In the context of the controversy before us, i.e., ‘deemed dividend’ under Section 2(22)(e) of the Act, obviously the same is not covered by the first two facets of the expression ‘dividend’ in Article 10(4) of the Treaty. So, however, the third facet stated in Article 10(4) of the Treaty, in our view, clearly suggests that even ‘deemed dividend’ as per Sec. 2(22)(e) of the Act is to be understood to be a ‘dividend’ for the purpose of the Treaty. The presence of the expression “same taxation treatment as income from shares” in the country of distributor of dividend in Article 10(4) of the Treaty in the context of the third facet clearly leads to the inference that so long as the Indian tax laws consider ‘deemed dividend’ also as ‘dividend’, then the same is also to be understood as ‘dividend’ for the purpose of the Treaty.”
8 [2019] 101 taxmann.com 19 (Mumbai - Trib.)
- The OECD Commentary on Article 13 supports the idea that domestic law treatment can be decisive in determining whether a transaction falls within the Dividend Article, even when the transaction involves the alienation of shares.
“If shares are alienated by a shareholder in connection with the liquidation of the issuing company or the redemption of shares or reduction of paid-up capital of that company, the difference between the proceeds obtained by the shareholder and the par value of the shares may be treated in the State of which the company is a resident as a distribution of accumulated profits and not as a capital gain. The Article does not prevent the State of residence of the company from taxing such distributions at the rates provided for in Article 10: such taxation is permitted because such difference is covered by the definition of the term “dividends” contained in paragraph 3 of Article 10 and interpreted in paragraph 28 of the Commentary relating thereto, to the extent that the domestic law of that State treats that difference as income from shares.”
- Klaus Vogel’s Commentary (5th Edition, Page 939) also emphasises that domestic law treatment should prevail when determining whether a payment is considered a dividend, thereby supporting the inclusion of Section 2(22)(f) within the DTAA’s Dividend Article.
“Sale proceeds of shares and other corporate rights generally fall under Article 13 and not under Article 10 ODCD and UN MC, as such income is not derived from shares within the meaning of the OECD MC but stems from the alienation of shares. If one considered sale proceeds to come within the meaning of ‘income from shares’, Article 13 OECD and UN MC would still prevail, however, by virtue of its more specialised nature regarding such transactions. Problems may arise, however, in either case, to the extent that such proceeds may represent undistributed profits of the paying company, as it would open up an easy way to avoid source taxation, in particularly by way of share repurchase in lieu of dividend distribution. Thus, the OECD MC Comm. Acknowledges that Article 13(5) does not prevent source State from taxing ‘the difference between the selling price and the par value of the shares’ as dividend in accordance with Article 10 OECD and UN MC where the shares are sold to the issuing company.
……… (Page 981)
Moreover, nothing in the provision requires income to be derived from an ‘equity investment’: a mere recharacterisation of the income (rather than the underlying right) under domestic law is sufficient to trigger the application of Article 10.”
In the author’s view, the reference to domestic law is broad enough to encompass payments falling within the scope of Section 2(22)(f), allowing them to be treated as dividends under the DTAA. This interpretation aligns with the intention to provide clarity and consistency in the application of tax treaties.
TRANSFER PRICING IMPLICATIONS
Under the Buy-Back Tax (BBT) regime, it was possible to argue that in cases involving Associated Enterprises (AEs), the amount of consideration paid by the company needed to be benchmarked against the Arm’s Length Price (ALP) criteria. Shareholders were largely indifferent to this aspect since the income from the buy-back was exempt in their hands. However, the new taxation regime introduces an intriguing dimension to this issue.
Transfer pricing regulations focus on the substance of the transaction. While the transaction is still treated as a dividend in the hands of the company, it will now require benchmarking as if the buy-back were a transfer, meaning the company must determine the ALP of the consideration paid. Theoretically, there should not be any adverse implications if the consideration paid does not align with the ALP, since buy-back payments are not deductible expenses for the company. The company’s primary responsibility remains the withholding of tax.
A plausible interpretation is that the withholding tax obligation applies to the transaction value rather than the ALP value. In hands of shareholder Section 46A deems the consideration to be Nil for tax purposes. This fiction is absolute and is not affected by the ALP price. Thus, benchmarking needs to be done for compliance purposes without any impact on tax computation.
INTERPLAY WITH SECTION 56(2)(X)
Buybacks often involve a company using its free cash flow to purchase its own shares, leading to an increase in the remaining shareholders’ stakes without them having to dip into their own cash reserves. This tactic has become a popular method for realigning shareholding structures, particularly in the context of family arrangements or the elimination of cross holdings. However, when buy-backs are executed at prices below the Rule 11UA value, questions inevitably arise regarding the applicability of Section 56(2)(x).
At first glance, Section 56(2)(x) applies to the “receipt” of property, a term that has been interpreted to mean the receipt that benefits the recipient. In the case of a buy-back, the shares are technically received by the company solely for the purpose of cancellation, with no economic enrichment resulting from this transaction. This lack of enrichment leads to the failure of the charge under Section 56(2)(x). This line of reasoning has found favour in various judicial decisions9.
9. Vora Financial Services (P.) Ltd. v ACIT [2018] 96 taxmann.com 88 (Mumbai); DCIT v Venture Lighting India Ltd [2023] 150 taxmann.com 523 (Chennai - Trib.); VITP (P.) Ltd v DCIT [2022] 143 taxmann.com 304 (Hyderabad - Trib.);
Section 115QA adds another layer of defence. By shifting the liability to pay Buy-Back Tax (BBT) onto the company, Section 115QA acts as a special provision and a self-contained code. According to the principles of statutory interpretation, a special provision like Section 115QA should override more general provisions such as Section 56(2)(x).
However, the new taxation regime introduces a fresh angle to the interplay with Section 56(2)(x). Section 2(22)(f) deems the payment by a company on the purchase of its own shares as a dividend. Sections 194 and 195 impose an obligation on the company to withhold tax on such payments. Following the fiction created by Section 2(22)(f) to its logical conclusion, this payment should be treated as a dividend for all purposes under the Act, effectively preventing the application of Section 56(2)(x) from the outset.
In the absence of any anti-abuse provision requiring the company to pay dividends at fair market value, it is arguable that considerations below the Rule 11UA value should not be taxed under Section 56(2)(x).
COMPARISON WITH CAPITAL GAIN
Under the new regime, long-term capital gains are taxed at a rate of 12.5 per cent, and short-term capital gains are taxed at 20 per cent on net gains (i.e., consideration minus the cost of acquisition). For non-resident shareholders, dividend income is taxed according to the provisions of the applicable DTAA, with most DTAAs providing a concessional rate of 10 per cent for dividend taxation.
Shareholders, particularly those holding stakes in startups or joint ventures, will need to carefully evaluate buy-back as an alternative to conventional exit strategies. In cases where shares have significantly appreciated, opting for buy-back could result in the gains being taxed as dividends, potentially reducing the overall cash tax outflow. Additionally, the cost of acquisition can be offset against other capital gains, thereby improving overall tax efficiency.
This scenario presents an opportunity to structure transactions more efficiently. Instead of providing an exit through secondary sales, shareholders might consider infusing equity into the company, followed by a buy-back. This approach could optimize the tax implications and enhance the financial outcome of the transaction.
BUY-BACK AND INDIRECT TRANSFER
Explanation 5 to Section 9(1)(i) of the Income-tax Act provides that the shares of a company are deemed to be situated in India if they derive their value substantially from assets located in India. Circular No. 4 of 2015, dated 26th March, 2015, clarified that the declaration of dividends by a foreign company does not trigger the provisions of indirect transfer under Indian tax law. The term “dividend” in this context, as stated in the Circular, derives its meaning from Section 2(22)(f) of the Income-tax Act, which includes payments made by a company on the purchase of its own shares from a shareholder in accordance with the provisions of Section 68 of the Companies Act, 2013.
A pertinent issue arises when considering buy-backs by foreign companies, which are not conducted in accordance with Section 68 of the Companies Act, 2013. This raises the question of whether a buy-back under the corporate law of a foreign jurisdiction falls within the scope of the indirect transfer provisions.
Non-resident shareholders may consider invoking the Non-Discrimination Article under the applicable DTAA to address this issue. Article 24(1) of many DTAAs provides that nationals of one contracting state shall not be subjected in the other contracting state to any taxation or related requirements that are more burdensome than those imposed on nationals of the other state under similar circumstances.
An argument can be made that the reference to Section 68 should be interpreted as indicative of a buy-back governed by corporate law in general, rather than being limited to Indian law. Non-resident shareholders should not be expected to comply with Section 68 of the Companies Act, 2013, as it applies exclusively to Indian companies. The argument of discrimination has been accepted by the Tribunal in the context of Section 79 in the case of Daimler Chrysler India (P.) Ltd. vs. DCIT10, where similar principles were considered.
10 [2009] 29 SOT 202 (Pune)
CONCLUDING REMARKS
There’s no denying that Income Tax is fundamentally a tax on real income — at least, that’s the theory. However, with the numerous fictions introduced over the years — each one merrily overriding the last —the Income-tax Act has started to resemble a novel with more plot twists than logic. It’s like watching a thriller where the protagonist, just when you think you understand the story, wakes up to find themselves in an entirely different movie.
As we navigate these convolutions, it’s worth remembering that all of this complexity is supposed to bring us closer to fairness and clarity. But in reality, it’s a bit like trying to assemble flat-pack furniture without the instructions — there’s always one piece that doesn’t seem to fit, and you’re never quite sure if that extra screw was supposed to go somewhere.
With the introduction of a new Income-tax Act on the horizon, one can’t help but feel a mix of hope and trepidation. Will this new Act finally streamline these fictions, or will it just add a few new chapters to the saga? Either way, as tax professionals, we’ll be here — armed with our calculators and a good sense of humour — ready to decipher the next instalment of this ever-evolving tax code.
