Buyback Tax Rules - Some issues still remain unanswered
Manish Shah (Partner –Direct Tax, Sudit K. Parekh & Co.)
Dipna Agte (Manager – Direct Tax)
Section 46A dealing with Capital Gain on buy back of shares was introduced way back in 2000 by the Finance Act, 1999. The Memorandum explaining the Finance Bill 1999 has stated the objective of introduction of this provision as under:
“The promulgation of the Companies (Amendment) Ordinance, 1998 has inserted section 77A in the Companies Act, 1956 which allows a company to purchase its own shares subject to certain conditions. The shares bought back have to be extinguished and physically destroyed and the company is precluded from making any further issue of securities within a period of 24 months from such buy-back.
The above newly introduced provisions of buy-back of shares has thrown open certain issues in relation to the existing provisions of Income-tax Act. The two principal issues are whether it would give rise to deemed dividend under section 2(22) of the Income-tax Act and whether any capital gains would arise in the hands of the shareholder. The legal position on both the issues is far from clear and settled and there is apprehension that there will be unnecessary litigation unless the issues are clarified with finality.”
Thus, the object of introduction of this provision was to clear the air surrounding the taxability issues arising due to buy back of shares and accordingly it was made subject to capital gain tax. This position continued from the year 2000 to year 2013. In 2013, a new chapter XII – DA comprising of section 115QA to Section 115QC was introduced which provided for tax on distributed income of domestic company on account of buy back of shares. The term “Distributed Income” was defined as consideration paid by the company on buy-back of shares as reduced by the amount which was received by the company for issue of such shares. The shareholder, on the other hand, enjoys complete exemption from tax under the newly inserted section 10(34A). The Memorandum explaining the Finance Bill 2013 has stated as under:
“Unlisted Companies, as part of tax avoidance scheme, are resorting to buy back of shares instead of payment of dividends in order to avoid 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 lower rate. In order to curb such practice it is proposed to amend the Act…”
Thus, the object of introduction of this provision was to prevent the tax payers from taking benefit of some tax treaties and avoiding payment of Capital Gain Tax. The genesis of introduction of this provision was the decision in AAR ruling in case of A, In re (2012)343 ITR 455 wherein the taxpayer could avoid the payment of capital gain tax by virtue of favourable India- Mauritius tax treaty.
In process of introduction of this provision, several unintended consequences have crept in which are discussed in the ensuing paragraphs. There were a lot of ambiguities on determining the “amount received“ by the company in various forms of acquisitions such as reconstruction/restructuring of the company in form of amalgamation, demerger, and capital reduction or in cases where shares are on account of conversions from debentures/bonds/preference shares or shares are without consideration such as bonus shares or transfers at various levels changing hands from primary shareholder to another one.
But before we deal with the several issues, the basic framework of the provisions of section 115QA and the recently introduced draft rules are discussed herein below:
The Finance Act, 2016 amended the definition of “distributed income”, with effect from 01.06.2016, to mean the consideration paid by the company on buy back of shares as reduced by the amount, which was received by the company for issue of such shares, determined in the manner as may be prescribed. Accordingly, the Central Board of Direct Taxes (CBDT) has now come up with the draft rules to prescribe the manner of determining the “amount received” by the company in respect of issue of shares under different circumstances. The said draft rules are summarised below:
Situation | Manner of determination of “amount received” |
Share issued by a company on its subscription | Paid up Amount actually received by the Company including Share Premium |
where certain sum is returned back prior to buy back | Amount received minus sum so returned |
In case of any amalgamation of the Company prior to buyback, shares issued by amalgamated Company in lieu of shares of amalgamating Company | Amount received by the amalgamating company in respect of such share |
In case of demerger, shares issued by resulting company | Amount received by demerged Company in respect of original shared to be divided in ratio of net book value of the assets transferred in a demerger bears to the net worth of the demerged company immediately before such demerger |
In case of demerger, in hands of demerged company | Amount received shall be reduced by the amount determined in situation 4 above |
Bonus Shares or shares issued without consideration | NIL |
Share issued on conversion of bond or debenture, debenture-stock or deposit certificate | Amount received by the company in respect of the instrument so converted |
In any other cases | Face value of the shares |
Being at draft stage, it is necessary for us to evaluate whether all the questions and ambiguities that were prevailing have been addressed by the said rules or is there still scope for clarifications to be added. Certain typical issues are outlined here to form a framework for recommendations:
1. Shares issued by the Company to one shareholder and the same are transferred to other:
The Company allotted shares to Shareholder A say for Rs. 10. Such shares are transferred to Shareholder B say for Rs. 100. On account of the said transaction, shareholder A has already paid taxes on the capital gain of Rs. 90. Now, on account of buyback at Rs. 150, will the Company pay taxes on Rs. 140 (Rs. 150 minus Rs. 10) or on Rs. 60 (Rs. 150 minus Rs.90). On plain reading of the rule and law, it seems the taxable amount for computing buy back tax would be Rs. 140.
Why should there be double taxation of same amount, once in the hands of the shareholder A and again in the hands of the company?
2. Shares issued in tranches and buyback of partial number of shares:
Where shares are held in demat form and acquired in tranches at different prices, whether the amount received should be based FIFO method or average method or it should specifically be identified on the basis of each of the acquisitions?
3. Shares issued for consideration other than cash including ESOPs:
There can be situations where the company would have issued shares –
- Against Intangibles acquired or any other assets towards the value of such asset
- To the employees for its loyalty and work towards the company in form of ESOPS at a discounted value
In above scenarios the rules are still silent and will the computation mechanism fails for want of determining the cost of acquisition or amount received by the company.
4. Conversion of preference shares:
In respect of conversion of bonds/debentures into equity, the rules provide that the amount received by the Company in respect of instrument so converted. However, Buy back Rules are silent on account of such conversions of preference shares into equity.
Apart from the above issues with respect to the introduction of draft rules, there are certain other issues with respect to buy back tax itself which needs to be addressed:
i. In the zeal to plug the loophole of preventing the tax payer of taking advantage of the tax treaty, the legislation has ignored the aspects such as other commercial objectives of buy back being motive to increase the promoter shareholding, rationalizing the capital structure or returning the surplus cash.
ii. In euphoria of preventing tax avoidance, even allowability of underlying credit for those shareholders specifically foreign shareholders in whose hands such gains would be taxable will not be available.
iii. If the buyback of shares would have been taxable in hands of shareholders as per the erstwhile law then the shareholders holding the shares for more than two years would have got the benefit of indexation towards the cost of shares. Now, in case of buy back no such provision is made to keep such benefit at par for the company.
iv. Last but not the least, if buy back tax is tax on distributed “income”, why expenses incurred by the Company in its buying back of shares should not be allowed to be claimed? And hence, this is an additional income tax in itself!!