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Buy Back of Shares – Key Income Tax Implications | CA. Anand R Bhat

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Buy-back of shares – Key income-tax implications

  • By Anand R Bhat, Chartered Accountant 
  1. Introduction 
  • Companies having surplus reserves and economic resources often resort to buy-back shares to reward its shareholders when no visible investment plan exists in future and perceived internal rate of return on investment of such economic resources is not so attractive. Often, buy-back is also resorted to as a tax planning tool.
  • Finance Act, 2013 made significant changes in the scheme of taxation of buy-back of shares in the case of unlisted companies, while existing scheme of taxation continues for listed companies. Recently, the Finance Act 2016 carried some amendments and CBDT has issued rules providing operational guidelines and clarity to the subject. In the light of above background, key tax implications are analysed in the ensuing paras.
  1. Listed Companies – how it is taxed?
  • Taxation of buy-back of shares of listed companies is covered u/s 46A of Income-tax Act. The provision was introduced by the Finance Act, 1999, with effect from 1/4/2000. According to this section, shareholder (or holder of specified securities) is liable for income-tax on account of capital gains. The differential between the buy-back price (consideration) and the cost of acquisition which is computed in accordance with provisions of S. 48 would be the taxable income. These are taxable in the year in which the shares are purchased by the Company.
  • It may be pointed out that the income arising to shareholder cannot be regarded as dividend income in view of specific provision u/s 2(22)(e)(iv).
  • Prior to introduction of S. 115QA (with effect from 1/6/2013), the buy-back of shares by unlisted companies were also covered under the provisions of S. 46A. There was an issue relating to interpretation as to whether dividend distribution tax u/s 115-O would be applicable or capital gains u/s 46A. It has been contented that subsequent to introduction of S.115QA and placing reliance on a decision of the Authority for Advance Ruling, income-tax authorities, in some cases have sought to re-characterise the purchase consideration received on account of buy-back of shares, undertaken prior to 1/6/2013, as dividend and accordingly, subjecting the amounts so distributed by the companies to dividend distribution tax. It is in this context, CBDT has issued a Circular (No. 3/2016 dated 26/2/2016) and clarified that consideration received on buy-back of shares between the period 1/4/2000 till 31/05/2013 would be taxed as capital gains in the hands of the recipient in accordance with S. 46A and no such amount shall be treated as dividend. It is further clarified and directed, as a step towards non-adversarial tax regime, that no fresh notice for assessment/reassessment/non-deduction of tax at source shall be issued where buy-back of shares has taken place prior to 1/6/2013 and the case is covered u/s 46A r.w. 2(22)( e)(iv). It is further directed that pending cases shall be completed by applying above principle.
  1. Scheme of taxation in case of buy-back by unlisted companies
  • The scheme of taxation in case of buy-back of shares by unlisted companies is significantly changed by Finance Act, 2013 with effect from 1/6/2013. Prior to 1/6/2013 the scheme of taxation for listed and unlisted company shares were same as noted in the preceding para.
  • Consequent to the levy of DDT, the amount of dividend received by the shareholders is not included in the total income of the shareholder. The consideration received by a shareholder on buy-back of shares by the company is not treated as dividend but is taxable as capital gains under section 46A of the Act. A company, having distributable reserves, has two options to distribute the same to its shareholders either by declaration and payment of dividends to the shareholders, or by way of purchase of its own shares (i.e. buy-back of shares) at a consideration fixed by it. In the first case, the payment by company is subject to DDT and income in the hands of shareholders is exempt. In the second case the income is taxed in the hands of shareholder as capital gains. Unlisted Companies, as part of tax avoidance scheme, were 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 a lower rate.
  • In order to curb such practice, the law was amended by insertion of new Chapter XII-DA, to provide that the consideration paid by the company for purchase of its own unlisted shares which is in excess of the sum received by the company at the time of issue of such shares (distributed income) will be charged to tax and the company would be liable to pay additional income-tax @ 20% of the distributed income paid to the shareholder. The additional income-tax payable by the company shall be the final tax on similar lines as dividend distribution tax. The income arising to the shareholders in respect of such buy-back by the company would be exempt where the company is liable to pay the additional income-tax on the buy-back of shares.
  • In the light of above, following are the key features of the taxation :
  • The provisions of S. 115QA is an overriding provision. It starts with the expression “Notwithstanding any-thing contained in any other provisions of this Act…”
  • Income-tax levied u/s 115QA is additional tax on the Company. In other words, it is in addition to income-tax levy on the taxable income of the Company. Even if the company is not liable to pay income-tax, in the event of buy-back of shares, the company is required to pay tax.
  • The provisions apply to domestic company which is not listed in the stock exchange.
  • The provisions apply to distributed income on account of buy-back of shares.
  • The tax rate is 20% (base rate) on the distributed income.
  • The term “distributed income” was defined 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 issues of such shares.
  • The taxes are to be paid within 14 days from the date of payment of consideration to the shareholder. Failure to pay tax attracts interest at 1% p.m.
  • The taxes so paid are treated as final tax in so far as buy-back is concerned and no further tax deduction or tax credit is permissible to the Company or to the shareholder under income-tax law.
  1. Limitations

The scheme of taxation u. S 115QA suffered from following limitations:

  • Earlier the term buy-back was defined to mean purchase by a company of its own shares in accordance with the provisions of S. 77A of the Companies Act, 1956. In the year 2013, the Companies Act, 2013 is implemented and it contained legal provision u/s 68 relating to buy-back of shares which was effective from 1/4/2014. Hence, any buy-back of shares effected after 1/4/2014 would not affected taxation u/s 115QA. Additionally, the provisions of S. 115QA will not have any application if the shares are required by companies under any other provisions of the Act for example capital reduction.
  • There could be situations where the shares of the company would have been allotted/issued at different point in time and at different prices. There could be situations such as amalgamations, mergers or demergers and the main issue was how to computed cost in such situations.
  1. Amendments by Finance Act, 2013
  • In order to overcome above limitations, the Finance Act, 2013 amended definitions of “buy-back” as well as “distributed income”. The Memorandum explaining the provisions in Finance Bill, 2016 stated the rationale for modifying the definition and explained that for the purpose of S.115QA, it is the effect of buy-back being in the nature of distribution of income which is relevant rather than particular provision of law relating to companies under which it has been undertaken. It further stated that lack of clarity in the manner of determination of consideration received by the company would lead to avoidable disputes and also presents a tax arbitrage opportunity of scaling up of consideration particularly under a tax neutral business reorganisation followed by buy-back of shares.
  • Accordingly, the definitions now reads as follows :
  • “buy-back” means purchase of its own shares in accordance with the provisions of any law for the time being in force relating to companies.
  • “distributed income” means the consideration paid by the company on buy-back of shares as reduced by the amounts, which was received by the company for issue of such shares, determined in the manner as may be prescribed.
  • With reference to amendment to buy-back definition, the modified definition applies with effect from 1/6/2016. Hence, a question/controversy may arise as to the scheme of taxation for the period 1/4/2014 till 31/5/2016 where the shares are subjected to buy-back under the provisions of S. 68 under new Companies Act, 2013 ?. Possible interpretation can be found in the Memorandum explaining the provisions in Finance Bill 2016 which stated that it is the effect of buy-back being in the nature of distribution of income which is relevant rather than particular provision of law relating to companies under which it has been undertaken. In spite of this, there exists possibility of interpretation as to taxability u/s 46A. Hence, it is hoped that forthcoming Finance Bill may address this issue.
  • With reference to the amounts received by the company for issue of shares, now the manner of determination is as per the Income-tax Rules, 1962. Accordingly, CBDT has amended the Income-tax Rules, 1962 by Income-tax (28th Amendment), Rules, 2016 vide Notification No. GSR 982(E), dated 17/10/2016, which is effective from 1st June 2016. Rule 40BB now prescribes provisions for computing amounts received by the company for issue of shares.
  1. Rule 40BB and determination of amounts received by the company :

Following table explains various situations and the computation mechanism with regard to amounts received by the company:

Situation Computation mechanism
shares issued by way of subscription Amount actually received by the company for such shares. It includes share premium received
If part of the shares are returned earlier.

 

 The amount received for issue of shares to be reduced to the extent of amount so returned. However,  if the sum or any part of it so returned was chargeable to additional income-tax under section 115-O and the company has paid such additional income tax then such sum or part thereof, as the case may be, shall not be reduced.
Share issued under any plan or scheme under which an employees’ stock option has been granted or as part of sweat equity shares Fair market value of the share [as computed in accordance with sub-rule (8) of rule 3], to the extent credited to the share capital and share premium account
Shares issued by an amalgamated company, under a scheme of amalgamation, in lieu of the share or shares of an amalgamating company the amount received by the amalgamating company in respect of such share or shares
The amount received by a resulting company in respect of shares issued by it under a scheme of demerger the amount which bears the amount received by the demerged company in respect of the original shares determined in accordance with this rule in the same proportion as the net book value of the assets transferred in a demerger bears to the net worth of the demerged company immediately before such demerger.
Share has been issued or allotted by the company as part of consideration for acquisition of any asset or settlement of any liability Amount received = A/B

Where,

A = an amount being lower of the following amounts-

(a) the amount which bears to the fair market value of the asset or the liability, as determined by a merchant banker, the same proportion as the part of consideration being paid by issue of shares bears the total consideration;
(b) the amount of consideration for acquisition of the asset or settlement of the liability to be paid in the form of shares, to the extent credited to the share capital and share premium account by the company;

B = the number of shares issued by the company as part of consideration:
Shares issued or allotted by a company on succession or conversion,  of a firm into the company or succession of sole proprietary concern by the company,  

Amount received = A-B
C

A = book value of the assets in the balance-sheet as reduced by any amount of tax paid as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act and any amount shown in the balance-sheet as asset including the unamortized amount of deferred expenditure which does not represent the value of any asset;

Explanation.—For determining book value of the assets, any change in the value of the assets consequent to their revaluation shall be ignored.

B = book value of liabilities shown in the balance-sheet, but does not include the following amounts, namely:—

(a) capital, by whatever name called, of the proprietor or partners of the firm, as the case may be;
(b) reserves and surpluses, by whatever name called, including balance in profit and loss account;
(c) any amount representing provision for taxation, other than amount of tax paid, as deduction or collection at source or as advance tax payment as reduced by the amount of tax claimed as refund under the Income-tax Act, if any, to the extent of the excess over the tax payable with reference to the book profits in accordance with the law applicable thereto;
(d) any amount representing provisions made for meeting liabilities, other than ascertained liabilities;
and
(e) any amount representing contingent liabilities,

C = number of shares issued on conversion or succession.

 
Shares issued or allotted, without any consideration Deemed value is at “Nil”.

 
Shares issued on conversion of preference shares or bond or debenture etc. The amount received by the company in respect of such instrument.
If shares are held in dematerialised form and the same cannot be distinctly identified On the basis of the first-in-first-out method.
In any other case (not covered above) Face value of the share
  1. Conclusion :

The law tried to bring simplicity in the scheme of taxation akin to dividend distribution tax. While there is no clarity as to how these provisions u/s 115QA will address the treaty situation, underlying tax credits in cross border context and transfer pricing aspects, which in the near future may lead to controversy and litigation. Hence, the Government should proactively clarify tax position so that there should not be any legal controversies.