18.89% Buyback Tax Advantage Diminishes After Recent Amendment

Buybacks, often employed to return capital to shareholders and improve financial ratios, have historically been favored for their tax efficiency compared to dividends. However, the amendments in Finance (No 2) Act, 2024, have altered the tax treatment of buybacks, impacting both companies and investors. With the removal of the buyback tax, there are broader implications for corporate tax planning, dividend policies, and shareholder returns, triggering a need for strategic adjustments in how companies manage their capital.

A company with distributable reserves can return value to shareholders either through dividend payments or buyback of shares.

If a company intends to declare a dividend in the absence of sufficient profits, and it proposes to do so from accumulated profits that are transferred to reserves, then it must comply with the conditions prescribed under Rule 3 of Companies (Declaration and Payment of Dividend) Rules, 2014.

A company must fulfil the said conditions to declare a dividend from reserves in case of a loss. In contrast, there are no comparable restrictions on share buybacks. A company can buyback shares even if it is not currently profitable, provided it uses funds from permissible sources such as free reserves or securities premium.

Understanding the concept of Buyback

Section 68 of the Companies Act, 2013 deals with buyback of shares. The relevant provisions are as under:

Provided that no buyback of any kind of shares or other specified securities shall be made out of the proceeds of an earlier issue of the same kind of shares or same kind of other specified securities."

Buyback allows the company to reduce its share capital by buying back its issued shares, typically to return surplus cash to shareholders, increase the value of remaining shares, or consolidate ownership.

Additional considerations relating to Buyback

• Buyback should be permitted under the company's Articles of Association.
• The securities proposed to be bought back must be fully paid up.
• A company can buyback up to 25% of its aggregate of paid-up capital and free reserves.
• A special resolution authorizing the buyback must be passed at a general meeting. However, buybacks up to 10% of the total paid-up equity share capital and free reserves can be authorized through a board resolution.
• Notice of general meeting for passing of special resolution authorizing buyback must contain prescribed particulars.
• Post buyback, the debt-to-equity ratio must be maintained at a minimum of 2:1
• Buyback of listed shares must comply with SEBI buyback regulations.
• Buyback should be completed within 1 year of passing of board resolution or special resolution.
• No buyback offer can be made until one year has elapsed since the completion of the previous buyback.

Taxation in case of Buybacks

Existing Provisions

Prior to the introduction of Section 115QA, in case of buyback of shares, income was taxed in the hands of shareholders as capital gains u/s 46A of Income Tax Act, 1961 (hereinafter referred to as 'ITA').

The government vide Finance Act 2013 inserted Section 115QA whereby the company was liable to pay tax on income distributed to shareholders on buyback. The definition of "dividend" under Section 2(22) of the ITA was amended to specifically exclude buybacks from being treated as dividends.

Section 115QA – Tax on distributed income to shareholders

Section 115QA provides as under:

1. Notwithstanding anything in the ITA, in addition to the income-tax chargeable in respect of the total income of a domestic company for any assessment year, any amount of distributed income by the company on buy-back of shares from a shareholder shall be charged to tax and such company shall be liable to pay additional income-tax at the rate of twenty per cent on the distributed income.

As per the Section, income distributed through the buyback of shares by domestic companies was subject to tax at a rate of 20%, plus an additional surcharge of 12% and a cess of 4%, resulting in a tax rate of 23.296% to be paid by the company.

Distributed income means = [Consideration paid by the company on buy-back of sharesLessAmount which was received by the company for issue of such shares, determined in the manner as may be prescribed].

Tax u/s 115QA was applicable regardless of the company's overall tax liability on its income. To compound the issue, neither the company nor the shareholders were allowed to claim any credit or deduction for the tax paid on the buyback. This meant that the tax applied to buyback transactions became an additional financial burden, without any possibility of offsetting or reducing the tax liability for either the company or the shareholders involved.

Under Section 10(34A) of the ITA, any income arising to a shareholder from the buyback of shares, as referred to in Section 115QA, was exempt from tax in the hands of the shareholder. The rationale behind this exemption was to avoid double taxation. Given that the company had already paid tax on the buyback distribution, the income was not subjected to additional tax at the shareholder level.

In comparison to dividends, which are taxed according to the applicable slab rates of shareholders, buyback transactions were taxed at a lower effective rate of 18.89% (refer the calculations below). Due to this difference in the tax implications, companies often preferred share buybacks over dividend distribution.

Let us understand with an example:

A company has a surplus of INR 1,00,000 that it plans to distribute to its shareholders. The company has two options for this distribution: (i) declaring a dividend; or (ii) executing a share buyback. Below are the tax implications for each option:

Option A: Declaring dividend

If the company chooses to distribute INR 1,00,000 as a dividend, shareholders will be liable to pay tax on the dividend as per their applicable slab rates. For instance, an individual shareholder subject to the highest tax rate of 35.88% will pay INR 35,880 in taxes on the INR 1,00,000 dividend received.

Option B: Share buyback

If the company opts for a share buyback, it is required to pay tax on the distributed income. In this case, INR 1,00,000 to be distributed may be considered inclusive of the buyback tax, which the company is responsible for. After accounting for the tax, the company would distribute INR 81,105 as buyback proceeds and pay INR 18,894 as buyback tax. This results in a total distribution of INR 1,00,000 with an effective tax rate of 18.89%

Although the statutory tax rate on buybacks was 23.296%, the effective tax rate came out to be 18.89%, allowing shareholders to retain a higher net amount in the case of a buyback compared to a dividend distribution.

Amendment in Finance (No 2) Act, 2024

The Finance (No. 2) Act, 2024 has abolished Section 115QA, effective from October 1, 2024. As a result, companies will no longer bear the tax liability for buybacks. Instead, the tax on buybacks will be directly imposed on shareholders.

In line with the amendment in Section 115QA, the following amendments also took place:

• Section 2(22)(f) - A new clause (f) has been added to Section 2(22) of the ITA which provides as below:

• Section 46A – A new proviso was added w.e.f. 1^st October 2024 which reads as follows:

• Section 194 - Section 2(22)(f) has been brought within the scope of Section 194 of the ITA, which governs the withholding tax on such dividends.
  
  Companies will be liable for withholding taxes under Section 194 and Section 195 of the ITA, as the proceeds from buybacks are now considered taxable as dividend income. This alignment ensures that buyback proceeds are treated as dividends for tax purposes and subject to relevant withholding tax provisions.

• Section 10(34A) – The amendment in Finance (No 2) Act 2024 has shifted the tax liability from companies to shareholders. Effective from October 1, 2024, the shareholders will not be eligible for any exemption for income from buyback of shares u/s 10(34A) of the ITA.

• Section 57 – Expenses incurred in connection with such buyback proceeds will not be allowed to be claimed as deductions. This means that the entire gross amount received from the buyback will be fully taxable in the hands of shareholders, without any opportunity to offset the income with related expenses or costs.

Tax Implications of Buybacks for Non-Resident Shareholders – Effects of Recent Amendments

Under the ITA, income received by a non-resident in the form of dividends is taxable under Section 115A, with a standard tax rate of 20%.

Non-residents have the option to choose the lower tax rate available under Double Taxation Avoidance Agreement (DTAA) between India and their country of residence if it is more beneficial than the rate prescribed under domestic law. To avail of the DTAA benefits, non-residents must provide the necessary documentation as prescribed, such as a Tax Residency Certificate and other relevant forms, to substantiate their claim for the reduced tax rate.

Post-amendment, in case of buyback, the non-resident shareholders will be required to determine the classification of the income in accordance with DTAA between their country and India which would ultimately help them to evaluate the tax implications on such income and claim treaty benefits.

Conclusion

The above amendments are intended to align the taxation of dividends and buybacks for companies. However, the effectiveness of these changes will depend on their practical implementation, which may reveal the need for further refinements to address any issues and ensure the t

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.