Introduction
In a bold move, the Government has abolished the buy-back distribution tax vide the Finance Act 2024, making the proceeds arising out of a buy-back taxable as deemed dividend at the hands of the shareholder. This amendment has a series of challenges and implications that further the tax burden on individual shareholders. This article will examine the concept of buy-back by shedding light on its legislative history. Further, the piece will delve into the implications for various stakeholders. Lastly, it will draw international comparisons from different countries and analyse the key challenges posed by legislative action.
Pre-Amendment Landscape
The landscape for taxing buy-back has seen a significant overhaul through the decade. Before 2013, buy-back was taxed at the hands of shareholders in the form of capital gains. However, the Finance Act 2013 introduced special provisions under Section 115QA of the Income Tax Act 1961 (“IT Act”) where the incidence of tax was shifted to the companies. Such changes were made to align the taxation process with the Dividend Distribution Tax (“DDT”), which was also levied in the hands of the company. As a result, the income was exempted from the assessment of a shareholder. The intent of the legislation was to align tax implications, through dividends and buy-back, which led to the introduction of a Buy-Back Distribution tax (“BDT”).
However, the Finance Act 2020 abolished the dividend distribution tax, implying a shift in the onus of taxation from companies to the shareholders. At present, the Finance Act 2024 has proposed to abolish buy-back tax payable by companies, again, shifting the onus of taxation from the companies to the shareholders. The proposed changes have taken effect from 01 October 2024.
Implications
Companies
The companies will be exonerated from paying any tax for buy-back undertaken on or after 01 October 2024. This implies that companies will have at their disposal surplus funds, which they can utilise in other sectors or corporate governance. However, Sections 194 and 195 of the IT Act will oblige them to withhold taxes because the buyback funds are now taxable as dividends. This could imply rethinking of share repurchase strategies by companies, making the option less attractive.
Shareholders
After the date of enforcement, the entire advance received by the shareholder on the sale of shares in a buy-back will be taxable as a dividend under the head “Income from Other Sources”. This implies that for a company planning a buyback, the dividend amount won’t be limited to the entire amount of accrued profits. As a general rule, shareholders are allowed to claim a deduction in case of dividends received by them which goes up to 20% of the income received from it. However, in case of buy-back occurring after the date of enforcement, no deduction is allowed against such proceeds and they are taxed as deemed dividends. To surmise, the taxable income of shareholders would substantially increase without any allowable deductions.
Non-Resident Shareholders
To gauge the impact on non-resident shareholders, it becomes pertinent to assess the relevant tax treaties between India and non-resident countries. The liability would depend upon the interpretation of the language used in the treaty. For instance, if buy-back consideration is interpreted as a dividend, it may attract Tax Deducted at Source (“TDS”) at a specific rate. If the consideration is classified as capital gains, its tax treatment will be determined by any exemptions governed by the treaty. Further, if the shares are bought back as “stock-in-trade,” it could be considered as “business profits.” Lastly, if the consideration fails to fall under any of the aforementioned heads, it may be treated as “other income” and its treatment will depend upon the governing treaty.
International Landscape
In the United States (US), with the introduction of the Inflation Reduction Act in2022, a 1% excise tax was introduced on the buy-back of shares by publicly traded corporations. This excise tax can be reduced if the company issues new shares to the public or its employees but is not deductible. Despite this excise tax, buybacks remain advantageous in terms of tax as compared to dividends, as the tax rate is comparatively low. Even with a proposed increase in the excise tax to 4% under the 2024 budget, buybacks would still generally be more tax-efficient than dividends.
In the United Kingdom (UK), buy-back is generally taxed as dividends which can lead to higher tax rates unless specific conditions are met for taxing it as capital gains. To benefit from the more favourable capital gains treatment, which can reduce the tax rate to as low as 10% under Business Asset Disposal Relief, strict conditions must be met. Securing capital gains treatment often requires clearance from His Majesty’s Revenue and Customs (“HMRC”). This makes the UK more restrictive compared to the US in terms of tax benefits from buybacks.
Repurchases are considered capital expenditures for firms in Singapore, and the buyback’s purchase price or share value is subject to a 0.2% stamp duty that must be paid by the entity. For shareholders, proceeds from buybacks are treated as capital gains which are generally exempt from tax as gains or losses from share sales are considered personal investments.
In terms of global practices, many countries do not impose tax on companies for buybacks, but instead tax shareholders on the capital gains they receive. The move aligns with international practices where the tax burden is on shareholders instead of the companies themselves. However, it deviates from the same by classifying buybacks as dividends rather than capital gains resulting in significant implications for both shareholders and companies. This decision to shift the tax burden to shareholders is intended to create parity between treatment of dividends and buybacks ensuring that the companies do not use buybacks solely as a tax-saving mechanism. However, this shift increases tax burden on shareholders, making buybacks a less efficient exit option. Companies, in turn, may now use buybacks in situations where there is a genuine need for capital reduction or may redirect their surplus funds towards capital expenditure rather than using them as a means to distribute profits to lower tax liability. This also limits their options for rewarding shareholders in a tax-efficient way and leads them to consider alternatives like dividends which are less beneficial to the investor. Conversely, treating buyback proceeds as capital gains, as seen in jurisdictions like Singapore, allows shareholders to benefit from lower taxes making buyback a more attractive option.
Analysing The Removal of BDT
I. Distributions Exceeding Accumulated Profits
When companies buy back their shares, sometimes the amount distributed to shareholders exceeds their accumulated profits. The issue here is whether this excess amount is to be considered as dividends or capital gains. Generally, only distributions from accumulated profits are treated as dividends and anything above that is considered capital gains.
In the proposed amendment, it is unclear if the entire distribution from buy-backs is to be treated as dividend income. However, the bill’s literal interpretation is inclined towards taxing the entire distribution as dividend income which could lead to heavier tax burdens on shareholders asdividend income is generally taxed more heavily than capital gains. Ideally, only that part of the distribution that comes from accumulated profits should be treated as a dividend while any excess should be taxed as capital gains as it has lower tax rates. This lack of clarity might confuse and potentially higher tax liabilities until further clarification is provided. This could lead to over-taxation on buy-backs and create uncertainty for shareholders.
II. Tax Benefits for Non-Resident Shareholders
It is essential to determine whether the money they receive from buy-backs will be taxed as dividend income or as capital gains, particularly for Non-resident shareholders. Different tax treaties between India and other countries specify lower tax rates for dividends, hence it becomes important to know how buy-back proceeds will be classified.
If buy-back proceeds are treated as dividend income, non-resident shareholders may benefit from lower tax rates if applicable under their country’s tax treaty with India. However, if treated as capital gains, different tax rates may apply which could either benefit or disadvantage the shareholder depending on the tax treaty. This lack of clarity could make foreign investors hesitant as they may not know the exact tax liability they will face.
This introduces uncertainty for foreign investors which could be seen as a downside of the proposed amendment. However, in cases where tax treaties offer lower dividend rates, it could potentially be a positive for non-residents.
III. Deductions for Resident Corporate Shareholders
Section 80M of The IT Act allows resident companies to claim a deduction on dividends they receive from other companies if they redistribute those dividends to their shareholders. With buy-back proceeds now potentially treated as dividends, the question is whether resident companies receiving buy-back proceeds can claim a deduction under Section 80M.
If buy-back proceeds qualify as dividends under Section 80M, this could be advantageous for resident corporate shareholders. It would allow them to reduce their tax liability by claiming a deduction which would encourage them to participate in buy-backs. However, if buy-back proceeds do not qualify for this deduction, resident companies could face higher taxes and reduced benefits from buy-back transactions.
Conclusion
In conclusion, the proposed amendment pertaining to the removal of the buy-back tax gives rise to a series of complexities that remain to be adequately addressed. Such complexities are a result of the legislative intent to streamline taxation between dividends and buy-backs. The higher tax rate on buy-back considerations and associated capital loss is likely to reduce the option of buy-backs. A specific examination by dissection of these provisions will reveal a plethora of challenges, opening doors for further regulatory changes and warrants careful navigation by various stakeholders.
This blog is written by Ayush Singh Verma and Preeti Talreja, HNLU, 3rd Year, B.A. LL.B (Hons.).