Preamble

Real estate industry is known for redevelopment. Similarly, reel industry rereleases its classical movies. On those lines, it is now the turn of the tax laws to bring back some of the erstwhile provisions. The Finance (No.2) Bill, 2024 (FB,2024) has brought in few of the older provisions back on track, namely, block assessment for search cases, VSVS and buy-back taxation (BBT).

The origin of buy-back taxation travels back to the year 2013. Generally, a company having distributable reserves, have 2 options to distribute to its shareholders, namely, declaration and payment of dividends or by way of purchase of its own shares at a consideration fixed by it.

The erstwhile law provided that any consideration received by a shareholder on buy-back is not treated as ‘dividend’ in view of specific exemption provided under section 2(22)(iv). However, such buy-back considerations are charged under section 46A as ‘capital gains’ in the hands of the shareholders. In view of this position, many corporates as part of tax avoidance device, were resorting to buy-back route instead of payment of dividend to circumvent the then dividend distribution tax - DDT (@20%). In a capital gains scenario, many shareholders are either not paying taxes at all or paying very low rate of tax (by claiming exemptions /availing basic non-taxable limits /utilizing benefits under DTAA etc.).

The AAR in a landmark decision in the case of A Mauritius, In re [TS-5006-AAR-2012-O] has held that only a genuine buy-back is excluded from the definition of ‘dividend’ under section 2(22)(iv) and be exempt from DDT. A colorable device will attract tax. In the case referred, the buy-back was held to be a colorable device for tax avoidance – to distribute dividends in the guise of buy-back to avoid payment of DDT. 

Taking a cue from the above decision, the Finance Act, 2013 has introduced section 115QA what the then Finance Minister referred to in his speech introducing the Finance Bill, 2013 as ‘a final withholding tax at the rate of 20% on profits distributed by unlisted companies’. Section 115QA got legislated and later, it was extended to listed companies through the Finance (No.2) Act, 2019. While the distributing company pay 20% additional tax under section 115QA on the buy-back, the recipient shareholder shall be exempt from tax by virtue of section 10(34A).

From the inception, BBT had its own challenges. Besides the cashflows strain on the companies, in certain cases, it has resulted in double taxation. For example, if a company issued shares at face value of Rs.500 and was subscribed by M, which he sold later to N for Rs.1,000 and suffered capital gains tax. When the company offers buy-back for Rs.1,250, the actual gain for N would be Rs.250. However, BBT levied 20% tax on the difference between issue price (Rs.500) and buy-back price (Rs.1,250). This has resulted in recognizing gain of Rs.750 as against the actual gain of Rs.250 for N, causing unintended double taxation. 

Migration to classical form of taxation of dividend     

Taxation of dividend income, which has undergone numerous changes from charging tax in the hands of the company to the shareholder and vice-versa has finally settled down with an amendment in Finance Act, 2020, wherein section 115-O, which levied additional income-tax on the company has been abolished and shareholder taxation was brought-back.

From the foregoing discussions, one could appreciate that the BBT was introduced to counter the menace of distribution of reserves and profits in the form buy-back to the shareholders, instead of dividend, which would suffer DDT. While the DDT itself abolished and the classical form of taxation of dividend was reintroduced, continuance of BBT posed an anomalous situation.

Key features of the amendment to buy back taxation  

From the statistical view, 221 companies, in the last 5 years until June,2024 have distributed a whopping sum of Rs.1,43,244 crores as buy-back proceeds. The departmental focus might have increased in views of the substantial amount involved in BBT. Needless to mention dividend as well as buy-backs are the methods to distribute accumulated reserves and thus, ought to be treated similarly.

To bring in parity with dividend taxation, the Finance (No.2) Bill, 2024 has amended/introduced few sections on BBT, the summary of which are discussed hereunder:

1. In respect of any buy-back, that takes place on or after 1^st October, 2024, section 115QA shall not apply, which means that the company is absolved from payment of BBT.

2. Section 2(22), which defines ‘dividend’ has been amended to insert a new sub-clause (f) to provide 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’. Accordingly, the BBT shifts to recipient-shareholders, in view of this deemed provision.

3. As the buy-back proceeds are packaged with dividend, as a corollary, the same shall be chargeable to tax under section 56 as income from other sources in the hands of the shareholders.

4. Section 194 which provides for withholding tax on dividend now mandates 10% TDS on the proceeds of buy-back, if the recipient is a resident. For non-residents, TDS shall be governed by the provisions of section 195 as per the rates in force under the Income-tax Act or as per the double taxation avoidance agreement, if any.

5. Section 57(i) deals with deduction for certain reasonable expenses, namely, commission, remuneration or interest which are incurred for the purpose of earning dividend. Clause (i) has now been amended to provide that no deduction shall be allowed against buy-back proceeds which are deemed as dividend.

6. Section 57(i) enables deduction against dividend income in the form of interest expenses, to the extent of 20% of such dividend income, irrespective of the actual interest. There may be a case where a shareholder invested interest-bearing borrowed capital in shares, which is now bought back by the company. In respect of buy-back proceeds, though it is deemed as dividend, no deduction, including interest expenses shall be allowed. Thus, there is a differential tax treatment between general dividends and the buy-backs deemed as dividend.

7. The shareholder who participates in the buy-back arrangement, extinguishes his right in the shares, which constitutes a ‘transfer’ by virtue of section 2(47). Being a capital asset and there is a transfer, the cost of acquisition attributable to such share needs to be accounted for in some manner.

8. Section 46A, as amended, provides that the full value of consideration shall be deemed to be ‘nil’, while computing buy-back capital gains in the hands of the shareholder. This amendment is justifiable as the entire consideration is already brought to tax under section 56 as dividend and thus, eliminates the possible notional taxation under the head ‘capital gains’.

9. While computing the capital gains under section 46A, the shareholder would be entitled to reduce the proportionate cost of acquisition attributable to the number of shares bought back by the company. As the consideration is deemed to be ‘nil’, reducing the cost of shares would result in capital loss. Based on the holding period of shares (12 months for listed and 24 months for unlisted), the loss shall be categorized in to long-term or short-term, as the case may be.

10. Set-off of loss attributable to buy-back shall be governed by the well-established principles of section 70 – inter source adjustment; section 71 – inter head adjustment, besides section 74 – carry forward and set-off of losses. Needless to mention that while short-term capital losses could be set-off against long-term or short-term capital gains, long-term losses shall be set-off only against long-term capital gains.

11. Section 48(i) provides for allowance of expenditure incurred wholly and exclusively in connection with transfer. As the amendment to BBT has not specially excluded section 48(i), assessee may contemplate claiming expenses, provided such expenditure is incurred wholly and exclusively related to transfer of shares under buy-back.

12. While charging buy-back proceeds as dividend, interest on borrowed capital cannot be allowed as deduction, in view of specific denial under section 57(i). A tax payer may contemplate adding such unclaimed interest as part of the cost of acquisition of shares, which are bought back. With this, the enhanced cost of acquisition of shares, including interest, would result in higher capital loss available for set-off. So long as there is no double deduction for the same interest, adding the unclaimed interest as part of the cost of acquisition should not pose a challenge.

13. By virtue of section 56(2)(i), dividend shall always be charged to tax under the head ‘other sources’. This position remains even where an assessee carrying on a business of dealing in shares and securities and earns dividend from such shares. Now the moot question would be whether an assessee could set-off capital loss from buy-back computed under section 46A with that of buy-back proceeds offered as dividend income under other sources. This scenario poses a greater challenge in view of the restrictive provisions of section 71 and 74, which does not enable capital losses to be set-off against income computed under any other heads of income.

14. Readers may note that through buy-back, the rights of the shareholder in the capital asset (i.e. shares) gets extinguished and thus, shall be regarded as ‘transfer’ by virtue of section 2(47). Accordingly, the tax incidence on buy-back proceeds shall fall under the head ‘capital gains’. However, through a deeming fiction of section 2(22)(f), the buy-back proceeds have been brought to tax under the head ‘other sources’ leaving the capital gains computation as loss, with full value of buy back consideration deemed to be ‘nil’.

15. A tax payer should not be deprived of the set-off benefits merely because the income ought to have been taxed under a particular head has been forcibly moved to another head of income. This principle has found favor from the decisions in the case of: (i) Western States Trading Co. (P.) Ltd. vs. CIT (1971) 80 ITR 21 (SC)] = [TS-5010-SC-1971-O]; (ii) CIT vs. Ramnath Goenka [(2003) 259 ITR 26 (Mad)] = [TS-5661-HC-2002(Madras)-O]; (iii) Orient Hospital Ltd. vs. Dy. CIT [(2009) 315 ITR 422 (Mad)] = [TS-5480-HC-2009(Madras)-O]; (iv) CIT vs.Parrys (Eastern) (P.) Ltd. [(2016) 66 Taxmann 330 (Bom)] = [TS-5135-HC-2016(Bombay)-O]. In view of this established legal precedence, there is still a way to set-off the buy-back dividend income (offered under section 56 read with section 2(22)(f)) with that of buy-back capital loss computed under section 46A. In other words, the restrictive capital loss set-off provisions as envisaged under sections 70, 71 and 74 could well be mitigated even under the new regime of buy-back taxation.

16. Again, deduction for inter-corporate dividends as provided under section 80M shall equally apply for buy-back dividend, if it is included in the total income of the domestic company. Accordingly, the recipient-company, by declaring dividend to its shareholders within the time limit for filing return of income under section 139(1) could save tax on the buy-back dividends.

Conclusion

When the distribution-based tax in the hands of the company (i.e.115-O/115QA) were introduced, it was stated that the same was done with a view to bring clarity on taxation of dividend and because the taxability of dividend in the hands of the recipient posed serious problem of collection of tax liability and extensive litigation with numerous shareholders.

 Now, let us believe that the reintroduction of tax on buy-back in the hands of the recipient is made for the reason that section 115QA was considered to be iniquitous and regressive as the buy-back proceeds was taxed at a flat rate irrespective of the marginal rate at which recipient is otherwise taxed.  Lastly, with the advent of technology and multiple tracking systems in the armory of the Government, the justification for the distribution tax, in any form, is outlived itself.

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