In a corporate set-up, a shareholder may be entitled to different forms of receipts from the company on account of their corporate rights. Depending upon their nature, the taxation of these receipts may vary according to the relevant tax laws.
Under the Indian Companies Act, 2013, a company can distribute proceeds in lieu of a cancellation of its shares, which could be undertaken by way of a capital reduction or a buy-back. While the procedural aspects of undertaking a capital reduction and buy-back are different, both these transactions result in a distribution of capital in lieu of the cancellation of shares.
Despite a similarity in the results, prior to recent amendments made through the Finance (No. 2) Act, 2024 (FA, 2024), distribution by way of a capital reduction and a buy-back entailed different treatments for the purpose of taxation.
Taxation of a buy-back prior to the amendment
Prior to FA, 2024, while a capital reduction was deemed to be dividend income of the shareholders (see Section 2(22)(d) of the Income-Tax Act, 1961, or the IT Act), a company undertaking a buy-back was obligated to pay tax on the income distributed by way of a buy-back at a rate of 20%, excluding surcharge and cess (see Section 115QA of the IT Act).
Consequently, the proceeds from a buy-back were exempt in the hands of the shareholder (see Section 10(34A) of the IT Act). Thus, the modus of a reduction of capital had a different income tax implication for a company and its shareholders.
Amendment by the Finance (No. 2) Act, 2024
Proceeds of a buy-back taxed as a dividend
Under the latest amendment, the proceeds from a buy-back will be treated at par with a capital reduction and taxed as dividend income. Under the Memorandum Explaining the Provisions in the Finance Bill, 2024, explaining the intent of the proposed amendment, a capital reduction and a buy-back of shares by a company are methods to distribute accumulated reserves and ought to be taxed similarly. Interestingly, unlike a capital reduction, the taxation of proceeds from a buy-back as dividend income is not expressly capped to the accumulated profits of the company.
Cost of shares to be allowed as a capital loss
Considering a buy-back also results in a ‘transfer’ of shares by the shareholder (according to Section 2(47) of the IT Act, a transfer of capital assets includes a sale and an extinguishment of the capital asset), the amended provision suggests that a capital gain in the hands of shareholders must be calculated considering the full value of the consideration of such shares as nil.
Thus, the entire cost of acquisition of the shares will be available as a capital loss to shareholders. Furthermore, the capital loss will be available for set-off against other capital gains, in accordance with the mechanism provided in sections 70, 71, and 74 of the IT Act. As dividend incomes may generally be taxed at higher rates than capital gains, the amendment thereby creates a tax arbitrage in favour of government.
Dual approach to taxation: a conundrum for non-resident shareholders?
Having discussed the proposed amendment, it is worth considering its impact on buy-backs of shares held by non-resident shareholders.
Prior to an amendment in 2013 (the Finance Act, 2013 introduced provisions wherein a company undertaking a buy-back was made liable to pay tax on income distributed by way of the buy-back), the Mumbai bench of the Income Tax Appellate Tribunal, taking note of domestic law, held in the 2016 case of Goldman Sachs (India) Securities Private Limited that the proceeds from a buy-back were taxable as capital gains in the hands of the shareholders and not as dividend income.
In another case, Cognizant Technology Solutions India Private Limited (2023), concerning the purchase of shares from a non-resident by way of a capital reduction scheme, the Chennai bench of the Income Tax Appellate Tribunal held that the scheme entailed the distribution of accumulated profits and was taxable as dividend income.
The tribunal benches’ different interpretations can be attributed to the different taxation treatment of buy-backs and capital reductions under domestic law. However, the taxation scheme concerning buy-backs according to domestic law when considering recent amendments is significantly different from the legal position examined by the tribunal benches. Therefore, it may not be correct to mechanically apply the earlier interpretation to the amended provisions.
Difference in taxation based on classification
If one were to go by paragraph 31 of the OECD Commentary on Article 31 Concerning the Taxation of Capital Gains, it is open for India to classify the sums received by way of a buy-back as dividend income. If as per the tax treaty, the receipts are classified as dividend income and not as capital gains, the shareholder may end up paying a tax on income subject to treaty rates without the benefit of a loss on the cancellation of shares.
On the other hand, if one were to argue that as per the tax treaty, buy-back income should be taxed as capital gains and not as dividend income, India, in most cases, will end up having an unlimited right to tax any income from buy-backs.
A computation under domestic law should also allow a non-resident to book a tax loss from a transfer of shares. In most cases, this approach will increase the Indian tax liability for non-resident investors, as they may end up paying taxes beyond the rates prescribed for dividend income in the relevant tax treaty. This approach may be beneficial for residents of certain countries (such as the Netherlands, Mauritius, and Singapore) where the tax treaties, in particular circumstances, grant taxing rights from an alienation of shares to the resident country only.
Consequently, it is conceivable that, contingent upon the tax liabilities and circumstances of individual cases, tax authorities and taxpayers might advocate for the categorisation of income as capital gains in tax treaties.
And then there is the possibility of arguing for a middle path. Respecting the dualistic characteristics of a buy-back, the proceeds from a buy-back could be subject to tax as dividend income subject to the rates provided in a tax treaty. Furthermore, considering an alienation of shares, any capital gains arising from a transfer of shares should also be subject to tax in India. Since capital gains will be calculated according to domestic law, this approach will allow the shareholder to book a tax loss equivalent to the cost of the shares. Such an approach may be in consonance with the provisions of domestic law and the historical judicial approach to tax on buy-back proceeds.
Final thoughts on buy-backs in India
Despite the good intentions behind the amendment, without clarity on the interplay between the IT Act and tax treaties, it may act as a deterrent for buy-back schemes for non-resident investors.
Given the multifaceted issues surrounding the amendment, clarity is required regarding the taxation of proceeds under tax treaties. Though tax treaties cannot be unilaterally amended, a clarification stating the Indian government’s position on taxation under a tax treaty would provide certainty to foreign investors. Pending such clarification, the amendment will definitely act as a recipe for litigation for non-resident investors.
