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Analyzing tax treatment of buy-back of shares vis-à-vis dividend payout

JULY 09, 2020

By Vinay Verma, Advocate, KRS Legal

A. Introduction

A company having a distributable surplus may reward its shareholders in two main ways. The company can either offer dividend payout to its shareholders or purchase its own shares (i.e. buy-back of shares) at a consideration fixed by it. Dividend payout and stock buy-back, both offer a robust arrangement that can boost shareholder returns significantly. The decision for a company to declare dividend or buy- back its shares depends on several factors such as current stock price, long-term vision of the company, tax structure applicable to the company and its shareholders, investment opportunities and other related factors.

With the significant impact of COVID-19 on the economies and negative stock market fluctuations, the companies are planning to opt for buy-back of shares, thereby increasing the value of stock options. There have been recent trends in the market, wherein the promoters have increased their share in the companies by purchasing stock from open market. This reflects a positive sign for investors about the confidence of the management in the underlying fundamentals of the business. In the case of non-resident shareholders / foreign companies, the companies have always been in favor of declaring dividend on account of low rate of tax and tax treaty benefits being availed by shareholders.

In this article, I have encapsulated a brief analysis of tax treatment (including transfer pricing provisions) in the case of buy-back of shares vis-à-vis dividend payout.

B. Buy back of shares and its tax treatment

The buy-back refers to purchasing of own shares by the company from its existing shareholders at a decided price, thereby reducing the number of outstanding shares in the market. The buy-back of shares increases the proportion of shares a company owns by reducing the number of shares outstanding in the market.

The buy-back of shares is being undertaken by a company to return surplus funds to the equity shareholders of the company. The buy-back of shares may support in improving financial ratios like earning per share, return on assets and return on equity calculated on the basis of consolidated financial statements by reducing the equity base of a company.

Further, the buy-back of shares provides an option to equity shareholders to either prefer to participate in the buy-back and receive cash in lieu of their equity shares which are accepted under the buy-back or prefer not to participate in the buy-back and get a resultant increase in their percentage shareholding in the company post buyback, without an additional investment.

The provisions of Section 68 to 70 of Companies Act, 2013 and Rule 17 of the Companies (Share Capital and Debentures) Rules, 2014 deals with buy-back of shares. In this article, we have not dealt with provisions of Companies Act, 2013 in detail and have mentioned them briefly for understanding purposes.

A company may purchase its shares out of:

- its free reserves;

- the securities premium account; or

- proceeds of issue of any shares or other specified securities.

However, no buy-back of any kind of shares can be made out of the proceeds of an earlier issue of the same kind of shares.

The maximum permissible limit of buy back is 25% of paid up capital and free reserves, provided total shares to be bought back do not exceed 25% of paid up equity capital; and debt equity ratio to not exceed 2:1 (on consolidated basis for listed companies), post buy-back of shares.

I. Tax treatment

a) Applicability of Section 115QA of Income Tax Act, 1961 ("IT Act") on unlisted and listed shares

By undertaking aggressive tax planning to avoid tax, the unlisted companies began resorting to buy-back of shares instead of declaring dividends. To counter the same, Finance Act, 2013 introduced Section 115QA under the IT Act as an anti-tax avoidance measure.

The provisions of Section 115QA of the IT Act were initially applicable only to 'Unlisted Companies'. However, vide the Finance (No. 2) Act, 2019, the provisions of section 115QA were amended to include 'Listed Companies' as well. Such amendment to section 115QA was introduced with intent to bring the tax on dividend and the tax on buy-back of shares at par. Both listed and unlisted companies are liable to pay additional tax on distributed income on buy-back of shares from shareholders. The tax rate on the same is 20% plus a surcharge of 12% plus 4% cess, which converts into an effective rate of 23.29%.

Section 115QA of IT Act is a separate section for income distributed as consideration to the shareholders on buy-back of shares undertaken by the company. The explanation 1 to Section 115QA of the IT Act provides the formula for computation of amount to be charged to tax. The clause (ii) of the aforesaid explanation states that:

"distributed income" means the consideration paid by the company on buy-back of shares as reduced by the amount which was received by the company for issue of such shares."

Thus, the company is liable to pay tax on the difference between the buy-back price and issue price, which is referred to as distributed income.

The company and principal officer of company is liable to pay tax within a period of 14 days from the date of payment of any amount to the shareholders on the buyback of shares.

The tax on distributed income (i.e. buy-back) is payable by the company even if such company is not liable/ required to pay income tax. The tax on distributed income paid/ payable shall be treated as final payment of tax. No credit shall be claimed either by the company or any other person in respect of the amount of tax so paid. Income charged under Section 115QA shall not be allowed any deduction under any other provisions of the Act either to the company or shareholders.

b) Applicability of Section 10(34A) of IT Act

As per Section 10(34A) of IT Act, the tax on buy-back of shares is levied at the level of company and the consequential income arising in the hands of shareholders is exempt from tax. Since, income arising in the hands of shareholders is exempt, there arises no tax outflow in the hands of shareholders. The same is applicable even for shareholders, which are companies, on whom provisions of Section 115JB of IT Act are applicable.

c) Applicability of Section 56(2)(x) of the IT Act

The Finance Act, 2017 introduced a clause (x) in Section 56(2) of the IT Act to provide that receipt of the sum of money or the property by a person without any consideration or upon breach of a particular threshold would be liable to tax in the hands of the receiver under the head 'Income from other sources'. In simple words, Section 56(2)(x) prevents the practice of transferring shares of companies at prices below their fair market value ("FMV"), either for inadequate consideration or without consideration where the recipient is a firm or company.

To attract the provisions of Section 56(2)(x) of the IT Act, following conditions must be cumulatively satisfied:

i. the recipient must "receive" specified "property" from another person; and

ii. the receipt should be for a consideration which is less than the FMV of such "property".

For the purposes of Section 56(2)(x) of the IT Act, the definition of the expression "property" would be the same as defined under Explanation (d) to Section 56(2)(vii) of the Act. The relevant definition is extracted below:

"(d) "property" means the following capital asset of the assessee, namely, ………….

(ii) shares and securities; …………."

Thus, Section 56(2)(x) is applicable on a company, buying back its shares, the shares so bought back should become the "property" of such company.

It is important to analyze here the definition of term "receives" as mentioned in the Section 56(2)(x) of IT Act. Since, the definition is not provided in IT Act, it would be prudent to rely on the definition mentioned in Advanced Law Lexicon dictionary wherein it has been defined as "to receive means to get by a transfer, to receive a gift, to receive a letter, or to receive money and involves an actual receipt". Thus, it is important to understand if the temporary custody of shares with the company in accordance with the provisions of Section 68 of Companies Act, 2013 would be covered within the meaning of the term "receives".

However, Section 67 of the Companies Act, 2013 restricts a company to issuing shares to itself and thus a company cannot hold its own shares.

Further, as per Sub-Section (7) of Section 68 of Companies Act, 2013 "Where a company buys back its own shares or other specified securities, it shall extinguish and physically destroy the shares or securities so bought back within seven days of the last date of completion of the buy back.."

In other words, post completion of process of buy-back, the company shall within seven days of completion extinguish and physically destroy the shares bought back by the company.

Thus, in a scheme of buy-back, the shares purchased are extinguished and do not remain in existence. Hence, when a company buys back its own shares, such shares do not become "property" or asset of the company.

In view of the above, the provisions of Section 56(2)(x) cannot be invoked in the case of buy-back of shares.

Furthermore, the Hon'ble Tribunal in case of a taxpayer 1 while analyzing the implications of Section 56(2)(viia) of the IT Act in the context of a buyback of shares, observed that for the purpose of levy of tax on buy-back of shares under section 56(2)(viia), shares should become "property" of recipient-company whereas in case of buy-back, such shares are mandatorily cancelled and cannot become property of a company. Accordingly, buy back of shares should be out of the ambit of section 56(2)(viia) of the Act.

Though the ruling was passed in the case of Section 56(2)(viia) of the IT Act, which was effective till 31 March 2016, the ratio laid down by Hon'ble Tribunal shall apply with equal force while drawing reference to Section 56(2)(x) of IT Act. Thus, the provisions of Section 56(2)(x) of IT Act are not applicable in the case of buy-back of shares, in the hands of recipient shareholder.

Another issue which arises here that if a company undertakes buy-back of shares at a price below Net Asset Value ("NAV") or Discounted Cash Flow ("DCF"), whether provisions of Section 56(2)(x) of the IT Act would be attracted in the instant case? - As mentioned in earlier paragraphs, the provisions of Section 56(2)((x) of the IT Act are not applicable in case of buy-back of shares, then undertaking buy-back of shares at price below NAV/DCF would not attract the aforesaid provisions.

II. Treatment under transfer pricing provisions

a) In the hands of company

As mentioned earlier, the provisions of Section 56(2)(x) of IT Act are not applicable in the case of buy-back of shares. Hence, the transfer pricing provisions are also not applicable in the absence of taxable transaction or no charging section.

In case the tax authorities take a position and states that provisions of Section 56(2)(x) of the Act are applicable on the company, then the valuation as per Rule 11U and Rule 11UA of the IT Rules (being NAV) would be required to be undertaken for buy-back of shares.

In such a case, a question arises whether under the transfer pricing provisions the NAV can be replaced by FMV (being DCF value)? - Clearly, the provisions of Section 56(2)(x) of the IT Act do not allow the company to replace NAV by FMV. Section 56(2)(x) of the IT Act clearly defines that the FMV should be in accordance with Rule 11U and Rule 11UA of the IT Rules i.e. being the NAV. Hence, for the transfer pricing purposes, the company shall be required to adhere to the valuation based on NAV in accordance with IT Rules and would not be required to undertake a separate benchmarking analysis i.e. the transaction undertaken at NAV should satisfy the arm's length criteria.

b) In the hands of non-resident shareholders

Any income arising to a shareholder on account of buy-back of unlisted or listed shares by the company as referred to in Section 115QA shall be exempt under section 10(34) of IT Act. Thus, where income arising on account of buy-back is exempt from tax, even where the arm's length price is determined, there ought not to be any tax implications arising in the hands of shareholder and thus, no benchmarking analysis is required in the instant case. However, the shareholder still would be required to follow the disclosure norms under the transfer pricing provisions and hence, would be required to file the Form No. 3CEB in India with the arm's length price of the transaction restricted to the valuation determined as per Rule 11UA of IT Rules.

C. Dividend payout to shareholders and its tax treatment

Dividend is a share of profits and retained earnings that a company pays out to its shareholders. Dividends can be declared out of the profits of the company for that year, after providing for depreciation or out of the profits of the company for any previous financial year arrived at after providing depreciation. A company can declare an 'annual', 'regular', 'special' or 'one-time' dividend from its distributable surplus.

Dividend Distribution Tax ("DDT") is a tax levied on dividends that a company pays to its shareholders out of its profits.

I. Tax treatment

The Finance Act, 2020, provides that DDT is not applicable to dividends declared, paid or distributed on or after 1st April, 2020 (AY 2021-22 onwards). Further, Section 10(34) which provided for exemption to income, in the nature of dividend referred to in Section 115-O, i.e. dividends on which DDT had been paid, is no longer in force. Also, Section 115BBDA levying tax, at the rate of 10%, on dividend income in excess of INR 10 Lacs is no longer applicable. Thus, on or after 1st April, 2020, the dividend will be taxed in the hands of the shareholders, at the rates applicable to them.

Resident individual shareholders: In this scenario, the taxability of dividend shall be on the basis of slab rates applicable to the individual. Thus, it would be advantageous for an investor with an effective tax rate of below 20% to receive dividend. Similarly, individuals with income upto INR 5 lacs would also gain from these provisions, since dividend shall be exempt in the hands of such shareholders. However, individuals falling within the highest tax bracket of 42.74% 2 (30% plus 37% plus 4%) shall pay taxes on a significantly higher rate on the dividend income as compared to the DDT.

Resident corporate shareholders: In this scenario, the taxability of dividend shall be on the basis of applicable tax rates ranging from 25.17% (22% plus 12% plus 4%) to 34.94% (30% plus 12% plus 4%). However, note that dividend received from a foreign company would continue to be taxed at applicable rates in the hands of a domestic company and only dividend received from domestic company is sought to be allowed as a deduction.

Non-resident corporate shareholders: In this scenario, the Indian company 3 shall be liable to withhold taxes at 21.84% 4 (20% plus 5% plus 4%) on payment of dividend to a non-resident corporate shareholder. The benefit of provisions of tax treaty available to such shareholder could lower the tax rate. The foreign shareholder gets the credit of such withholding tax against tax payable in their home country as per the taxation laws in their home country.

II. Treatment under transfer pricing provisions

a) In the hands of company

The transaction in the nature of payment of dividend is essentially an appropriation of profits of the company and does not require any benchmarking analysis due to non-application of transfer pricing provisions specified in Section 92(1) of IT Act. The aforesaid transaction does not require any disclosure in Form No. 3CEB due to non-application of transfer pricing provisions.

However, a view can be taken to disclose the transaction in the nature of 'payment of dividend' in Form No. 3CEB out of abundant caution, to avoid any penal consequences.

b) In the hands of non-resident shareholders

The transaction in the nature of 'receipt of dividend' by the shareholder may be reported in Form No. 3CEB, however, do not require any benchmarking analysis.

D. Comparison of tax outflow in case of Buy Back of shares vis-à-vis Dividend payout and conclusion

Table 1: Buy-back of shares

Particulars
Amount in INR
Cash available for distribution 100
Tax @ 23.29% under section 115QA in the IT Act in the hands of company [100*23.29%] 23.29
Cash received by shareholder [100-23.29] 76.71

Note: The amount received on issue of shares has been considered as Nil in computing the buy-back tax. 

Table 2: Dividend payout

Particulars
Resident individual shareholder (Amount in INR)
Corporate shareholder
(Amount in INR)
Resident
Non-resident
Cash available for distribution 100 100 100
Tax in the hands of shareholder 42.74%/34.94%/21.84% 42.74 34.94 21.84
Cash received by shareholder 57.26 65.06 78.16

Note: For the purpose of dividend tax, we have assumed the respective highest tax rates

The comparison of table 1 and table 2 clearly summarizes that the resident individual shareholder and corporate shareholder shall receive INR 19.45 (INR 76.71 minus 57.26) and INR 11.65 (INR 76.71 minus 65.06) respectively, more in the case of buy-back of shares.

However, in the case of non-resident corporate shareholder shall receive INR 11.65 (INR 78.16 minus 76.71) more in the case of dividend payout. Furthermore, the non-resident corporate shareholder may receive higher amount on dividend payout after availing the benefits of tax treaty.

Pursuant to amendment vide Budget 2020, domestic companies are no longer required to pay DDT and dividend income is instead taxable in the hands of shareholders at the applicable tax rates.

The abolition of payment of DDT by corporate is a positive amendment, which will enhance the abilities of the companies to invite investments. The dividend received from foreign companies would be eligible to claim relief under section 90/90A as per specific provision under the tax-treaty or under section 91 in case of no tax treaty.

In the wake of COVID-19 outbreak and difference in the tax treatment of two options is compelling some companies in utilizing the buyback mechanism to save on the tax outflow. However, a dividend or share buyback is a prerogative of the board of the company. The board can choose to 'return money' to its shareholders by either of the two options or by both, depending on the cash position, profitability, future outlook and tax incidence. Also, buy-back of share could be better than dividend payout because of the beneficial effect on the earning per share from a reduced share amount.

However, in case of non-resident shareholders, the companies may prefer dividend payout option, owing to the low tax rate of 21.84%, which may even reduce to 5% after availing the benefits of tax treaty.

[The views expressed in the article are strictly personal.]

1 Vora Financial Services P. Ltd vs. ACIT - 2018-TIOL-1342-ITAT-MUM

2 Being the highest tax rate

3 Including foreign portfolio investor

4 Being the highest tax rate

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