Investors shaken, not stirred to action

Finance Minister P. Chidambaram in his Budget presentation said that he would endeavour to introduce during the Parliament’s Budget session the amended Direct Taxes Code (DTC) after considering the standing committee’s recommendations. Though very few changes are proposed in the Income-tax Act, they may impact mergers and acquisitions.

Buyback of shares is an important exit tool used in M&As. With this, a company that has substantial net-worth and cash liquidity but no distributable profits can return its excess net-worth to shareholders. Such a transaction cannot be considered a tax avoidance instrument.

It is proposed that unlisted companies should pay 22.66 per cent tax on the profits distributed through buyback of shares. It is explained in the Memorandum that some unlisted companies have avoided dividend distribution tax (DDT) through arrangements involving buyback of shares and, therefore, the proposal to tax unlisted companies.

There are contradictory statements here. First, under the proposal the entire group would be penalised for the conduct of some. Secondly, the proposal is to tax profits distribution, but it involves tax on any distribution to shareholder through buyback, regardless of whether the company has distributable profits or not.

One of the side effects, intentional or otherwise, is the loss of the higher cost incurred by investors. The distributable profit is defined as “consideration paid — issue price of the shares”. This computation clearly ignores the cost in the hand of the shareholder. It is quite possible that the shareholder had acquired shares at Rs 100, and it is proposed to be bought back at Rs 100. However, if the shares were issued at Rs 10, the investor won’t gain on buyback, but the company will pay tax on Rs 90.

The shareholder is exempted from taxation on receipt of the buyback amount. However, as the income is exempt, the shareholder cannot claim set-off/ carry forward of loss suffered due to buyback.

This provision overrides all the provisions of the Income-tax Act and hints at taking away the benefits allowed and documented in various treaties. Besides raising doubts on sovereign integrity, it is sufficient to shake investor confidence and impact M&A transactions. The provisions will be applicable from June 1, 2013.

In the case of non-residents, it is proposed to clarify that production of Tax Residency Certificate is a necessary but not sufficient condition to claim treaty benefits. This again shook investor confidence, as claims for treaty benefits would be subject to greater scrutiny. Luckily, a circular clarifying the issue was released.

Another major change is the increase in tax on royalty or fees for technical services paid to a non-resident from 10 per cent to 25 per cent. This may indirectly impact M&A involving transfer of technology, knowhow, and so on.

One beneficial amendment is the proposal to allow, subject to condition, dividends received from a foreign subsidiary by an Indian company as a deduction from dividend paid, which is liable for dividend distribution tax under section 115O.

It is also pertinent to note that the suggestions given by the Shome Committee on indirect transfers (as in the Vodafone case), including retro amendments, and clarity on the term substantial — necessary to boost investor confidence — was not dealt with in the Finance Bill.

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