It’s an old conflict of objectives — maximising investment returns for the taxpayer and increasing tax revenues for the government. The fund requirement for developmental activities has from time to time necessitated changes in law aimed at reining in schemes to minimise taxes. With this objective, Finance Act 2013 introduced Sections 115-QA to 115-QC in the Income-tax Act — effective from June 1, 2013 — to tax income distribution by unlisted companies through buyback of shares in specified cases.

To simplify the dividend tax regime, Finance Act 1997 had introduced a new scheme under which the company declaring dividend is liable to pay Dividend Distribution Tax and, thereafter, such dividend income is exempt in the hands of the recipient shareholders (residents and non-residents). However, buyback of shares by the Indian company was not liable to DDT and was, instead, taxable as capital gains, subject to treaty benefit for the foreign shareholders.

Recently, the Government found that certain unlisted companies with surplus income were buying back shares, instead of declaring dividend, in a manner that shareholders paid nil/ lower tax. To plug this loophole, Finance Act 2013 inserted the taxation of buyback scheme, which provides that any income distributed by an unlisted company on buyback of shares (in accordance with Section 77-A of Companies Act 1956) shall be taxed at 20 per cent. The distributed income would be computed as the difference between the buyback consideration and the amount received by the company for issue of such shares. Such buyback would, thereafter, be exempt in the hands of the shareholder under Section 10(34A).

To illustrate, if an unlisted company issued shares at Rs 30 (face value of Rs 10, plus premium of Rs 20) to A, and buys them back at Rs 60, then the distributed income would be Rs 30. The company would pay an additional tax at 20 per cent on Rs 30, and the shareholder would be exempt from tax.

While the intention is to curb avoidance of DDT, there is likelihood of litigation.

How would the taxable amount be computed if the seller had bought the shares in a secondary purchase? In the above example, let’s say B purchases the shares from A at Rs 50. The company makes a buyback at a future date at Rs 60. For tax under Section 115-QA, would the amount reduced from the buyback price be Rs 30 or the cost of acquisition by B — that is, Rs 50. With the current wording, if the amount received by the company alone were considered, the subsequent buyer would pay tax to the extent of his cost of acquisition.

Likewise, where a shareholder subscribes to the convertible instruments of an unlisted company at, say, Rs 20 and these are later converted into equity shares at face value (say, Rs 10), should the face value be reduced or would the subscription price of the convertible instruments be considered?

There could be other cases involving shares issued to shareholders of the transferor companies in a merger/ demerger, and the amalgamated/ resulting company issues shares for no cash consideration. Here, would the cost of shares be nil, or would the methodology hitherto prescribed for computing their cost in an amalgamation/ demerger apply?

Interestingly, the provisions do not differentiate the tax rate based on the holding period — that is, the tax rate is 20 per cent irrespective of whether the shares are long-term capital assets or short-term. Further, the shareholder may not be able to set off any brought-forward capital losses.

Moreover, such taxes pertaining to buyback of shares from non-resident shareholders, may cause hardship to those who cannot claim credit in their home country.

Given the already shrinking investment in the Indian economy, unless the Government clarifies on the various practical issues involved, the amendment may only add to the uncertainty of overseas and other investors.

Girish Vanvari is Co-Head of Tax, and Arinjay Jain is Director, KPMG in India

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