Legal Implications of the New Buyback Tax Amendment and Potential for Tax Avoidance

The introduction of tax laws aims to curb the exploitation of tax planning opportunities and prevent tax avoidance. Anti-avoidance rules, including Specific Anti-Avoidance Rules (SAAR) and General Anti-Avoidance Rules (GAAR), are established to address such tax abuse. SAAR encompasses various anti-abuse provisions in domestic law, treaties, or specific scenarios, forming the initial threshold for compliance in targeted abuse situations. In India, the Central Board of Direct Taxes (CBDT) has clarified that GAAR will serve as an additional threshold alongside SAAR.

Section 115QA of the Income Tax Act (applicable until 30 September 2024) is a distinct provision imposing a tax on the income of domestic companies arising from the buyback of their own shares. According to this section, any income generated from the buyback of unlisted shares (and listed shares) is subject to an additional income tax at the rate of 20%. "Income" in this context refers to the difference between the consideration paid by the company for the buyback and the amount originally received by the company from the issuance of those shares. This provision, introduced by the Finance Act 2013, functions as a SAAR.

The explanatory memorandum to the Finance Act 2013 articulates the purpose of Section 115QA as follows:

“Unlisted companies, as part of a tax avoidance scheme, are resorting to buyback of shares instead of payment of dividends to avoid tax by way of DDT, particularly where the capital gains arising to the shareholders are either not chargeable to tax or are taxable at a lower rate. To curb this practice, it is proposed to amend the Act by inserting new Chapter XII-DA, providing that the consideration paid by the company for the purchase of its own unlisted shares, which exceeds the sum received by the company at the time of issue of such shares (distributed income), will be charged to tax, and the company would be liable to pay additional income-tax at 20% of the distributed income paid to the shareholder.”

The intent is to treat buyback income neither as a dividend nor as capital gain but as a SAAR against tax avoidance schemes. Treating buybacks as either dividends or capital gains presents challenges in the Indian context.

Under the Companies Act, 2013, a buyback is treated separately from dividends. Although a buyback releases assets to the shareholder, its motive differs from that of a dividend. The key differences are as follows:

1. Restriction: A buyback is restricted to 25% of the paid-up capital, whereas dividends are declared for all shares.

2. Consolidation of Shares: Canceling and buying back shares allows shareholders to enjoy elevated share value in the mid to long term, as the number of issued shares decreases.

3. Higher Earnings Per Share (EPS): Repurchasing shares boosts EPS, as the net income remains the same, but the total number of outstanding shares decreases.

4. Reflection of Investor Confidence: Companies that buy back shares are often seen as having a strong market presence and solid pricing power, enhancing the company's market image and appealing to potential investors.

5. Relinquishment of Property: A buyback involves canceling shares or dissolving the existing capital in hand.

Risks of Tax Avoidance with the Recent Amendment

While the objective of the amendment, according to the explanatory memorandum for the Finance Act 2024, is to widen the tax base and prevent tax avoidance, certain scenarios may still facilitate tax avoidance. Domestic shareholders might bear the tax burden on dividends from buybacks, but the situation differs for non-resident shareholders who can leverage treaty benefits. The following analysis is theoretical and does not endorse any tax avoidance schemes.

Consider a company based in Mauritius, referred to as Mauritius Co., which has a subsidiary in India named Indian Co. Mauritius Co. invests in Indian Co. via a purchase transaction from the Netherlands, say at INR 50 crores. A year or two after Mauritius Co. purchases the shares of Indian Co. (post-2017), it proposes a buyback of shares from Mauritius Co., resulting in the transfer of shares from the foreign holding (Mauritius Co.) back to the Indian company (Indian Co.).

Section 115QA was introduced through the Finance Act, 2013, effective from 1 June 2013. Prior to this section, many Indian companies distributed dividends to shareholders in treaty-friendly countries through buybacks. This route avoided capital gains tax as the Indian company benefited from the relevant tax treaty. Thus, both the Indian company and the shareholder (in Mauritius) went untaxed. Under section 115-O, companies distributing dividends must pay Dividend Distribution Tax (DDT). Artificially characterizing dividends as buybacks helped companies avoid DDT. Section 115QA ensured parity between buyback and dividend treatment when DDT was in place.

Now, with Section 115QA repealed, the release amount is considered a dividend, and the recipient is taxed accordingly. With the treaty benefit for Mauritius (assuming the Principle Purpose test is met), the taxability for Mauritius Co. is 5%. Additionally, Mauritius Co. can benefit from a 12.5% set-off against capital gains for long-term holdings.

Here's a numerical example:

- Amount released to Mauritius as part of Buy Back Scheme: INR A100 Crores (gross)

- Tax paid by Mauritius: INR 5 crores

- Cost of acquisition of Mauritius shares: INR 50 crores

- Long-term capital gain (LTCG) from disposal of other Indian company shares: INR 60 crores

- Taxable LTCG: INR 10 crores

- Tax on LTCG: INR 1.25 crores

- Effective tax on INR 160 crores (INR 100 as dividends and INR 60 as Capital gains): INR 6.25 crores (3.90%)

- Taxation as per existing 115QA regime: INR 23.296 crores + Capital Gain tax @12.5% on INR 60 crores (INR 7.5 crores)

If this transaction were undertaken by the Indian company, the taxation would be at least INR 30 crores (assuming 30% tax rates for other income). This allows a foreign multinational to exploit treaty provisions and the new legislation regarding capital gains.

While the new taxation regime of buyback as dividends imposes an additional burden on Indian companies and residents, it also opens potential tax avoidance schemes in cross-border taxation. The Indian Government should amend the current treatment for buybacks before its implementation on 1 October 2024. Additionally, the practical applicability of buyback provisions in treaty situations, including the interplay between Articles for Dividend and capital gains, should be clarified with explanatory memoranda, illustrations, and treaty interpretations.