Buy back of unlisted shares  – Anomalies and Potholes ...
CA. Anant N. Pai

1. The proposed taxation of buy back transactions relating to unlisted shares in the Finance Bill, 2013 requires careful scrutiny of the Readers

The Finance Bill proposes to introduce a new Chapter XII-DA into the Income-tax Act. The Chapter is titled as – "Special provisions relating to tax on distributed income of domestic company for buy back of shares" contains new provisions sections 115QA to 115QC. The explanatory memorandum accompanying the Finance Bill spells out the purpose of this intended legislation. For the sake of maintain brevity in the article, I am not reproducing these verbatim. I shall however deal with the provisions in its substance and discuss the practical tax effects flowing from these provisions, if the same are adopted into the statute with the same language.

  1. To begin, with let me set out the intention canvassed behind the proposed amendment as given to understand from the explanatory memorandum. The memorandum cites that presently, section 115-O provides for levy of Dividend Distribution Tax {DDT} on the company at the time when the company distributes, declares or pays any dividend to its share holders. Consequent to this levy, the amount of dividend is not included in the total income of the share holder.

The consideration received by a share holder on buy back of shares by the company is not treated as dividend but is taxable as capital gains under section 46A. The memorandum states that unlisted companies, as part of tax avoidance scheme, are resorting to buy back of shares instead of payment of dividends in order to avoid payment of tax by way of DDT particularly where the capital gains arising to share holders are either not chargeable to tax or are taxable at a lower rate.

The proposed amendment is stated to curb this practice. The new Chapter XII-DA contains provisions whereby the consideration paid by the company for purchase of its own unlisted shares, which is in excess of the sum received by the company at the time of issue of such shares {the excess is styled as ‘distributed income in the provisions} will be charged to an additional tax @ 20% in the hands of the company. It is stated that the additional income tax shall be final on similar lines as dividend distribution tax. The income arising to the share holder in respect of such buy back would be exempt where the company is liable to pay the additional tax.

This is the legislative intention behind the proposed amendment as professed in the explanatory memorandum.

  1. Let us now see the proposed amendments. As stated before there are three sections proposed in the new Chapter viz. – sections 115QA to 115QC.

Section 115QA is the charging section which authorises the levy of the additional tax. The Explanation to sub-section provides two definitions for the section.

It firstly defines ‘buy back’ as meaning purchase by the company of its own shares in accordance with the provisions of section 77A of the Companies Act, 1956.

It secondly defines an expression called "distributed income" as meaning 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 its own shares.". In other words, if share of face value ` 100 was issued at a premium of ` 10 and is bought back by the company at ` 140, then the ‘distributed income’ would be ` 30. [140 minus ` 110 {i.e. ` 100 + ` 10}]. The company will have to pay additional tax @ 20% on this ` 30 to the treasury just like a Dividend Distribution Tax.

  1. Readers may note that the amendment had been proposed to curb avoidance of dividend distribution tax u/s 115-O. For example, suppose an unlisted company had disposable reserves of ` 200 in its hands available for distribution as dividend. Let us suppose that the company was proposing to distribute ` 20 as dividend. In this case, the company would be liable to pay DDT u/s 115-O @ 15% on this ` 20 i.e. ` 3. In order to avoid this DDT of ` 3, the company may buy-back some of its own shares of face value of
    ` 100 issued by it at par at ` 120.

Now under the definition of ‘dividend’ in section 2[22] of the Income-tax Act, a payment made by a company on purchase of its own shares from its share holder in accordance with the provisions of section 77A of the Companies Act, 1956 is specifically excluded from the meaning of ‘dividend’. As a consequence, the company would not have to pay ` 3 as DDT in the buy back of its shares.

In the hands of the share holder, the amount of ` 20 is taxable as capital gains in his hand u/s 46A of the Income-tax Act. If the gain is long term, then it would be entitled to concessional tax treatments under the Income-tax Act. Thus, according to the lawmakers, this is case where the DDT of ` 3 is avoided by the company in guise of a buy back transaction of shares.

The proposed amendment is to plug this loophole by subjecting the amount of escaped dividend of ` 20 by a new additional tax of 20% {in comparison to DDT of 15%}.

  1. But, the issue involved is not so simple and does not stop here. This is because if the amendment was proposed as a ‘remedy’ to cure the ‘malady’ of DDT avoidance, it can result in to a case where the ‘remedy’ is even worse than the ‘cure’. I shall explain why it is so in the forthcoming paragraphs.

  2. It is pertinent that the amendments have proceeded on a wrong assumption that every buy back at a gain to the share holder results in an avoidance of DDT. The amendments have assumed that the company indulging the buy back necessarily has distributable surplus in its hands for declaring dividend. This is not correct.

As per the provisions of section 77A of the Companies Act, a company may buy back its own shares only out of three options viz:-

[a] Out of its free reserves.

[b] Out of securities premium account and

[c] out of proceeds of any shares or other specified securities.

The readers must understand why these conditions have been imposed. There is a marked difference between reduction of share capital made by a company u/s 100 of the Companies Act and a buy back of its own shares u/s 77A. Whereas in reduction of capital, the effective capital of the company is reduced, in buy back of shares, the effective capital is maintained even after the buy back incident.

When the buy back is made out of its free reserves, the company is bound u/s 77AA to transfer a sum equal to nominal value of share purchased to the capital redemption reserve. Capital redemption reserve is a capital reserve and is not a free reserve available for dividend distribution. In this manner, the effective capital of the company is maintained at the same level even after the buy back.

If the buy back is made at a premium and the premium amount is appropriated out of the share premium account, the payment of buy back premium is compensated from the share premium account without any loss to the paid-up share capital.

It is also permissible to finance the buy back from a prior issue of issue of shares of a different category. {Issue of shares of same category is not permissible}. In this case, the reduction in share capital on buy back of Type Share A is compensated by the prior issue of shares of Type Share B.

On the whole, the principle involved is there is no reduction in the effective capital in a buy back transaction

  1. Therefore, one may come across a case where a company does not have disposable surplus on hand for dividend distribution and yet indulges in a buy back of its shares financed out a prior issue of shares of different category. The buy back may also involve a gain to the share holder in the buy back price. But, the payment of gain is not financed by the company not from any free reserves, but from fresh capital.

For example, let say a company wishes to buy back some of its shares {Type A} issued at its face value of ` 10 at a buy back price of ` 30. The company has no disposable surplus on hand for dividend distribution. It finances the buy back by a prior issue of another category of shares {Type B} of say face value ` 100. This is permissible because the types of shares are different – one has face value of ` 10 and another has face value of ` 100. Now, under the provisions of section 115QA, the gain of ` 20 to the share holder is treated as ‘distributed income’ and additional tax is levied on the same in hands of the company even though there was no avoidance of DDT.

This is the unintended damage that will be done by the provision.

  1. In short, unlike the provisions of section 2[22], where a ‘deemed dividend’ is taxed only subject to the availability of ‘accumulated profits’ on hand to curb dividend tax avoidance, the proposed amendments of section 115QA do not trace the incidence of additional tax to ‘profits available for distribution of dividend’. This should appear quaint especially when the amendment professes to curb avoidance of dividend distribution tax. On the other hand, one may see a levy of additional tax u/s 115QA even when there was no possibility of distribution of dividend in the first place.

  2. The issue for consideration of the readers is whether the levy of the additional tax u/s 115QA in this state is constitutionally valid in absence of a valid nexus between the levy and its professed object? Or because there are no safeguards to ensure the additional tax is not levied when there was no avoidance of DDT in the first place at all?

  3. To consider this issue, one may take a parallel from a case where reduction of capital was taxed as deemed dividend u/s 2[22][e] based on ‘accumulated profits’ available with the company.

Commercially, a dividend is normally declared by the company by way of distribution of some of its profits earned. There would be a tax on such dividend and hence revenue involved to the State. But, a company, despite having sufficient distributable profits on hand, may try to circumvent the dividend tax by compensating the share holder by returning him a segment of his share capital invested instead of paying him the dividend. In other words, the company which has ` 200 as accumulated profits on hand, instead of distributing ` 50 as dividend from these profits, may opt to keep the accumulated profits intact and pay ` 50 to the share holder by share capital reduction. This would deprive the Revenue of the tax on the dividend. It is precisely to rope in such a situation, that the provisions of section 2[22] [d] of the Income-tax Act were placed on the statute.

Such a provision also existed in the erstwhile 1922 Income-tax Act. Section 2[6A][d] was the relevant provision at that time, which read as under:-

"Dividend includes any distribution by a company on the reduction of its capital to the extent to which the company possesses accumulated profits which arose after the end of the previous year ending next before the 1st day of 1933, whether such accumulated profits have been capitalised or not.."

It may be noted that the provisions in 2[6A][d] of the 1922 Income-tax Act are, in effect and essence, the same as its counterpart provisions in section 2[22][e] of the 1961 Act. The constitutional validity of these provisions came directly for consideration before the Supreme Court in the case of the Punjab Distilling Industries Ltd. v. CIT [1965] 57 ITR 1 {SC}.

The Supreme Court held that the deemed dividend provisions qua the share capital reduction are not ultra vires the Government of India, 1935. This is because it is permissible for the Legislature to formulate a law to prevent evasion of tax. The law embodied in section 2[6A] [d] is one such law. The provision in section 2[6A] [d] was valid even though share capital reduction is permissible under the Company Law. The provision is meant to rope in cases of circumvention of dividend tax by not paying normal dividend out of accumulated profits on hand, but choosing to pay the shareholder otherwise by way of return
of share capital in the guise of share capital reduction.

  1. Here, the readers may note that the Supreme Court had upheld the constitutional validity of the ‘deemed dividend tax’ because there was a nexus between the provisions and the dividend tax avoided.

In the instant case of the proposed amendment in section 115QA, there is no such nexus of the provision with availability of disposal surplus for dividend distribution in the hands of the company. We have seen above that it is possible that the additional tax u/s 115QA may be levied on a buy back transaction even when there is no disposable surplus in hands of the company to distribute dividend. This is the issue which the readers may consider.

  1. There is also a corresponding amendment by proposing a new sub-section (34A) in section 10 for exempting the gains from the buy back in the hands of the share holder, when the additional tax is chargeable u/s 115QA.

The amendment reads as under:-

"(34A) any income arising to an assessee, being a share holder, on account of buy back of shares (not listed on a recognised stock exchange) by the company as referred to in section 115QA".

According to me, the words ‘as referred to in section 115QA’ creates a reference link of the ‘income’ arising in the hands of the share holder on buy back with the ‘income’ referred in section 115QA i.e. the income chargeable in hands of the company u/s 115QA. The income referred in section 115QA is the ‘distributed income’ i.e. the excess of the consideration paid by the company to the share holder on buy back over the amount received by the company for issue of the share.

It is therefore possible that the entire capital gain chargeable in hands of the share holder may not be exempt u/s 10 (34A) if the same is more than the ‘distributed income’ charged to additional tax u/s 115QA in respect of the share. This can be more particularly so if the share has changed hands after its issue.

For example, suppose the company has issued the share to Mr. A at ` 10 at a premium of ` 20. The amount received by the company at the time of issue is ` 30. Let us suppose, Mr. A transfers the share to Mr. B at a price of ` 20. The company then buy backs the share at ` 40. The company pays the additional tax on ` 10
(` 40 minus ` 30}. The capital gains in the hands of Mr. B are ` 20 {` 40 received on buy back minus ` 20 paid for acquiring it from Mr. A}. The income referred in section 115QA is ` 10 which would be exempt in hands of Mr. B. The balance of capital gains of ` 10 {` 20 minus ` 10 taxed u/s 115QA} would be taxable in hands of Mr. B.

This is a possible interpretation that may result from usage of the words ‘as referred to in section 115A’ in the proposed section 10 (34A) in the Finance Bill. It may therefore not wise to assume that the capital gains in hands of the share holder is necessarily fully exempt as made out in the explanatory amendment.

  1. At the end, I personally feel that if the law makers wanted to curb avoidance of dividend distribution tax in buy back transactions, it could have simply amended the dividend definition provisions of section 2[22] itself and related the incidence of escaped dividend tax to accumulated profits available for dividend rather than bringing in this Chapter XII-DA in which there are no safeguards to ensure that the levy of this new additional tax is confined to cases only where there is a actual avoidance of dividend distribution tax.

These are the thoughts which I would share with the readers.