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Buy back rulesground covered

Introduction

1. Buy back of shares is a common method of rewarding investors. It also provides the investors an opportunity to exit from their investments, especially in case of unlisted companies. In addition to benefits to shareholders, buy back of shares also provides various benefits to companies like optimizing capital structure, returning excess cash to shareholders, improving earnings per share, stabilizing share prices, etc.

Repatriation of profits to shareholders through buy back of shares gained momentum in India, as repatriation through distribution of dividend attracted dividend distribution tax (DDT) in India. Distribution to shareholders on buy back of shares was not liable to DDT and was, instead, taxable as capital gains in the hands of shareholders, subject to treaty benefit for foreign shareholders. Therefore, Indian companies with surplus income bought back shares instead of declaring dividend and shareholders were taxed depending upon their tax attributes.

Advent of buyback tax in India

2. To curb the practice of taxpayers of escaping DDT by taking the buy-back route for repatriation of cash to shareholders, the Indian legislature introduced buy back tax (BBT) in India. The Income Tax Act, 1961 was amended in the year 2013 and tax on “distributed income” on buy back of shares by unlisted companies was levied at 20% (plus applicable surcharge and cess). On the other hand, shareholders were given complete exemption from capital gain tax. “Distributed income” was defined as consideration paid by the company on buyback of shares as reduced by the amount received by the company for issue of such shares.

Controversy around interpretation of the words “the amount received by the company for issue of such shares”

3. There were certain interpretation issues of the words “the amount received by the company for issue of such shares,” while determining distributed income on buy back of shares. The disputes were particularly in situations where shares were issued for non-cash consideration such as issue of shares in a scheme of amalgamation or demerger, swap of shares, shares issued in consideration for acquisition of an asset or for settlement of liability.

The Memorandum to Finance Bill, 2016 stated that the lack of clarity in the manner of determination of consideration received by the company would present a tax arbitrage opportunity of scaling up of consideration, particularly under a tax-neutral business reorganisation followed by buyback of shares. To resolve such disputes, the definition of “distributed income” provided under section 115QA was amended by the Finance Act, 2016 with effect from 1 June, 2016. As per the new definition, distributed income shall mean the consideration paid by the company on buy back of shares as reduced by the amount that was received by the company for issue of such shares, determined in the manner as may be prescribed.

Accordingly, the Central Board of Direct Taxes (CBDT) had come up with draft rules in July of this year to prescribe the manner of determining the “amount received.” The CBDT also invited comments from stakeholders before publishing final rules, thereby encouraging public participation and transparency. The industry and professional bodies made various representations on issues that were not specifically covered by the draft rules and would cause hardship to taxpayers. The CBDT considered the concerns raised by the stakeholders and notified the final rules on 17 October, 2016. The final rules provide for determination of “amount received by the company for issue of shares” in different situations, which are discussed below.

(i) When a company issues shares by way of subscription: amount received would be that actually received by the company on issue of shares including the premium amount.
(ii) When the company, prior to buy back, returned any sum out of the sum received on issue of shares: amount received by the company as reduced by the sum so returned.
It is also clarified that if the company paid tax on the sum so returned under section 115-O of the Act, then such sum shall not be reduced to arrive at the amount received.
Illustration 1
Particulars Amount in INR (per share)
Amount received by A Co. on issue of shares 20 (including INR 10 premium)
Amount distributed by A Co. on capital reduction 5
Consideration paid by A Co. on buy back of shares A 100
Amount received (20-5) B 15
Distributed income (A-B) 85
In the above illustration, if A Co. had paid DDT under section 1150-O on INR 5 returned to shareholders on capital reduction, then amount received by the company for the purpose of computation of distributed income on buy back of shares would have been INR 20 and not INR 15. The BBT in such case would have been levied on distributed income of INR 80 and not INR 85.
(iii) When shares are issued under ESOP or as part of sweat equity shares: amount received shall be the fair market value (FMV) of the shares as determined by the merchant banker on the specified date to the extent credited to the share capital and share premium account by the company.
Merchant banker means a Category I merchant banker registered with SEBI.
Specified date means the date of exercising the option or any date that is earlier than the exercise date and is not more than 180 days earlier than the exercise date.
(iv) When shares are issued under a scheme of amalgamation in lieu of shares of amalgamating company and such shares are being bought back by the amalgamated company: amount received shall be the amount received by the amalgamating company in respect of such shares
Illustration 2
Particulars Amount in INR (per share)
Amount received by amalgamating company on issue of shares 20 (including INR 10 premium)
Share exchange ratio on amalgamation: for every five shares held in the amalgamating company, the shareholders will get one share of the amalgamated company
Consideration paid by amalgamated company on buy back of shares A 100
Amount received by amalgamated company B (one share was issued in lieu of five shares of amalgamating company. Therefore amount received by amalgamating company for five shares would be taken as the amount received in the hands of amalgamated company i.e., 5 * INR 20) 100
Distributed income (A-B) Nil
(v) When shares are issued under a scheme of demerger by resulting company: amount received shall be computed in accordance with the following formula
A x B/C
where A = amount received by the demerged company in respect of issue of original shares
B = net book value of assets transferred in demerger
C = net worth of demerged company
Illustration 3
Particulars Amount in INR
Amount received by the demerged company on issue of shares A 20 per share (including INR 10 premium)
Share issuance ratio on demerger: for every five shares held in the demerged company, the shareholders will get one share of the resulting company
Net book value of assets transferred on demerger B 50cr
Net worth of the demerged company before demerger C 100cr
Consideration paid by resulting company on buy back of shares X 100 per share
Amount received for one share of resulting company YA x B/ C i.e., INR 100* x (50/ 100)]

*As one share of resulting company was issued for five shares of the demerged company, the amount received by the demerged company for 5 shares would be taken for computing the amount received i.e., 5 x INR 20 = INR 100

50 per share
Distributed income (X-Y) 50
(vi) When the original shares in the demerged company are bought back: amount received shall be the amount received by the demerged company as reduced by the amount so arrived above in point no. 5.
Illustration 4 (in continuation to illustration 3)
Particulars Amount in INR
Consideration paid by the demerged company on buy back of shares A 100
Amount received by the demerged company B[Amount received by the demerged company on issue of shares: amount so arrived in illustration 3 i.e., INR 20 – INR 10*]

*As one share of resulting company was issued for five shares of the demerged company, the amount received by the demerged company for one share would be taken for computing the amount received i.e., INR 50/ 5 = 10

10
Distributed income (A-B) 90
(vii) When shares are issued as part of consideration for acquisition of any asset or settlement of any liability: amount received shall be determined using the following formula
A/ B
where A = lower of the following:
(a) the amount which bears to the FMV of the asset or liability, as determined by a merchant banker, the same proportion as part of consideration being paid by issue of shares bears to the total consideration;
(b) the amount of consideration for acquisition of the asset or settlement of liability to be paid in the form of shares, to the extent credited to the share capital and share premium account by the company.
B = number of shares issued by the company as part of consideration
Some examples of issue of shares that would fall under this case are swap of shares i.e., issue of shares as a consideration for acquisition of shares of another company; issue of shares as a consideration for acquisition of machinery; conversion of loan into shares, etc.
Illustration 6
Particulars Amount in INR
Fair market value/ purchase price of machinery 1,000
Consideration discharged in the form of shares (10 shares at INR 10 plus premium of INR 40 per share) 500
Consideration discharged in cash 500
Consideration paid per share on buy back of shares X 100
Amount received per share = A/ B = 500/ 10 YA = lower of

(a) FMV of asset x (consideration discharged by issue of shares/ total consideration) i.e., INR 1000 x (500/ 1,000) = INR 500
(b) consideration paid by issue of shares to the extent credited to share capital and share premium account i.e., INR 500

A= lower of the above = INR 500

B = number of shares issued = 10

50
Distributed income (X – Y) 50
(viii) When shares are issued on succession or conversion of a firm or proprietary concern by company: amount received would be determined by using the following formula
(A – B)/ C
where A = book value of assets in the balance sheet – (TDS/ TCS/ advance tax – refund) – amount shown as an asset in the balance sheet that does not represent value of any asset including unamortised amount of deferred expenditure.
Revaluation of assets, if any, shall be ignored while computing book value of assets.
B = book value of liabilities shown in the balance sheet excluding capital, reserves, provision for taxation, provision for unascertained liabilities and contingent liabilities.
C = number of shares issued on conversion or succession
(ix) When shares are issued without any consideration i.e., issue of bonus shares: amount received shall be deemed to be nil.
(x) When shares are issued on conversion of preference shares, bonds or debentures, debenture stock or deposit certificate or warrants or any other security: amount received shall be the amount originally received by the company in respect of instrument so converted.
(xi) When shares are held in dematerialised form: amount received by the company shall be determined in accordance with this rule on the basis of first-in-first-out (FIFO) method.
The practical implementation of this rule may need further guidance.
(xii) In any other case: amount received shall be the face value of shares.

Despite the clarity provided in the rules on the above situations, some scenarios need to be addressed. For instance, there can be two ways of calculating the BBT when a company has previously issued bonus shares. Take for example, Company A issued 1,000 shares for INR 450 per share (i.e., fair market value per share), and subsequently, gave bonus shares in the ratio of 20 shares for every 1 share reducing the fair market value to INR 21.43 per share. Now if this company undertakes to buy back 5,000 shares at fair value of INR 21.43, there could be two scenarios for the calculation of the BBT.

Scenario 1: computation of BBT separately for each type of shares i.e., original shares and bonus shares

Particulars Amount (in INR)
Buy back of original shares
Buy back consideration (1,000 x INR 21. 43) 21,430
Less: amount received (1,000 x INR 450) 4,50,000
Distributed income (4,28,570)
BBT Nil
Buy back of bonus shares
Buy back consideration (4,000 x INR 21.43) 85,720
Less : amount received Nil
Distributed income 85,720
BBT @ 20% 17,144

Scenario 2: computation of BBT on a consolidated basis for both types of shares

Particulars Amount (in INR)
Buy back consideration (5,000 x INR 21. 43) 1,07,150
Less : amount received (1,000 x INR 450 + 4,000 x INR 0) 4,50,000
Distributed income (3,42,850)
BBT Nil

The rules as currently drafted reckon amount received for each share issuance separately. Therefore, scenario 1 seems to be the correct approach of computing BBT. The rules do not provide any provision for set-off of distributed income for calculation of BBT (as in scenario 2), and thus, requires clarification.

Takeaways

4. The CBDT has followed a holistic approach and has accommodated commercial considerations related to issue of shares in the final rules. This is a welcome move to reduce the ambiguity involved in computation of BBT and is in line with Government’s philosophy of bringing more certainty in the tax regime.

However, one aspect that warrants more clarification is BBT on secondary market deals. The new rules do not recognise the secondary transactions between investors in unlisted companies, and thus, leads to double taxation. For perspective, suppose a company issues shares to a shareholder at INR 100 and after a few years, such shareholder sells these shares to another investor at INR 200. The shareholder will be subject to capital gains tax on the same. Subsequently, the company comes out with a buyback offer at INR 300 in which the investor tenders its shares. Under the proposed tax rules the investor would be liable to 23.08% tax on INR 200 (against an actual income of INR 100), as under the buyback rules the BBT is calculated on the difference between the amount paid on buy back and original price at which shares were issued by the company. This is because buy back law do not recognise step-up price in secondary deals, which leads to double taxation. Each time the shares exchange hands in the secondary market, their step-up price would be ignored in such computation and would result in double taxation on the same amount, once as capital gains, and thereafter, as BBT. This ambiguity in the Income Tax Law has existed since the introduction of BBT in India. It will be interesting to see what the legislature will do to plug this loophole.

Category: M/S R P L & CO

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