Buyback - A closed door?

Share buyback has been one of the most favored routes of the MNC’s for repatriating profits from their Indian arm. With government of India proposing to tax buyback of unlisted equity shares as dividend in the finance bill 2013, literally one could imagine all the MNC rushing to run past the door that is closing on them.

A per the double tax avoidance treaty that India has with Mauritius and Singapore, capital gains arising on sale of shares in India are taxable in Mauritius and Singapore. Given that there are no capital gains tax in Mauritius and Singapore, MNC’s use Mauritius and Singapore as intermediate jurisdiction to invest in India to make a tax free exit from India in the future. This mode of tax neutral profit repatriation in the past drew lot of government attention and which has now made the policy makers to shut the doors by taxing buyback of unlisted equity shares as dividends.

The Authority for Advance Ruling in India in the case of OTIS Elevator dubbed the buyback as a colorable device disguised to repatriate dividends tax free as the company had not declared any dividend in the past.  Therefore, to plug in the revenue leakage the government has introduced section 115QA which reads as follows.

(1)   Notwithstanding anything contained in any other provision of this Act, in addition to the income-tax chargeable in respect of the total income of a domestic company for any assessment year, any amount of distributed income by the company on buy-back of shares (not being shares listed on a recognised stock exchange) from a shareholder shall be charged to tax and such company shall be liable to pay additional income-tax at the rate of twenty per cent on the distributed income.

Explanation.—For the purposes of this section,—

(i) “buy-back” means purchase by a company of its own shares in accordance with the provisions of section 77A of the Companies Act, 1956;

(ii) “distributed income” means 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 such shares.

As we proceed to dissect the section, we would understand that the section starts with an Non Obstinate clause and thus overrides other provision of the Indian Income-tax Act, 1961 (‘the Act’) especially section 46A of the Act which deals with capital gains on buyback of shares.  The section also provides the computation mechanism for arriving at the amount taxable as distributable income, which is the consideration paid by the company on buyback reduced by the amount received by the company on issue of shares brought back.  On examining of the term distributed income defined in the explanation, one would find contrasting that the term “amount” is used when defining what was received by the company on issue of shares and the term ‘consideration’ is  used when defining what is paid by the company on buyback of shares. As we all would understand that the term ‘consideration’ is much wider than the term ‘amount’, indicating that consideration can be in kind or in monetary form while the ‘amount’ has to be in the monetary form.  When the above interpretation is put to use say for example in a case where a resulting company in a demerger buybacks the share issued to the shareholders of the demerged company on demerger, the computation mechanism would fail as no ‘amount’ would have been received by the resulting on issuing of shares to the shareholders of the demerged company. Following the above pattern one would also find that the computation mechanism would also fail in the case of bonus shares issued or shares issued on amalgamation being brought back. Further, it would also need to be seen that when the buyback is undertaken below the issue price of the shares whether the resulting loss is a capital loss in the hands of the shareholders.

As we delve further, we would understand that the section is applicable to buyback made in accordance with section 77A of the Companies Act, which deals with buyback of equity shares.  Therefore, buyback of preference shares would still be chargeable to tax as capital gains, as buyback of preference shares are covered by section 80A of the Companies Act, 1956.

A parallel provision, section 10(34A) has been inserted to exempt the gains on buyback of shares in the hands of the shareholders. Section 115QR places the onus on the company buying back the shares to discharge the taxes at the rate of 20 percent plus surcharge and education cess on the distributed income.

Following are few pointers which the Indian subsidiaries of the MNC’s need to consider when undertaking buyback

• Arm’s length nature of the buyback price from Indian transfer pricing perspective ( the recent ruling of the AAR in the case of Castleton has held transfer pricing to be applicable even though income is not chargeable to tax in India).
• Discounted cash flow valuation from Indian foreign exchange regulation perspective.
• Transfer of shares at ‘Fair market value’ from section 56(2)(viia) of the Act perspective ( views exist that section 56(2)(viia) of the Act is not applicable to buyback)
• Substantiating the commercial substance behind the buyback of share and that it is not trigger reaction to proposed amendment.
• A Nil withholding tax order from the tax authority or an advance ruling would be a safest bet given the appetite of the Indian tax authorities to question the commercial substance.

The provision is proposed to take effect from 1 June 2013.  With the presidential assent to the finance bill still pending it would not be surprising if Indian subsidiaries of the MNCs are rushing to undertake buyback before the door closes on them.  It would also be fairly interesting to see the corporate India come up with innovative methods to circumvent the proposed buyback provision to avail the capital gains related treaty benefits.