Buyback tax: Prospective or retrospective?

While the increase in effective tax rate inter-alia for high net-worth individuals (HNIs) and the proposed rise in the minimum public shareholding for listed companies to 35% dominated the headlines following the budget, there was another move announced on 5 July 2019 that has got India Inc concerned.

As part of her maiden budget speech, Finance Minister Nirmala Sitharaman proposed to extend the buyback tax presently payable by companies on buyback of unlisted shares to listed shares with effect from July 5, 2019. This essentially translates to an additional tax burden of around 23% for listed companies looking to buy back shares. For companies that had initiated a buy-back prior to July 5, this means a bigger hit to their pockets than they had anticipated while formulating the terms of their buyback. The position has not been re-looked in the amendments to Finance (No.2) Bill, 2019 pursuant to discussion in the Lok Sabha.

First, let’s examine the why the government chose to go down this road when it comes to buy-back tax.

Rationale behind the move

The intention behind extending the buyback tax to listed shares was to discourage the practice of avoiding Dividend Distribution Tax (DDT) by opting for a buyback of shares instead.

Companies may employ their profits/excess cash in the form of either dividends to shareholders or via a buy-back of shares from investors. While a dividend is a specific amount paid to all investors per share, a buyback offer is optional in that shareholders who wish to tender their shares for a certain amount can choose to do so.

The government levies DDT on the dividends paid out at an effective rate of 20%. Also, shareholders who get more than ₹10 lakh in dividends per year are now charged an additional 10% in tax.

Many companies were reportedly opting to take the buyback route instead of distributing dividends to bypass these additional tax levies on dividends,

Buy-back tax: Concerns

Primarily, the underlying rationale does not seem to take into account the fact that dividend is a distribution to the shareholder out of the profits of the company where the rights of shareholder remains unaffected; whereas in a buy-back, the rights of shareholder are more likely to undergo a change and it also impacts the company’s market capitalisation. A company’s decision either to distribute dividend or buy-back shares is based on different commercial considerations due to which the two cannot be treated at par for taxation purposes.

The larger question that is worrying the industry is the proposed tax being made effective from July 5, leading to an ambiguity as to whether it is applicable on buyback offers launched prior to that date. The general reaction from the industry seems to be that the company would not have launched the buyback offer or would have offered different terms to shareholders had it known that an additional tax burden of around 23% would have to be borne.

Moreover, a buyback is a strategic decision taken by a company and is subject to approval from the board of directors and/or shareholders; the decision is also dependent on the cash available with the company that can be utilised for the same.

So companies that have got the approval for a buy-back prior to July 5, 2019 now find themselves in a no-win situation. On one hand, there may be challenges in withdrawing a buyback offer that has already been extended and on the other, if the proposed tax amendment is implemented in the present form it would entail a significantly larger pinch to the company’s pockets than anticipated. This additional cash outflow would in all probability impact the financial position of the company,especially the ones without sufficient cash balance to absorb the tax cost of around 23%.

Another valid argument is that historically long-term gains on listed shares was entirely exempt. Then the tax for shareholders was brought in but grandfathering was kindly allowed by the government. One would expect parity to be maintained, and a suitable mechanism to be devised such that, the cost paid by the respective shareholder for acquisition of shares would be considered while determining the amount on which the buy-back tax is to be paid.

One of the critical issues is the practical challenge in determining from whom the company has bought back the shares in an open market. This would mean the company would not be able to identify the cost to be reduced to determine the amount on which buyback tax is to be paid and hence, it would become practically challenging to compute buy-back tax liability. Similarly, shareholder would not know if the gain he has earned is tax exempt. Immediate clarification for this ambiguity is required to put the issue at rest.

Given that the fate of several buyback plans hangs in the balance, the government must provide some much-needed clarity on whether the additional tax burden will also be applied retrospectively to buy-backs already in effect at the earliest.

Views are personal.

Vinita Krishnan is a director and Rahul Jain is a senior associate at Khaitan & Co.