Under current rules, domestic companies that engage in share buybacks are subject to a 20% tax on distributable net income; shareholders receive the buyback proceeds tax-free. The buyback tax is similar to the now-repealed dividend distribution tax (DDT), which was applicable until March 2020. Since April 2020, dividends have been taxable in the hands of shareholders. From now on, money received from the buyback will be fully taxable in the hands of a shareholder.
New tax rules for buybacks starting October 1, 2024
From October 2024, the entire amount received by shareholders on buybacks will be treated as dividend income and will be taxed as per their respective income tax brackets, with liability to withhold tax (TDS) on the company. The company will deduct tax at the rate of 10%, in case of payment to resident individuals (provided the buyback proceeds are equal to or more than Rs 5,000) and at the rate of 20% in case of payment to non-resident individuals (subject to tax treaty benefit, if any). The buyback proceeds, which are now taxed as “dividend”, will not be taxable as “capital gains” under income tax laws. However, the cost of acquiring shares offered on a buyback will be treated as a capital loss (whether short-term or long-term) to the shareholders, which can be set off against other capital gains or extended for a period of up to eight years.
LTCG and STCG holding period changed for all assets
The change in income tax liability may discourage companies from using share buybacks as a preferred method of returning capital to shareholders, particularly if the tax burden on shareholders outweighs the profits.
Who benefits from the new buyback tax rules?
The new buyback taxation system in India offers several positive outcomes. First, the new regime aims to reduce tax arbitrage between dividends and buybacks, promoting a level playing field and fairness in the taxation of corporate payouts. Treating buyback income as dividend income brings greater clarity and uniformity to the tax landscape. In addition, the new tax rules would encourage companies to engage in buybacks only when they believe their shares are genuinely undervalued and not simply to take advantage of a lower tax rate. This focus on creating value for shareholders over the long term could lead to more prudent and strategically sound buyback decisions. Mutual funds, which pay no or minimal taxes due to exemptions available to them under income tax laws, will benefit from this change in buyback taxation. Non-resident shareholders are in a position to benefit from the changes. The ability to take advantage of lower tax rates under the new tax rules would also increase the tax burden on companies. tax treaties In the case of “dividend income” which typically ranges between 5% and 15%, coupled with the option to claim Indian tax credits in their home jurisdictions (something which was not available under the current regime as the buyback tax is a tax levied on Indian companies and not on shareholders), significant relief is provided. However, the benefit may differ depending on the jurisdiction of such non-resident shareholders and the peculiar interplay of the “dividends”, “capital gains” and “other income” article under the respective tax treaties.
For example, a UK shareholder in an Indian company would benefit from the India-UK tax treaty, under which any income classified as a dividend under Indian law is also considered as such for the purposes of the treaty. Furthermore, the scope of capital gains under the India-UK tax treaty is also based on the respective domestic tax laws. In such cases, a lower tax rate of 10% or 15% on dividend income should be available (as in the India-UK tax treaty), since repurchase income is provided for to be treated as dividends. In contrast, under the India-Mauritius tax treaty, while the dividend article is similarly worded, repurchase also gives rise to an “extinguishment of rights” in the shares, which is specifically provided for in the capital gains article. Therefore, the applicability of the treaty benefits needs to be carefully examined. In particular, capital gains are exempt for shares acquired before April 1, 2017, while dividends are subject to tax at a reduced rate of 5% or 15% as per the tax treaty between India and Mauritius.
Even when taking advantage of treaty benefits, non-resident shareholders must demonstrate their eligibility for treaty rights and “beneficial ownership” of the income, which requires detailed analysis.
The new LTCG tax rules will hit these owners hard
Who loses with the new buyback tax rules?
Despite these positive aspects, the new tax rules on share buybacks have notable drawbacks. The most immediate concern is the increased tax burden on resident shareholders. By shifting the tax liability to shareholders, particularly those in higher tax brackets, the overall attractiveness of buybacks has been reduced. This can be understood with an example:
Detailed report | Individual A: Dividend income included in the highest tax bracket (above Rs. 15 lakh) | Individual B: Dividend income included in the lowest tax bracket (for example, in the bracket of Rs 10 lakh to Rs 12 lakh) | ||
Position before the amendment | Position after the amendment | Position before the amendment | Position after the amendment | |
Amount of repurchase proceeds | 100 | 100 | 100 | 100 |
Company buyback tax | 23.3 | – | 23.3 | – |
Additional tax on individuals for repurchase income considered as dividends | – | 35.88 | – | 15 |
Impact on absolute income tax rates | Tax rate increased by 12.58% | Tax rate reduction to 8.3% |
All the above income tax rates assume the new tax regime for both individuals and the higher level of surcharge for Person A. Moreover, the cost of the investment for both individuals is considered to be negligible. Note: Figures in rupees.
While individuals who are taxed in a lower tax bracket will benefit from this proposal, high net worth individuals may face a significant tax cost for such buybacks. This higher tax burden could make buybacks less attractive. In certain cases, even if companies have no potential deployment areas, they may prefer to retain cash at the company level rather than conduct a buyback and reduce the effective return to shareholders.
Dividends are usually taxable only to the extent that the company has built up reserves. Under the new rules, however, shareholders must now pay taxes on the entire buyback amount, rather than just on the net profit, which can significantly reduce their return on equity investment.
Recognizing capital losses also presents a challenge. While it allows for future tax relief, this tax benefit is deferred and shareholders must generate sufficient capital gains in later periods to fully utilize these losses. This deferral may not provide immediate financial relief, particularly for those who do not have substantial capital gains in the near term.
Impact on financial markets due to new buyback tax rules
Changes to the taxation of repurchases could have broader implications for financial markets. By making repurchases less attractive, companies could be forced to re-evaluate their capital allocation strategies. This change could influence market dynamics, potentially leading to a reduction in repurchase activities and affecting overall market liquidity. Companies will face increased compliance and reporting requirements as they adhere to the new tax provisions and ensure accurate tax withholdings.
While the changes aim to reduce tax arbitrage between dividends and share buybacks and promote fairness, the increased tax burden on shareholders and deferred profits pose substantial challenges. Companies and investors will need to approach these changes carefully, reassessing their strategies to optimize returns and comply with the new provisions.
(Bijal Ajinkya is a Partner and Viraj Doshi is a Senior Associate at Khaitan & Co. The views expressed are personal.)
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