Buy-back tax inhibits business efficiency

Consequently, unlisted companies had to either pay DDT or buy-back tax, and their shareholders were tax-exempt on dividend income up to Rs 10 lakh or on income from buy-back of shares.

A large number of companies in India (particularly, IT) have announced buy-back of shares in the last five years. Many start-ups and unlisted companies too have made buy-back announcements. This lets their employees encash shares allotted through stock options. Companies with a distributable surplus can distribute it through dividends or through share buy-back. Buy-back is seen as a way of restructuring capital, returning surplus, increasing capital efficiency by increasing RONW and rewarding shareholders, since shares bought back are extinguished, thereby reducing the number of outstanding shares. This improves a company’s financial ratios and leads to better valuations. This is also a sign of confidence in the business’s future prospects.

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IT companies have opted for dividends as also buy-back as a means to reward shareholders. The surplus cash thus returned is better deployed by shareholders than companies in their business. Surplus cash earns little and negates the very reason shareholders give equity to business (to earn superior returns) and reduces business efficiency and investment. At times of pronounced market decline, a buy-back stabilises the stock-price as it shows confidence in the future.

A listed company may buy back shares from holders on a proportionate basis through a tender offer or from the open market through the stock exchange or book-building process. Unlisted companies can only do this through the tender offer. Under the ‘open-market’ route, a listed company fixes a maximum buy-back price and buys below the buy-back price through a stock exchange.

The Finance Act 1997 imposed a 10% Dividend Distribution Tax (DDT) to be paid by companies on payment of dividends, which was increased to 15% in 2007. DDT was required to be paid on grossed up dividends from October 2014, increasing the base DDT rate to 17.65%. The effective rate on dividends paid to shareholders before March 2020 was 20.56% after including 12% surcharge and 4% cess. When DDT was payable by companies, shareholders were tax-exempt on dividend income. From April 2017, they were required to pay income-tax at 10% (plus surcharge and cess) on excess of dividend income over Rs 10 lakh.

Upon buy-back, companies were not required to pay any tax and shareholders of unlisted companies were required to pay LTCG tax at 20% after considering indexation benefit. Many unlisted companies resorted to buy-back to avoid payment of DDT. Buy-back tax at 20% (plus surcharge and cess) was first imposed on unlisted companies in April 2013, as an anti-tax avoidance measure, and shareholders of unlisted companies were exempted from taxation on any income from buy-back.

Consequently, unlisted companies had to either pay DDT or buy-back tax, and their shareholders were tax-exempt on dividend income up to Rs 10 lakh or on income from buy-back of shares. Listed companies were not required to pay any tax on buy-back. From FY05, equity shareholders of listed companies were exempt from LTCG tax if Securities Transaction Tax (STT) was paid on sale of listed equity shares. If STT was not paid, they were required to pay LTCG tax at 10%. Buy-back tax was extended to listed companies from July 2019 to discourage use of buy-back to avoid DDT. Shareholders are exempted from taxation on any income from buy-back.

DDT was abolished in April 2020 and a withholding tax was introduced on payment of dividends by companies. Shareholders are now required to pay income-tax on dividend income. From April 2018, income-tax at 10% is imposed on LTCG exceeding Rs 1 lakh from sale of listed equity shares.

The buy-back tax on listed companies is inequitable for multiple reasons. It imposes a higher cost on the company, at 20%, compared to LTCG taxation of 10% on equity shareholders currently. Buy-back tax of 20% on listed companies was introduced in July 2019 after LTCG tax of 10% was imposed on sale of listed equity shares from April 2018. When companies buy back via the open market route, they have to pay tax at 20% and shareholders have to pay LTCG at 10%. Whereas under a tender offer, a company has to pay tax at 20% and shareholders are tax-exempt. The double taxation under the open market route makes buy-back very expensive for the company and its shareholders.

The methodology to determine buy-back tax makes it more expensive. For the shareholder, capital gains tax is imposed on incremental gains between sale consideration and purchase cost. Buy-back is imposed on the net consideration paid by the company after reducing the net amount received for original issue of shares. This results in double taxation of incremental capital gains on which capital gains tax is already paid. Lastly, buy-back tax is not a tax-deductible expense to the company or shareholder. Consequently, its impact is borne by all shareholders, including those who do not participate in buy-back under the tender route.

Shareholders of listed and unlisted companies are currently required to pay income-tax on dividend income and capital gains tax on sale of shares. However, in the case of buy-back under the tender route, listed and unlisted companies pay 20% buy-back tax whereas shareholders do not pay tax on income from buy-back. In the case of open market buy-back by listed companies, they pay buy-back tax at 20% and shareholders pay LTCG tax at 10%. The entire regime is complex and increases the cost of buy-back and reduces capital efficiency. To enable companies to restructure their capital and improve their capital efficiency in a regime where dividends and capital gains are taxed in the hands of the shareholder, it is much better to abolish buy-back tax and ensure shareholders pay income-tax on any income from buy-back.

This will eliminate all the shortcomings of buy-back tax and simplify taxation. Imposing a buy-back tax on companies is a penalty for increasing capital efficiency, and increases the cost of capital restructuring and financial flexibility. This hurts investments and job creation as it inhibits further investments and leads to higher idle cash in the books of companies. Financial markets need higher flexibility to boost capital productivity.

The author is Chairman, Aarin Capital Partners