[Opinion] Budget Expectation: Income Tax on Buyback of Shares

Authored by CA Naveen Wadhwa – DGM & Rachit Sharma – Manager | Taxmann Advisory and Research

Consider the scenario of being at a restaurant for lunch and being asked to pay for other guests’ meals after finishing your own. This would likely be viewed as unexpected and unfair, causing you to choose not to return to that restaurant and instead look for one with more fair policies. Similarly, when a company announces a buyback of shares and pays tax on the distributed income, it can be seen as an unfair situation for shareholders, causing them to look for other investment opportunities with more reasonable practices.

When a domestic company decides to buy back its own shares, it is required to pay a tax of 23.296% on the distributed income. The distributed income is the difference between the amount the company pays to purchase the shares and the amount it received when the shares were first issued.

When a lower number of shareholders choose to sell their shares and leave the company, it can negatively affect the interests of those who remain. The company must use its own funds to pay taxes on the distributed income, which reduces the value of the remaining shareholders’ investments. This can be seen as an adverse outcome for the remaining shareholders.

When a company buys back its shares, it can boost its future earnings per share (EPS) by reducing the number of shares outstanding. But if the company has to pay taxes on the distributed income, it will have less money to reinvest. This can cause the EPS to not reach the same level as it would have been, if the shareholders had paid the taxes on the distributed income.

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As an example, consider a company that has 1 million shares and a net income of Rs. 10 million, resulting in an EPS of Rs. 10 per share. If the company conducts a buyback of 250,000 shares and there is no change in net income, the EPS would increase to Rs. 13.33 per share. However, if the company must pay a tax of Rs. 1 million on the distributed income, the net income would be reduced to Rs. 9 million, resulting in an EPS of Rs. 12 per share.

This illustrates that the remaining shareholders collectively bear the tax burden that the company must pay on the buyback. It would be logical for the tax to be shifted to the shareholders. In November 2022, the Securities and Exchange Board of India (SEBI) released a consultation paper on the review of the SEBI (Buyback of Securities) Regulations, 2018, which proposed various changes to existing buyback norms. One of the proposed changes is to shift the tax burden of buybacks from the company to the shareholders.

SEBI recently conducted an analysis of buybacks by 68 listed companies during the 2020 fiscal year, and based on this analysis, proposed a change in regulations to shift the tax responsibility for buybacks from the company to the shareholders. This proposal was based on the fact that in 19 of the companies studied, promoters tendered more shares than their pre-buyback holdings, resulting in the company paying taxes not only on shares tendered by the promoters, but also on the additional shares tendered by them. These taxes, which amounted to Rs. 2,988.79 crores, including Rs. 2734.35 crores for shares tendered by the promoters, were paid from the company’s reserves on behalf of the existing shareholders and promoters at the expense of continuing shareholders.

It is suggested that the tax burden on buybacks should be shifted to the shareholders, similar to how it is handled with dividends distributions. This would align the tax treatment of buybacks with that of dividends.

By shifting the tax responsibility for buybacks from the company to the shareholders, it would make the tax treatment of buybacks more fair and equitable. This would result in a decrease in the tax rate on long-term holdings, which would be half of the current buyback tax rate, and also a decrease in the tax rate on short-term holdings. Additionally, shareholders would be able to claim a loss if the buyback price is lower than the issue price, which is not currently possible.

It’s worth noting that when a foreign company buys back shares from its Indian shareholders, the Indian shareholders are currently responsible for paying taxes on the capital gains from that buyback, which are calculated according to Section 46A of the Income Tax Act.

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