Buy-Back Taxation Shift to Shareholders from 1st October 2024

Buy-back of Shares: From Company-Level Tax to Shareholder-Level Tax – A Complete Analysis of the Finance (No. 2) Act, 2024

Introduction

Buy-back of shares has long been one of the preferred mechanisms for returning surplus funds to shareholders. Besides providing an exit opportunity to investors and improving capital structure, buy-backs also became a popular tax planning tool due to the varying tax consequences applicable at different points in time.

The taxation of buy-backs under the Income-tax Act, 1961 has witnessed a complete transformation over the last decade. The law has moved through three distinct phases:

1. Taxation in the hands of shareholders (up to 31 May 2013);

2. Taxation in the hands of the company through Section 115QA (1 June 2013 to 30 September 2024); and

3. Taxation once again in the hands of shareholders with effect from 1 October 2024.

The Finance (No 2) Act 2024 has reversed the existing regime and shifted the tax burden from the company back to the shareholder. This article examines the legislative journey, the rationale behind the amendments, and their practical implications.

With the Income-tax Return (ITR) filing season currently underway, taxpayers and professionals alike are encountering considerable confusion regarding the tax treatment of shares bought back by companies. The amendments introduced by the Finance (No. 2) Act, 2024 have fundamentally altered the taxation of buy-back transactions, resulting in uncertainty over the head of income, reporting requirements in the ITR, recognition of capital loss, and the interplay between the amended provisions of the Income-tax Act. Through this article, an attempt has been made to trace the legislative evolution of buy-back taxation, explain the changes introduced by the new law, and simplify the reporting and tax treatment of such transactions to assist taxpayers in correctly filing their income-tax returns.

Phase I – Position prior to 1 June 2013

Prior to the introduction of Section 115QA, a buy-back was treated as a transfer of capital assets.

The shareholder was liable to capital gains tax under Section 46A of the Income-tax Act.

The computation was straightforward:

Capital Gain = Buy-back Consideration – Cost of Acquisition

Accordingly:

• Long-term shareholders enjoyed concessional tax treatment wherever applicable.
• Non-resident shareholders could claim relief under Double Taxation Avoidance Agreements (DTAAs), subject to eligibility.
• The company had no additional income-tax liability merely because it bought back its own shares.

At this stage, buy-backs were taxed similarly to any other transfer of shares.

Why was Section 115QA Introduced?

The Government observed that several closely held companies were distributing accumulated profits through buy-backs instead of declaring dividends.

Under the then prevailing Dividend Distribution Tax (DDT) regime, dividends attracted tax in the hands of the company. However, if profits were distributed through buy-back, shareholders were merely subjected to capital gains tax, which was often significantly lower and, in certain situations, could even be exempt.

Consequently, buy-back became an efficient alternative for distributing profits while reducing the overall tax burden.

To curb this practice, the Finance Act, 2013 introduced Section 115QA.

Phase II – Introduction of Section 115QA (1 June 2013)

Section 115QA imposed an additional income-tax on the company undertaking the buy-back.

However, an important aspect is often misunderstood.

The provision did not apply to all companies.

It applied only where the buy-back related to shares not listed on a recognised stock exchange.

Therefore, during the period from 1 June 2013 to 4 July 2019:

It is therefore incorrect to state that Section 115QA applied only to “closely held companies”. The statutory language referred to unlisted shares, and accordingly even an unlisted public company was covered.

Tax Mechanism under Section 115QA

The tax was payable by the company on its “distributed income”.

Distributed income meant:

Consideration paid on buy-back less the amount received by the company at the time of issue of such shares.

The shareholder was generally exempt from tax on the buy-back proceeds under Section 10(34A).

Thus:

• Company paid tax.
• Shareholder paid no tax.
• Capital gains provisions practically ceased to operate for such buy-backs.

Extension to Listed Companies – Finance (No. 2) Act, 2019

Although Section 115QA effectively addressed tax avoidance by unlisted companies, listed companies still enjoyed favourable tax treatment.

In order to eliminate this disparity, the Finance (No. 2) Act, 2019 removed the restriction relating to listed shares.

With effect from 5 July 2019, Section 115QA became applicable to all domestic companies, including listed companies (subject to the transitional exception for certain announced buy-backs).

Consequently, between 5 July 2019 and 30 September 2024, every domestic company undertaking a buy-back was liable to buy-back tax.

A Paradigm Shift – Finance (No. 2) Act, 2024

The Finance (No. 2) Act, 2024 once again changed the entire taxation framework.

With effect from 1 October 2024:

• Section 115QA effectively ceased to apply to future buy-backs.
• Section 10(34A) exemption was withdrawn.
• The incidence of taxation shifted from the company to the shareholder.

This marks a return to shareholder-level taxation, albeit in a significantly different manner from the pre-2013 regime.

How is a Buy-back Taxed Today?

The Finance (No. 2) Act, 2024 introduced coordinated amendments to several provisions of the Act.

Section 2(22)

A new clause treats the amount received by a shareholder on buy-back as deemed dividend.

Therefore, the shareholder is taxed under the head Income from Other Sources.

Section 57

No deduction is permitted in respect of the cost of acquisition of shares while computing such dividend income.

This means the shareholder is taxed on the gross buy-back consideration.

Section 46A

A consequential amendment has been made to Section 46A.

For buy-backs covered under the new regime, the consideration is deemed to be NIL for capital gains purposes.

Accordingly:

Capital Loss = Cost of Acquisition – NIL

Thus, the shareholder recognizes a capital loss equivalent to the cost of acquisition.

The shareholder pays tax on the dividend income while separately recognising a capital loss, which may be set off or carried forward in accordance with Other Sections of the Act.

Is the New Regime More Burdensome?

The answer depends on the facts of each case.

For many resident shareholders:

• Dividend income is taxed at the applicable slab rate.
• The capital loss may not always be immediately utilizable.
• Consequently, the effective tax outflow could be significantly higher than under the earlier regime.

For non-residents:

• Treaty benefits need careful examination.
• Withholding tax under Section 195 assumes greater importance.
• The characterization of income and availability of treaty relief may differ across jurisdictions.

Practical Issues Emerging from the New Regime

The amendments raise several practical questions:

• Can the capital loss be effectively utilised where no capital gains exist?
• Will buy-back continue to be preferred over dividend distribution?
• How should foreign shareholders evaluate treaty benefits?
• What will be the impact on mergers, group restructuring, and promoter exits?
• Will companies reconsider capital reduction as an alternative?

These issues are likely to become areas of future litigation and judicial interpretation.

Comparative Position

Conclusion

The taxation of buy-backs has completed a full legislative cycle over the last decade.

What began as shareholder-level capital gains taxation shifted to company-level buy-back taxation in 2013 to prevent avoidance of Dividend Distribution Tax. After the abolition of DDT and a broader rethinking of the tax framework, Parliament has once again moved the tax burden back to shareholders through the Finance (No. 2) Act, 2024.

However, the present regime is not merely a return to the pre-2013 position. Instead, it introduces a unique hybrid model under which the buy-back proceeds are taxed as dividend while the shareholder is separately allowed a capital loss equal to the cost of acquisition.

Whether this achieves tax neutrality or results in a higher overall tax burden will depend on each shareholder’s ability to utilise the resulting capital loss. As companies and investors adapt to the new framework, careful tax planning and compliance will become increasingly important.