Buyback Consideration Pre-115QA: Deemed Dividend or Capital Gains?

[Shaswat Kashyap and Harshal Chhabra are students at Gujarat National Law University]

The buyback of shares involves a company repurchasing its shares and other specified securities issued by the company. This approach has consistently been a favoured means for Indian companies to distribute accumulated profits among their shareholders. Buybacks are also considered to be more tax-efficient when compared to dividends. Consequently, it has come under scrutiny from the Income Tax Authorities (ITA).

In the erstwhile Indian Companies Act, 1956 (1956 Act), companies were permitted to engage in share buybacks through both automatic and approval routes (presently, section 68 of the Companies Act, 2013 governs the buyback of shares). According to section 77A of the 1956 Act, companies could opt for the automatic route for share buybacks, provided the capital reduction through such buybacks is less than 25% of the company’s total paid-up capital and free reserves. If a company intended to reduce its capital by more than 25%, it was required to seek the approval of the court. This approval process fell under sections 391 to 394 of the 1956 Act. Consequently, buybacks could only be undertaken as per the methods of capital reduction outlined in sections 101 to 104 of the 1956 Act.

Moreover, the consideration provided to shareholders in connection with the buyback of shares was not expressly taxable under any provision of the Income Tax Act (IT Act) unless it qualified as a “deemed dividend” under section 2(22) of the IT Act. Such deemed dividends were subject to taxation under section 115O of the IT Act, applicable to the company executing the buyback. However, the Finance Act of 2013 introduced section 115QA, which entails special provisions for taxing the distributed income of a domestic company involved in share buybacks through the automatic route, specifically under Section 77A of the 1956 Act. This provision underwent further amendment effective June 1, 2016, expanding its scope to encompass all types of buybacks.

In a notable decision by the Chennai Bench of the Income Tax Appellate Tribunal (Tribunal), in the case of Cognizant Technology Solutions India v. ACIT, the Tribunal ruled that buyback transactions involving court-approved schemes, which did not fall within the ambit of section 77A of the 1956 Act, were subject to Dividend Distribution Tax (DDT). In the present case, the buyback of shares was undertaken after the introduction of section 115QA but before amendment in such provision.

Brief Factual Background and the Court’s Decision

Cognizant India, with four shareholders prior to the buyback, had three USA shareholders holding approximately 24% and a Mauritius shareholder owning the remaining 76%. Through a ‘Scheme of Arrangement and Compromise’ approved by the Madras High Court under sections 391 to 393 of the 1956 Act (Scheme), Cognizant India acquired the 24% shares of the USA shareholders and a significant portion from the Mauritius-based shareholder. Consequently, the Mauritius-based shareholder became the majority owner with a 99.87% stake in Cognizant India after the buyback.

The central issue in this case revolved around the tax treatment of the consideration paid by Cognizant India for repurchasing its shares. Cognizant India characterized this transaction as capital gains, withholding tax on the consideration paid to non-resident shareholders from the USA as the benefit of the India-USA tax treaty was not available. However, it did not withhold tax on the consideration paid to Cognizant (Mauritius) Limited, Mauritius, arguing that capital gains are not subject to taxation in India under the India-Mauritius Double Taxation Avoidance Agreement (DTAA).

In contrast, the Assessing Officer (AO) considered the consideration paid by Cognizant India to its shareholders as a “deemed dividend” under section 2(22)(a)/2(22)(d) of the IT Act, holding Cognizant India liable for the DDT under section 115-O of the ITA.

The Tribunal viewed the entire scheme adopted by Cognizant India as a colorable device designed to evade legitimate tax obligations, stating that the dominant and only commercial purpose is to shift the profit base to Mauritius. This perspective arose from the fact that, instead of utilizing the specific provision for share buybacks (section 77A of the 1956 Act), Cognizant India leveraged a general provision (section 391 of the 1956 Act) to conduct the buyback. This was perceived as a deliberate attempt to circumvent additional income tax liabilities under section 115QA of the ITA. Moreover, the Tribunal identified a lack of commercial nexus between the company’s activities and Mauritius. Consequently, the Tribunal held that such colorable devices lack genuine commercial purpose, allowing the AO to ‘look through’ rather than ‘look at’ the transactions.

Recently, Cognizant India has appealed against this decision of the Tribunal before the Madras High Court.

Analysis and Concluding Remarks

Cognizant India contended that the High Court’s approval of the scheme constitutes a judgment ‘in rem,’ asserting that once the Regional Director issues a ‘no objection,’ the central government, including the AO, cannot alter the nature of the court-approved scheme. However, the Tribunal took a different stance, emphasizing that the court’s role is to scrutinize the commercial wisdom of creditors and approve the scheme only if it is deemed just, fair, and free from illegalities. The Tribunal maintained that tax consequences fall within the purview of the AO, who is fully authorized to assess the scheme’s effects and determine its alignment with the provisions of the ITA. The Mumbai Bench of the Income Tax Appellate Tribunal adopted a similar perspective in the case of DCIT v. Grasim Industries Limited.

This decision has triggered a debate on the scope of section 46A of the ITA, questioning whether it applies to all forms of buybacks or only when securities are repurchased under Section 77A of the 1956 Act. Despite the arrangement being executed through a court-approved scheme, concerns have been raised regarding its commercial substance. This development holds significant implications for companies strategizing tax-efficient structures for future corporate reorganizations.

Looking ahead, tax authorities are likely to leverage this decision to scrutinize the business justifications behind corporate restructurings more closely. With anti-abuse provisions such as general anti-avoidance rules at their disposal, tax administrators are expected to adopt a stricter approach in evaluating transactions for their genuine business motives rather than being driven solely by tax considerations. Taxpayers must proceed cautiously, thoroughly considering all relevant facts and ensuring that such transactions are primarily motivated by business needs.

It is worth noting that after the amendment of section 115QA, effective June 01, 2016, the mentioned transaction is already subject to an additional tax levy. Therefore, the Tribunal’s judgment may have limited relevance to buybacks conducted after this period. However, considering the Tribunal’s findings on the timing of the scheme sanction, there is a potential risk of legal challenges to similar court-approved buyback schemes sanctioned between February 2016 and May 2016, leading to the possibility of prospective litigation in this regard.

The ruling underscores the importance of the actual content of the transaction rather than its formal structure. Despite being executed through a court-approved scheme, concerns have been raised regarding its practical business significance.

– Shaswat Kashyap and Harshal Chhabra

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