Buyback of shares Capital Gains or Deemed dividend?

Let’s understand this topic with the help of a query that we had recently received.

Question

I hold shares of a private consumer goods company for more than 10 years. Now, the company has said that it will commence a buy-back programme (through an open offer). What will be the tax implications if I apply for it? What will be the long-term capital gains (LTCG) tax? Will the amount received through the buyback be added to my current year’s income?

We understand that you hold the shares of an unlisted Indian company.

Broadly both reduction of capital and buy back of shares are only different forms of reorganization of the capital structure of the company. From both these events income can arise in the hands of the shareholder either as ‘deemed dividend’ or ‘capital gains’.

A part or portion of the divisible profits of the company is distributed among the shareholders as dividends. At the first instance dividend is paid on preference shares at fixed rates since preference shareholders have a preferential right to dividend over equity shareholders. Thereafter dividends is paid to the equity shareholders at or below the percentage recommended by the board as confirmed by the members at the annual general meeting.

Now let’s understand both the situation from a taxation perspective:

To the extent reduction of share capital is made out of accumulated profits of the company, these are ‘deemed dividend’.

Any sum paid out of accumulated profit to the shareholders of the company is treated as deemed dividend under section 2(22)(e) of the Indian Income Tax Act, 1961. However if the payment made by a company on purchase of its own shares from a shareholder in accordance with the provisions of Section 77A (more on this later) of the Companies Act, 1956 will not be treated as dividend.

Under Section 46(2) of the IT Act when a shareholder receives any money or other assets from a company on its liquidation, the resulting income will be chargeable under the head capital gains for amounts or market value of the assets received after deducting from there amount attributable to accumulated profits of the company assessable as dividend within the meaning of Section 2(22) (c).

Under Section 46A of the IT Act when a shareholder or holder of specified securities including shares under the employees’ stock option scheme receives any consideration from the company for the purchase of those shares, then the excess of such consideration over and above the cost of acquisition is assessable as capital gains. Here cost means the indexed cost.

Section 77A governs the buyback regulation under the Companies Act 1956, the buyback procedure should be as per this section.

Case

It has been held by the Supreme Court in Kartikeya Sarabhai vs. CIT reported in(SC)94 that redemption of preference share capital can also give rise to capital gains in the hands of the shareholder.

It has been held by the Supreme Court that where for reduction in the value of shares the member has not only been given cash but also property by the company, while computing receipts for capital gains the portion attributable to accumulated profits have to be deleted.

With effect from assessment year 2005-2006 long term capital gains on securities listed on a recognized stock exchange, liable to Security Transaction Tax, has been abolished vide exemption under new Section 10(38) of the IT Act.

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