Direct Tax Alert - Taxpayer liable to pay DDT on purchase of own shares through a Court approved sch

BACKGROUND

As per the Companies Act, of 1956, (Companies Act), a company can buyback its shares as per the modes mentioned below.  Either the company is required to fulfil requirements of Section 77A1 of the Companies Act or it is required to prepare a scheme of compromise and arrangement and get it approved by the Court2 under sections 391 to 3933 of the Companies Act, read with Section 77 and Section 100 to 1044 of the Companies Act to buyback its own shares. The Finance Act 2013 introduced Section 115QA in the Income-tax Act, 1961 (IT Act) with effect from 1 June 2013 to levy tax on the buyback of shares by a domestic company. The section applied only in the case of buyback of shares in accordance with the provisions of Section 77A of the Companies Act. However, the Finance Act 2016 enlarged the scope of Section 115QA of the IT Act with effect from 1 June 2016 to levy tax on the buyback of shares in accordance with the provisions of any law for the time being in force relating to companies.

In this regard, recently the Chennai Tax Tribunal 5 had an occasion to examine whether consideration paid by the taxpayer for the purchase of own shares in accordance with a court-approved scheme before 1 June 2016 amounts to distribution of accumulated profits. Hence, whether it amounts to a dividend under section 2(22)(a)6/2(22)(d)7of the IT Act thereby liable to Dividend Distribution Tax (DDT) under section 115-O of the IT Act in the hands of the taxpayer to the extent of accumulated profits of the taxpayer. We, at BDO in India, have summarised the ruling of the Chennai Tax Tribunal and provided our comments on the impact of this decision.

FACTS OF THE CASE
  • Taxpayer, an Indian company was engaged in the business of software development and related services/solutions.
  • Taxpayer was originally a wholly owned subsidiary of a US-based company. In Fiscal Year (FY) 2011-12, there was a restructuring of various businesses directly or indirectly under the control of Cognizant Technology Solutions Corporation, USA post which the taxpayer’s share capital was owned by four non-resident shareholders, three from the USA and one from Mauritius.
  • For the relevant year under consideration i.e., FY 2016-17, the taxpayer purchased equity shares from all shareholders in compliance with a restructuring scheme approved by the Madras High Court dated 18 April 2016. Post restructuring, the Mauritian entity became the majority shareholder with 99.87% shareholding and the remaining 0.13% was retained by one existing Delaware, US-based shareholder.
  • Taxpayer withheld tax at source (TDS) on consideration paid to the USA-based shareholders treating the income earned as capital gains, since no specific tax treaty benefit was available to non-resident shareholders of USA under the India-USA Double Taxation Avoidance Agreement (DTAA). However, taking benefit of the India-Mauritius Double Taxation Avoidance Agreement (DTAA), TDS was not withheld from the consideration paid to the Mauritian shareholder, since the entire capital gains earned by the Mauritian shareholder were not subject to tax in India.
  • The tax officer deemed the taxpayer in default and called upon the taxpayer to explain why an order under section 115-O of the IT Act, cannot be passed in respect of consideration paid for the purchase of its own share as deemed dividend under section 2(22)(a)/2(22)(d) of the IT Act.
  • The tax officer observed that the purchase of own shares under the provisions of Section 391 to 393 of the Companies Act is either under section 100-104/402 of the Companies Act or under section 77A of the Companies Act.
  • The tax officer held that the distribution by the taxpayer of accumulated profit entailing the release of the company’s asset is taxable as deemed dividend under section 2(22)(a) of the IT Act and the taxpayer was liable to pay DDT under section 115-O of the IT Act. Alternatively, the consideration received by the shareholders was in the nature of the deemed dividend under section 2(22)(d) of the IT Act, and the taxpayer was liable to pay DDT under section 115-O of the IT Act.
  • Aggrieved, the taxpayer filed an appeal before the First-Appellate Authority which upheld the order of the tax officer. Further, aggrieved, the taxpayer filed an appeal before the Chennai Tax Tribunal.    
TRIBUNAL RULING

The Chennai Tax Tribunal made the following observations while ruling in favour of the tax authorities to treat the transaction of the taxpayer as a dividend under section 2(22)(a)/2(22)(d) read with section 115-O of the IT Act:

  • Factual matrix
    • The shareholding prior to the scheme was 76.09% stake held by Mauritian shareholders and balance by US-based shareholders which after sanction of the scheme increased to 99.87% for Mauritian shareholders and 0.13% by US-based shareholders.
    • From the restructuring of the shareholding pattern, it is clear that there has been an artificial shifting of the shareholding base from the USA to Mauritius solely with the aim of claiming DTAA benefits because as per India-Mauritius DTAA, capital gains on transfer of equity shares is not taxable in India.
    • Taxpayer moved a proposed scheme for buyback of its own shares in terms of Section 391-393 of the Companies Act just before the effective date of amended section 115QA of the IT Act which levies additional tax on distributed profit by Indian companies on purchase of its own shares from shareholders. Therefore, it is necessary to ‘look through’ the scheme in light of relevant provisions of the Companies Act, and the IT Act to analyse tax implications.
  • Applicability of section 2(22)(d) of the IT Act
    • Two essential pre-requisites to be satisfied in order to come within the ambit of section 2(22)(d) of the IT Act- (a) there must be a distribution to the shareholders on the reduction of the capital and (b) it must be to the extent that the company possess accumulated profits.
    • The Supreme Court in the case of G.Narasimhan8, has clarified that section 2(22)(d) of the IT Act is automatically attracted once these parameters are satisfied. Further, Clause 7 of the scheme clarifies that the distribution of money will be out of general reserves and accumulated credit balance in the profit and loss account. Thus, both conditions are satisfied to treat the transaction within section 2(22)(d) of the IT Act.
  • Purchase through offer and acceptance is also “distribution.”
    • There is no merit in the taxpayer’s contention that the scheme of purchase of own shares was made through offer and acceptance and therefore it involves an element of quid pro quo hence there was no ‘distribution’ for the purpose of section 2(22)(d) of the IT Act.
    • Relying on the Supreme Court decision in the case of Punjab Distilling Industries9, it can be inferred that the definition of ‘distribution’ does not contain any aspect of quid pro quo or lack thereof. The prerequisites for distribution are that there must be payment, and the disbursal must be made to more than one person. Section 2(22)(d) of the IT Act does not distinguish whether the reduction of share capital is the intended result of the resultant consequence of the scheme.   
  • Scheme operates in ‘rem’
    • There is no merit in the taxpayer’s contention that the scheme approved by the Madras High Court operates in ‘rem’ and is binding on the tax authorities since if you go by this argument then the tax officer would be rendered functus officio and the assessment itself would be finalised under the scheme.
    • The order sanctioning the scheme clearly provides that the sanction shall not grant immunity to the taxpayer from payment of taxes under any law for the time being in force.
    • The High Court, while sanctioning the scheme will merely look at the commercial wisdom of the creditors and approve the same if it is just and fair and there are no illegalities. The tax consequences and otherwise would be for the tax officer to look into the scheme in light of the relevant provision of the IT Act.
    • Further reliance can be placed on the Mumbai Tax Tribunal decision in the case of Grasim Industries10 to support the view that the tax officer is fully empowered to analyse the effects of the scheme and to determine whether they attract the provisions of the IT Act or not.
  • Purchase of own shares would be “reduction of capital” if not buyback
    • The transaction of the taxpayer would either fall under section 391-393 read with section 77 and section 100 of the Companies Act or 391-393 read with section 77A of the Companies Act. The scheme clearly states that it is not buyback under section 77A of the Companies Act.
    • Therefore, once the taxpayer states it is not buyback under section 77A of the Companies Act, it should automatically fall back to section 77 read with sections 100-104 of the Companies Act. If said sections are applied, then said transaction was nothing but the reduction of capital and distribution of accumulated profits and thus, comes within the ambit of provisions of section 2(22)(d) and section 115-O of the IT Act.
  • Deemed Dividend vs. Capital Gains
    • There is no merit in the taxpayer’s contention that the consideration paid for the purchase of its own shares is to be taxed only in the hands of shareholders under section 46A11 of the IT Act, as capital gains. 
    • Section 46A of the IT Act is only applicable to buyback under section 77A of the Companies Act and not to other forms of purchase of own shares. In any event, assuming without conceding that Section 46A of the IT Act applies to all forms of buyback, Section 115-O of the IT Act contains a non-obstante clause which would override the provisions of Section 46A of the IT Act.
  • Reduction of Capital vs. Buyback
    • The contention of the taxpayer that the purchase of own shares by a ‘Scheme of Arrangement & Compromise’ under section 391-393 of the Companies Act is taxable under section 115QA of the IT Act, only after an amendment to the term ‘buyback’ by the Finance Act 2016 w.e.f. 1 June 2016, is incorrect.
    • There is a distinction between the purchase of own shares upon reduction of share capital and buyback. ‘Buyback’ is a term used only in respect of transactions covered under section 77A of the IT Act.
    • The amendment to section 115QA of the IT Act was brought in to clarify that the provisions would apply to the buyback of shares under section 77A as well buyback of shares under section 391-393 of the Companies Act.
    • If all conditions of Section 115-O read with section 2(22) of the IT Act are satisfied, the same cannot be impliedly excluded based on the amendment to Section 115QA of the IT Act.
  • Scheme was a colourable device
    • The taxpayer claims to have implemented the scheme to rationalise its shareholding and capital structure. The reasons given were to (a) increase earnings per share (b) streamline corporate ownership (c) optimise the overall capital structure (d) reduce the risk in terms of foreign currency fluctuations in respect of rupee funds.
    • On closer look, the real intent is to (a) transfer the capital base of the company to Mauritius-based shareholders and (b) distribute of company’s accumulated profits to non-resident shareholders without coming within the ambit of any of the provisions relating to taxation of payments made for the purchase of its own shares.
    • Therefore, from the facts of the case, it is undoubtedly clear that the scheme as such is only a colourable device intended to evade legitimate tax dues.
BDO IN INDIA COMMENTS

Taxation of buyback has been a contentious issue. In the case of the buyback of shares, companies are required to pay taxes as per the provision of section 115QA of the IT Act. Further, as per section 115-O of the IT Act, companies are required to pay dividend distribution tax at the rate prescribed. In the present case, the taxpayer claimed the benefit of India-Mauritius DTAA which was denied by the Chennai Tax Tribunal by treating the transaction as a distribution of accumulated profits under Section 2(22)(d) and levying DDT. It further held that the tax officer is empowered to adopt a “look-through” approach rather than a “look at” approach. It is pertinent to note that the case pertains to FY 2016-17 when the pre-amended Section 115QA of the IT Act was in operation. If the dividend is distributed on or after 1 April 2020, the domestic companies shall not be liable to pay DDT and consequently, shareholders shall be liable to pay tax on such dividend income.

 

1 Section 77A of the Companies Act pertains to the power of the company to purchase its own securities. It corresponds to section 68 of the Companies Act, 2013.

2 As per the Companies Act 2013, the National Company Law Tribunal is required to approve such a scheme.

3 Corresponding to sections 230 to 232 of the Companies Act 2013

4 Section 100-104 and section 391 of the Companies Act provide the procedure to be followed by the company for obtaining the consent of shareholders, creditors and Courts to the scheme for reduction.

5 M/s Cognizant Technology-Solutions India Pvt. Ltd. vs. ACIT (ITA No. 269/Chny/2022)

6 Section 2(22)(a) of the IT Act pertains to the distribution of accumulated profits, entailing the release of a company’s assets to its shareholders is deemed to be a dividend.

7 Section 2(22)(d) of the IT Act pertains to distribution by a company to its shareholder on reduction of its capital to the extent of its accumulated profits shall be deemed to be a dividend.

8 CIT vs. G. Narasimhan, 236 ITR 327 (Supreme Court)

9 Punjab Distilling Industries Ltd. vs. CIT [1965] 57 ITR 1 (Supreme Court)

10 Grasim Industries vs. DCIT, ITA No. 1935/Mum/2020

11 Section 46A of the IT Act pertains to capital gains on purchase by company of its own shares or other specified securities.