Business Other News 15 Aug 2016 Tax on buybacks to l ...

Tax on buybacks to leash startup deals

FINANCIAL CHRONICLE | ASHWIN J PUNNEN
Published Aug 15, 2016, 9:19 am IST
Updated Aug 15, 2016, 9:19 am IST
VCs, PEs will have to fork out more money for secondary market transactions in unlisted firms.
The central board of direct taxes recently published the draft rules for determining the gains booked by individual shareholders from buyback of shares by unlisted companies for tax purposes.
 The central board of direct taxes recently published the draft rules for determining the gains booked by individual shareholders from buyback of shares by unlisted companies for tax purposes.

Mumbai: The proposed guidelines on taxing buyback of shares in unlisted companies are likely to spell trouble for multimillion dollar secondary market deals in the startup space.

These transactions, involving early stage investors and private equity players, may lead to higher tax outgo, as the new rules do not recognise step-up pricing in secondary deals in the unlisted companies for tax tabulation of buyback gain.

 

The central board of direct taxes (CBDT) recently published the draft rules for determining the gains booked by individual shareholders from buyback of shares by unlisted companies for tax purposes.

For tax calculation, the draft rules termed capital gains in buybacks as “distributed income” and defined it as the profit made by a shareholder when a company buys back shares at a price over and above the amount at which it issued those shares in the first instance.

Under section 115QA of the Income-Tax Act, an additional tax of 20 per cent is levied on the distributed income arising out of buyback of unlisted shares by a company.

 

According to experts the new rules do not recognise the secondary transactions between investors in unlisted companies.

Secondary deals in unlisted space is quite active with over $8 billion worth of such transactions recorded last financial year, involving investors such as private equity, sovereign funds and venture funds.

To put things in perspective, for instance, suppose a company issues shares to investor A at Rs 100 and after a few years investor A sells these shares to investor B at Rs 200. 

And later the company comes out with a buyback offer at Rs 300 in which investor B subscribes and makes a capital gain of Rs 100. Under the proposed tax rules investor B would be liable to 20 per cent on Rs 200, as the under the new rule capital gain is calculated at the original price of shares issued by the company i.e. Rs 100. This is because the new rule does not recoginise step-up price in secondary deals.

 

Every time the shares exchange hands in the secondary market, their step-up price would be ignored in such computation.

Experts said the proposed rules suggest that in order to tax gain in buyback offers, the taxman will compute the difference between the consideration paid by the company for the shares being bought back and “the amount received by a company” at the time of issue of the shares. Here, it does not recognise the change in price, when shares change hands among investors. Because of this anomaly, the net returns of a large number of investors will be hit.

 

“This anomaly in the rules will put investors in the secondary transaction at a disadvantage. The whole startup space works on a model where early stage investors exits by selling out to private equity or venture funds through secondary transactions. The step-up price should be taken into consideration when gains are calculated and the government should make the necessary change when issuing the final rules,” said Riaz Thingna, partner at Grant Thornton India.

Companies have commonly used dividend and buyback of shares to pay distributable reserves to their shareholders. While payment of dividend is subject to dividend distribution tax (DDT) payable by the company paying the dividend, buy-back of shares is chargeable to tax as capital gains (CG) in the hands of the shareholder.

 

As a tax planning measure, some companies opt to buy back shares at a premium (rather than pay dividends). This makes it attractive, especially in the case of foreign investors from treaty countries such as Mauritius and Singapore. Premium on buy-back was treated as capital gains and these treaties provided for capital gains exemption. Thus, the companies were exempt from DDT and the shareholder, from CG tax.

Since the government appeared to be losing revenue on account of the adoption of this tax planning methodology by a few investors, it amended the tax laws in 2013 to introduce a 20 per cent tax on unlisted companies, in order to tax the difference between the consideration paid by the company for the shares being bought back and “the amount received by a company” at the time of issue of the shares.

 

However, the law had certain ambiguities around the mechanism for the calculation of such income. And CBDT recently issued draft rules for public consultation, enlisting the various scenarios for the computation of “the amount received by a company.”

While in most cases, this amount would be the issue price of the shares being bought back, the rules also clarify that the amount to be considered in cases of amalgamation, demurer and bonus issue. These rules are expected to be finalised soon.

“The buyback tax is an anti-avoidance provision. The government has recently renegotiated the India-Mauritius tax treaty, taking away the capital gains tax exemption. Other treaties will probably meet a similar fate. Since this provision has lived its utility, the government should now consider giving it a peaceful burial,” said Suresh Swamy, partner (financial services) at PricewaterhouseCoopers.

 

(This story originally appeared on Finance Chronicle)

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