How the 2024 tax rule change ruined buybacks for shareholders

The Union budget presented in July 2024 shifted the taxation responsibility from the company to the shareholder. The entire amount, and not just the profit, received by shareholders from a buyback is treated as income and taxed at slab rates as “income from other sources” (IFOS). This change effectively puts buybacks on the same footing as dividends for tax purposes.

How it hurts investors

Taxing buybacks in the hands of shareholders may seem more transparent. However, this method of taxation has a significant drawback for resident investors due to how the shares’ cost of acquisition (COA) is treated under the new system.

The acquisition cost of shares is part of the total payout amount that is taxed as a dividend. Since the COA is not allowed as a deduction, it’s treated as a capital loss that can be set off against other capital gains or carried forward.

This creates a tricky situation: The shareholder ends up paying tax at 15%, 20%, or 30% on the full buyback proceeds, including their original investment, while the tax saved by offsetting it against other capital gains is 12.5%.

Let’s understand with an example. Mr X is a multinational company executive in the 30% tax slab. He bought shares worth ₹2 lakh of company ABC. ABC bought back those shares after three years at ₹3 lakh. Mr X made ₹1 lakh profit, but he has to pay 30% tax on the entire ₹3 lakh, which is ₹90,000. Say, Mr X made ₹3.25 lakh long-term capital gains on equity mutual funds in the same year. He can offset the ₹2 lakh capital loss (the COA of ABC shares) with the ₹2 lakh taxable gains from mutual funds ( ₹1.25 lakh gains are exempt from tax). He saves ₹25,000 tax (12.5% *200,000) by offsetting capital loss, but has paid ₹60,000 tax on it.

In effect, Mr X has paid tax on his invested capital. Moreover, any relief in the form of a capital loss deduction is only usable against gains that may or may not arise in the future. So, all taxpayers in higher tax slabs will face a tax loss if they don’t have sufficient capital gains to offset the capital loss from share buybacks.

The unutilized losses can be carried forward up to eight years, after which they become a dead loss.

Why disproportionate taxation

Experts say that under the old rules, many high-net-worth individuals and big promoters took advantage of the tax rules by receiving the profits mainly as buybacks, as the tax liability fell on the company.

“Companies were taxed at a lower rate of 23.30% on these buybacks, while if the same profits were distributed as dividends, shareholders—especially in higher tax brackets—would have faced a tax rate of 30% plus additional surcharge and cess. This created a tax advantage (arbitrage) for shareholders,” said Ashish Karundia, founder of chartered accountancy firm Ashish Karundia & Co.

“To close this gap, the tax authorities switched to the traditional taxation approach, where the tax is now levied directly on the shareholders instead of the company.”

In response to a Mint’s query on the tax burden on the purchase cost in buybacks, the Central Board of Direct Taxes (CBDT) explained that a new clause (in Section 2(22)(f) of the Income Tax Act) has been inserted to the definition of “dividend” to include any payment by a company on the purchase of its own shares in accordance with Section 68 of the Companies Act, 2013. This deeming provision brings buybacks under the same tax net as dividends. This dividend income is taxed under the head IFOS and per the structure of the Act (Income Tax Act), no deduction for cost of acquisition is allowable because such costs are not admissible against dividend income.

“…as the shareholder’s shares are extinguished during the buyback, it constitutes a ‘transfer’ as defined under Section 2{47}(ii). Also, as per Section 46A sale consideration is deemed to be Nil. Therefore, the entire cost of acquisition becomes a capital loss…Thus, while the income in the nature of dividend gets taxed at the applicable rate, the capital loss gets the treatment available to income/loss in the nature of capital gains,” the CBDT said.

Silver lining for foreign investors

Interestingly, this proposal could work in favour of foreign shareholders. Under the former system, since the company paid the buyback tax, foreign investors couldn’t claim foreign tax credits (FTC) in their home countries. The new rules would make the tax fall on the shareholder directly, potentially allowing them to claim credit under Double Taxation Avoidance Agreements (DTAAs). Many such treaties offer preferential tax rates on dividend-like income, which could lead to a lower effective tax rate for these investors.