Direct Tax Alert

BACKGROUND

Share buy-back by companies has been an area of significant tax controversy in India. Section 56(2)(x) of the Income-tax Act, 1961 (the Act) provides that the receipt of property (including shares and securities) for inadequate consideration shall be chargeable to tax in the hands of the recipient. At various instances, when a company buys back its own shares at a price lower than the fair market value (FMV), tax authorities invoke the provision of section 56(2)(x) of the Act, treating buy-back of shares as an 'acquisition of property' for inadequate consideration.

Recently, the Divisional Bench of Delhi High Court has pronounced a ruling¹ on the issue whether the company's buy-back of its own shares is fundamentally a reduction of capital or an acquisition of an asset taxable under section 56(2)(x) of the Act.

FACTS OF THE CASE

• The taxpayer is a company engaged in the business of share broking and clearing of trades.

• During Fiscal Year (FY) 2017-18, the company bought back 28,62,500 equity shares at INR 313.40 per share. The said buy-back was done out of free reserves and securities premium, after board and shareholder approvals. Further, the taxpayer had also duly discharged the buyback distribution tax liability under section 115QA of the Act.

• During the course of assessment proceedings, the tax officer observed that the FMV of each share as per Rule 11UA of the Income Tax Rules, 1962, was INR 370.46.

• Accordingly, while passing the order, the tax officer added the differential amount of INR 57.06 per share to taxpayer's income under section 56(2)(x) of the Act, treating buy-back as an acquisition of property for inadequate consideration.

• Aggrieved by the same, the taxpayer preferred an appeal before the First Appellate Authority. The First Appellate authority deleted the addition of buy-back, holding that the buy-back amounted to a reduction of share capital rather than a purchase of a capital asset.

• On appeal by Revenue, the Second Appellate Authority, affirmed the First Appellate Authority’s view. Aggrieved by this, the Revenue then filed an appeal before the Delhi High Court.

DELHI HIGH COURT’S RULING

A Division Bench of the Delhi High Court, while dismissing the Revenue’s appeal, held that buy-back of shares is not an acquisition of asset which can be brought to tax under section 56(2)(x) of the Act. Further, while coming to this conclusion, the following key observations were made:

1. Buy-back is a capital reduction

Section 68 of the Companies Act, 2013, is the only provision which permits a company to purchase its own shares. Accordingly, buy-back in essence is nothing but merely a reduction of share capital. Further, as per Section 68(7) of the Companies Act, 2013, shares so bought back must be extinguished and physically destroyed within seven days of completion of the buy-back.

2. No 'Property' can survive after destruction

Since the shares are mandatorily extinguished post buy-back, the same ceases to exist. Therefore, a person cannot be taxed for deemed profit from a property that accrues consequent to the destruction of very same property.
The interpretation given by Revenue on textual reading of section 56(2)(x) of the Act appears to be attractive at first instance; however, when tested on the principles of the Companies Act, 2013, common prudence and provisions of Income-tax Act, the same turns out to be untenable.

BDO INDIA OBSERVATION

This is a significant ruling as it reiterates the principle laid down by the Mumbai Tax Tribunal in the case of Vora Financial Services Private Limited² wherein, under the identical facts, it was held that section 56(2)(viia) of the Act is applicable only where the shares become ‘property’ of the recipient. However, in case of buy-back, since the shares are extinguished within the timeline prescribed in law, it does not satisfy the definition of ‘property’ under section 56(2)(viia) of the Act.

The Delhi High Court herein has reaffirmed that even under the provisions of section 56(2)(x) of the Act, buy-back of shares would not constitute acquisition of an asset. The ruling also clearly distinguishes buy-back from the ordinary acquisition of shares in another company, confirming that section 56(2)(x) of the Act is targeted at genuine asset acquisitions and not at capital reorganisations involving a company's own equity.