India's Union Budget 2024 has introduced significant changes to the country's buyback tax regime, set to take effect from 1 October 2024. These changes mark a fundamental shift in how tax liability is handled for share buybacks, moving it from companies to shareholders. Here’s a simplified overview of these amendments, their potential benefits, and drawbacks.
What are the changes?
Under the current system, domestic companies undertaking share buybacks are taxed at a rate of 20% on their net distributable income. Shareholders, in turn, receive these buyback proceeds without any tax burden.
The Finance Budget 2024 proposes to abolish the buyback tax entirely. Instead of companies bearing the tax on such buybacks, shareholders will now be taxed on buyback proceeds, as dividend, at the applicable ordinary tax rates. Companies will be responsible for withholding tax at source on such payments. Importantly, buyback proceeds will no longer be taxed as capital gains. Shareholders will also be able to treat the cost of shares tendered in buybacks as a capital loss, which can be offset against other capital gains or carried forward for up to eight years.
Potential benefits
1. Fairer tax regime: The new rules aim to level the playing field between dividend income and buyback proceeds. By taxing both similarly, the changes promote fairness and reduce tax arbitrage, where companies might have used buybacks to exploit lower tax rates.
2. Encouragement for genuine buybacks: With the tax burden shifted to shareholders, companies may be more inclined to undertake buybacks only when they believe their shares are genuinely undervalued, rather than as a tax-saving maneuver. This could lead to more strategic and value-driven buyback decisions.
3. Advantages for mutual funds and non-residents: Mutual funds, which generally pay little to no taxes, will benefit from the new regime. Non-resident shareholders could also gain from leveraging lower tax rates, depending on the manner in which tax treatment of dividend and capital gains income is articulated in the relevant international tax treaties.
Potential drawbacks
1. Increased tax burden on resident individual shareholders: The most immediate impact of the changes is the increased tax burden on resident individual shareholders, especially those in higher tax brackets. Previously, the effective tax rate on buybacks was 23.296% for companies. With the new system, this could rise to 35.88% when the tax burden shifts to shareholders. For high-net-worth individuals, the increased tax liability might make buybacks less appealing compared to other methods of capital distribution. Companies might also prefer to retain cash rather than undertake buybacks if the tax burden outweighs the benefits.
2. Tax on entire amount: Unlike the current system where only the net gain from buybacks is taxed, shareholders will now face tax on the entire buyback amount. This could significantly reduce the return on investment for many shareholders.
3. Deferred capital loss: Although the new rules allow shareholders to treat the cost of buyback shares as a capital loss, this benefit is deferred. Shareholders need to generate capital gains in the future to use these losses, which may not provide immediate relief.
Conclusion
The changes could also affect market dynamics and companies might reassess their capital distribution strategies, potentially leading to reduced buyback activity and affecting overall market liquidity.
The amendments to the buyback tax regime introduced in Union Budget 2024 represent a major shift in tax policy. While the changes aim to create a more equitable tax environment and encourage genuine share buybacks, they also bring challenges such as increased tax burden for shareholders and potential impact on market dynamics. Companies and investors will need to carefully navigate these new rules, adjusting their strategies to optimise returns and comply with the updated tax provisions. The new regulations will take effect from 1 October 2024, and companies are expected to make a beeline for undertaking share buybacks in the lead-up to this date.
