Taxation of buyback of foreign instruments: still awaiting clarity?

Buyback has been a time-tested and popular method for the management to repatriate
cash to shareholders and boost the economic value of the company. Tax regimes all-over
the world have been slow to react to taxing this method of capital repatriation. India too
introduced taxing provisions of sections 46A and 115QA in the Income-tax Act, 1961
("Act"), around the turn of the millennium. Each of these sections serve different
purposes, namely:

♦   115QA - Taxation of buyback of shares of domestic company in the hands of the

company
  46A - Taxation of buyback of shares of "other companies" or specified securities
of companies, in the hands of shareholders
In this article we will focus on taxation of buyback governed by section 46A of the Act
with a pointed eye on buyback of foreign instruments.

Legal provisions

As per provisions of section 46A, buyback of the following cases shall be deemed to be
capital gains in the hands of the shareholder:

♦   Buyback of shares of foreign companies

♦   Buyback of specified securities of any company
As per provisions of section 48, the difference between the cost of acquisition and the
value of consideration received is charged as the capital gains in the year in which such
shares or other specified securities are repurchased. Further, any cost of improvement
and expenditure incurred exclusively for such transfer is also allowable under section 48.
Thus, in these cases no buyback tax under section 115QA, is levied in the hands of the
company.

"Specified securities" are defined as per section 68 of the Companies Act to include
employees' stock option or other securities as may be notified by the Central
Government from time to time.

The context leading to the genesis of section 46A, explains its purpose succinctly. The
newly introduced provisions of buyback via the Companies Act ordinance created a void
in taxation of the transaction and lacked clarity thereby, taxing it as deemed dividend as
per section 2 of the Act. The memorandum to Finance Act 1999 explains as follows:
"…. newly introduced provisions of buy-back of shares has thrown open certain issues
in relation to the existing provisions of Income-tax Act. The two principal issues are
whether it would give rise to deemed dividend under section 2(22) of the Income-tax
Act and whether any capital gains would arise in the hands of the shareholder. The
legal position on both the issues are far from clear and settled and there is
apprehension that there will be unnecessary litigation unless the issues are clarified
with finality. It is, therefore, proposed to amend clause (22) of section 2 of the Income-
tax Act by inserting a new clause to provide that dividend does not include any
payment made by a company on purchase of its own shares in accordance with the
provisions contained in section 77 of the Companies Act, 1956…."
Here, the author wishes to interject the logical flow of thought, referring to CBDT
Circular No.6/2016. The Circular states that shares and other securities can be held
either as capital assets or stock-in-trade/ trading assets or both. It further states that, in
respect of listed shares and securities if the assessee itself, irrespective of the period of
holding the listed shares and securities, opts to treat them as stock-in-trade, the income
arising from transfer of such shares/securities would be treated as business income.
Therefore, the author wants the readers to appreciate a scenario where shares are held as
stock-in-trade rather than as investments.

It is also pertinent to note the usage of the word "consideration", which indicates that
not only currency but consideration received in any form such as property/virtual digital
assets, shall be included. The rudimentary classification of instruments as shares and
debentures is also required to truly appreciate the application of this section. This
becomes very important for Indian resident corporates and individuals in the light of the
new ODI rules and regulations introduced.

International commentary

As per the OECD Model convention ("convention"), capital gains, dividends and interest
are governed by Articles 13, 10 and 11 respectively. Further, business profits are governed
by Article 5 read with Article 7. Our research primarily focuses on capital gains and
business profits arising from buyback of foreign instruments.

A. Capital gains

In most of the Tax Treaties which India has entered into with other countries, gains
arising from alienation / buyback of shares may be taxable in both the contracting states.
The Indian resident is provided relief via tax credit method or the exemption method, as
per Articles 23A/ 23B of the convention and Section 90 of the Act. In case of debentures
or other securities, alienation is commonly governed by the residuary clause which
provides for taxation of gains on buyback only in the state of residence of the
alienator i.e., India.

Further, the commentary of Article 13 of the Convention states that even in cases where
buyback / reduction of capital / debentures is treated as dividend / interest in the
country of origin of the foreign instruments, tax credit shall be allowed to tax residents of
India where this income is treated as capital gains. Further, tax rates applied on such
buy-back in the Source Country cannot exceed the rates specified in the respective
articles of the Tax Treaty.

B. Business profits

In most of the Tax Treaties which India has entered into with other countries, Business
profits are taxable in the other Contracting State only in the presence of a permanent
establishment("PE") in such State. Therefore, in cases where shares / debentures / other
securities are being held as trading assets, in the absence of a PE in the other Contracting
State for the purpose of trading in the financial instruments, buyback of such
instruments will not be taxable in the Other State.
This view is supported by the definition of PE as per Article 5 of the Convention, which
requires a fixed place of business in the Other Contracting State to trigger the taxation of
business profits. Further, report on profit attribution to PE released by OECD covers
attribution of profits from global trading owning to a presence of PE in the Other
Contracting State. However, guidance on taxation of income from global trading in the
absence of a PE in the Other Contracting State appears to be limited.

Domestic taxation

A. Instruments held as investments

a.   Shares of foreign company

  In this case, such instruments being bought back will be charged to tax as capital
gains under section 46A. The Capital gains shall be the difference between the
value of consideration received and the cost of acquisition. The benefit of
indexation shall also be available in terms of section 48 for all shares held
beyond 24 months. Further, Foreign exchange fluctuation is to be factored in,
according to Rule 115 of the Income Tax Rules.
  These gains will be charged to tax in India as given below:
•   Long-term capital gains - 20% as per section 112
•   Short-term capital gains - Normal rates as per the Act
b.   Debentures of foreign company
  In this case, such instruments being bought back will be charged to tax as capital
gains under section 45. This is due to the fact that debentures are not covered
under "specified securities" as defined under Companies Act. The capital gains
shall be the difference between the value of consideration received and the cost
of acquisition. The benefit of indexation will not be available in terms of section
48 for debentures of any kind.
  These gains will be charged to tax as mentioned in point (a).
c.   Other specified securities of any company
  In this case, such instruments being bought back will be charged to tax as capital
gains under section 46A. The capital gains shall be the difference between the
value of consideration received and the cost of acquisition. The benefit of
indexation shall also be available in terms of section 48 for securities beyond 36
months.
  Since, specified securities includes stock options, it is essential to note that
exercise of options is taxable as perquisites under section 17, whereas buyback of
options under the Companies Act, is taxable as capital gains under section 46A.
Further, any gains will be charged to tax as mentioned in point (a).
B. Instruments held as stock-in-trade

The primary question to address in this case is whether buy-back of foreign instruments
held as stock-in-trade will still be taxed as capital gains in India. Since, the definition of
capital asset clearly excludes property held as stock-in-trade, buy-back of stock-in-trade
leading to capital gains sounds like an impossibility in itself. Further, the wordings of
section 46A impart that such gains from buy-back are "deemed" to be capital gains.
Though, the word "deem" is not defined in the Act, it has been held in several
judgements that a legal fiction cannot carry more weight than for the purpose of
implementing the requirement of the section. It should not be extended beyond that
legitimate field.

However, currently there is little clarity on the possible treatment of income from buy-
back under section 46A as business income. Though it can be argued in favour of section
46A that the income from buy-back shall be taxed as capital gains to give meaning to the
legal fiction created by the deeming provision of section 46A, this cannot go beyond the
field of section 46A. Application of deeming provisions to the sections 50CA and 56(2)
(x) are highly questionable, as shares in this case are not capital assets even though the
income arising from buyback is being offered to tax as capital gains. Accordingly,

a.   Shares and debentures of foreign company

  In such a scenario, taxation of such buy-back may be in accordance with sections
28 to 43 of the Act or section 46A of the Act. Further, Foreign exchange
fluctuation is to be factored in, according to Rule 115 of the Income Tax Rules.
The rate of tax charged will vary depending on the head of income.
b.   Other specified securities of any company
  The possibility of employee stock-options being held as stock-in-trade is very
hypothetical. Hence, the taxation of such a buyback of options will be governed
by section 46A.
As mentioned in the previous section, taxation will be only in India and the other
Contracting State cannot tax business profits in the absence of PE in said State.
Treatment of capital losses and business losses will be no different from usual treatment
as per the provisions of the Act.

To conclude, buyback of foreign instruments comprises of multiple unanswered

questions in the domestic and international context. As we prod deeper, the plot
thickens. Given the fast-paced movement of cross-border investments and transactions,
the requirement for clarity on an international scale is the need of the hour.