The Finance Act, 2024 has introduced a pivotal amendment to Section 115QA of the Income-tax Act, altering the taxation framework for share buy-backs conducted by domestic companies. Earlier, companies undertaking buy-backs were liable to pay a buy-back distribution tax at an effective rate of 23.296%, inclusive of surcharge and cess. Shareholders, on the other hand, were exempted from paying any tax on the income received from such buy-backs under Section 10(34A).
However, the recent amendment fundamentally shifts this approach. Effective from October 1, 2024, the proceeds received by shareholders from a buy-back are now classified as “deemed dividends.” This income is taxable in the hands of shareholders under the head “Income from Other Sources” at their respective applicable slab rates.
Shift in Tax Liability: From Company to Shareholder
Previously, domestic companies bore the tax liability on distributed income from share buy-backs. Rule 40BB of the Income-tax Rules, 1962 provided the manner of computation of this tax. The tax was computed on the distributed income, which was the consideration paid by the company for buying back shares, reduced by the amount received by the company for issuing such shares.
Section 46A treated the buy-back consideration as capital gains in the hands of shareholders. After deducting the acquisition cost, the resultant amount was taxed under the heading “Capital Gains.” The exemption under Section 10(34A) ensured that this income was not taxed again in the hands of shareholders, thereby avoiding double taxation.
With the amendment, the tax burden has been effectively shifted from the company to the shareholders. Consequently, shareholders will now bear the tax liability on the income received from share buy-backs. This move aligns the tax treatment of buy-back proceeds with that of dividends post the abolition of Dividend Distribution Tax (DDT) in 2020.
Rationale Behind the Amendment
The primary objective of amending Section 115QA is to harmonize the tax treatment of share buy-backs with that of dividend distributions. Both buy-backs and dividends are mechanisms through which companies distribute accumulated profits or reserves to shareholders. The earlier system, where companies paid a buy-back tax while shareholders remained tax-exempt, created a disparity in tax treatment between these two forms of distributions.
Representations from various stakeholders highlighted this inconsistency. The government acknowledged that taxing buy-back proceeds at the shareholder level would ensure parity with dividend taxation, thereby broadening the tax base and discouraging tax avoidance strategies that leverage buy-backs as a substitute for dividend payouts.
Post-Amendment Taxation Mechanism
Under the amended regime, shareholders receiving proceeds from a buy-back transaction will now be taxed under the heading “Income from Other Sources.” The amount received will be treated as a deemed dividend and taxed at the applicable rates based on the shareholder’s income slab.
No deductions for any expenses or allowances will be permitted against such income while computing taxable income. Furthermore, the cost of acquisition of the shares bought back will not be available for offsetting against the buy-back consideration. Instead, for capital gains purposes, the buy-back consideration will be deemed to be NIL.
Treatment of Capital Loss
Since the buy-back consideration is deemed NIL for capital gains computation, shareholders will incur a capital loss equivalent to the cost of acquisition of the bought-back shares.
This capital loss can only be set off against other capital gains. It cannot be adjusted against the income from buy-backs which is now taxed as deemed dividends.
Illustration of Tax Implications Post-Amendment
To illustrate the tax implications, consider the following example:
A shareholder purchases 100 shares in 2020 at ₹40 per share, amounting to a total acquisition cost of ₹4,000. In 2024, the company bought back 20 shares at ₹60 per share, resulting in a total buy-back consideration of ₹1,200. Under the amended provisions, this ₹1,200 will be treated as a deemed dividend and taxed in the hands of the shareholder at the applicable slab rate.
For capital gains computation, the buy-back consideration is deemed NIL. Therefore, the shareholder will incur a capital loss of ₹800 (20 shares x ₹40 acquisition cost). This capital loss can only be set off against other capital gains.
In 2025, if the shareholder sells the remaining 50 shares at ₹70 per share, the total sale proceeds will amount to ₹3,500. The acquisition cost for these 50 shares is ₹2,000 (50 shares x ₹40). The resultant capital gain is ₹1,500. However, the shareholder can adjust the earlier capital loss of ₹800 against this capital gain, resulting in a net taxable capital gain of ₹700.
Effective Date of Amendment
The provisions of the amended Section 115QA will come into force from October 1, 2024. Any buy-back of shares conducted on or after this date will be governed by the new tax framework.
Broader Impact of the Amendment
The amendment has a far-reaching impact on shareholders, especially those in higher income brackets. The tax liability, which was earlier absorbed by the company at a flat rate, will now vary depending on the shareholder’s tax slab. High-net-worth individuals, who fall in the higher tax brackets, will now face a higher effective tax burden on buy-back proceeds compared to the earlier regime.
Additionally, shareholders can no longer offset the cost of acquisition of the bought-back shares against the buy-back consideration for computing capital gains. The deemed NIL consideration approach ensures that shareholders will incur a capital loss on every buy-back transaction, which can only be utilized against other capital gains, thus limiting its utility.
Strategic Considerations for Shareholders
Shareholders need to reassess their investment strategies in light of these amendments. With the tax burden shifting to them, it becomes essential to evaluate the net post-tax returns from buy-back offers. High-income shareholders may find buy-back offers less attractive compared to dividend distributions.
Moreover, the inability to claim deductions against deemed dividend income further erodes the effective returns from buy-backs. Shareholders must also strategically plan their capital gains and losses to ensure optimal utilization of the capital losses incurred due to buy-back transactions.
Compliance and Reporting Requirements
The amended provisions will necessitate meticulous compliance and reporting by shareholders. The income received from buy-backs will now need to be reported under “Income from Other Sources” in the income tax return. Shareholders must ensure accurate reporting of deemed dividend income and corresponding capital losses in their tax filings.
Failure to comply with the reporting requirements or misclassification of income could invite scrutiny and potential penalties. Therefore, professional tax advice and accurate documentation of buy-back transactions will be critical for shareholders to ensure compliance with the new tax regime.
The amendment to Section 115QA signifies a paradigm shift in the taxation of buy-back transactions. By transferring the tax liability from the company to the shareholders, the government aims to align the tax treatment of buy-backs with dividends, thereby ensuring tax equity and broadening the tax base. While this move rationalizes the tax structure, it necessitates careful tax planning and compliance by shareholders to navigate the new tax landscape effectively.
Overview of Capital Gains Tax Reforms
The Finance Act, 2024 has introduced comprehensive reforms to the capital gains tax structure with the objective of simplifying the tax framework, broadening the tax base, and ensuring equitable taxation across different asset classes. The amendments impact various aspects of capital gains taxation, including the classification of long-term and short-term assets, applicable tax rates, and the availability of indexation benefits.
The reforms are a part of the government’s broader strategy to streamline capital gains taxation and eliminate anomalies that provide unintended tax advantages to certain categories of taxpayers. These changes are expected to significantly impact investors, high-net-worth individuals, non-resident investors, and corporate entities.
Simplification of Holding Periods for Capital Assets
One of the primary reforms introduced by the Finance Act, 2024 is the simplification of holding periods used to determine whether a capital asset qualifies as a long-term or short-term capital asset. Prior to the amendment, the Act had varying holding period thresholds for different categories of assets, leading to complexity in classification.
Under the new regime, there are now only two holding period thresholds:
Listed Securities: 12 months All Other Capital Assets: 24 months
This amendment simplifies the determination of asset classification and aligns the holding periods for various financial instruments. Notably, the holding period for units of listed business trusts, which was previously 36 months, has now been reduced to 12 months. Similarly, bonds, debentures, and gold, which earlier required a holding period of 36 months, are now classified as long-term assets after 24 months.
The holding period for unlisted shares and immovable properties remains unchanged at 24 months. This standardization of holding periods is intended to eliminate complexities and streamline compliance requirements for taxpayers.
Revised Tax Rates on Capital Gains
The Finance Act, 2024 has also restructured the tax rates applicable on capital gains arising from the transfer of various categories of assets. The revised rates are aimed at ensuring a fair and consistent tax treatment across different asset classes.
Short-Term Capital Gains (STCG)
For listed equity shares, units of equity-oriented mutual funds, and units of business trusts where Securities Transaction Tax (STT) is paid, the tax rate on short-term capital gains has been increased from 15% to 20%.
For all other categories of short-term capital gains, including gains from unlisted shares, immovable property, and other capital assets, the tax continues to be levied at the applicable slab rate or corporate tax rate, as the case may be.
Long-Term Capital Gains (LTCG)
For listed equity shares, equity-oriented mutual funds, and business trusts where STT is paid, the tax rate on long-term capital gains has been increased from 10% to 12.5%. Additionally, the basic exemption limit for long-term capital gains has been enhanced from ₹1 lakh to ₹1.25 lakh.
For listed bonds and debentures, long-term capital gains will also be taxed at 12.5%. For unlisted bonds and debentures, capital gains will now be taxed at the applicable slab rate or corporate tax rate, irrespective of the holding period. This change is effected through the amendment of Section 50AA, which classifies such assets as short-term capital assets regardless of the duration of holding.
Withdrawal of Indexation Benefits
One of the most significant changes introduced by the Finance Act, 2024 pertains to the withdrawal of indexation benefits for long-term capital gains. Earlier, taxpayers were allowed to adjust the cost of acquisition of assets by applying the Cost Inflation Index (CII), thereby accounting for inflationary gains while computing capital gains.
Under the amended regime, the benefit of indexation will no longer be available for assets taxed at 12.5% on long-term capital gains. The government has justified this move by arguing that the revised lower tax rate of 12.5% sufficiently compensates for the withdrawal of indexation benefits.
However, recognizing the concerns raised by resident individuals and Hindu Undivided Families (HUFs), the government has allowed an optional regime. Taxpayers who acquired capital assets prior to July 23, 2024, can opt to pay tax at the existing rate of 20% with the benefit of indexation. This relief, however, is not extended to Non-Resident Indians (NRIs), who are mandated to pay tax at 12.5% without any indexation benefits.
Tax Computation Scenarios Post-Amendment
To understand the financial implications of these changes, consider the following scenarios:
Scenario 1: Property Acquired After April 1, 2001
Sale Price: ₹100 Cost of Acquisition: ₹20 Under the old regime with indexation, the Indexed Cost would be ₹53 (CII 2008-09: 137, CII 2024-25: 363), leading to a capital gain of ₹47 and tax liability of ₹9.40 (20%). Under the new regime without indexation, the capital gain is ₹80 and taxed at 12.5%, resulting in a tax liability of ₹10.
Scenario 2: Property Acquired Prior to April 1, 2001
Sale Price: ₹100 Value as on April 1, 2001: ₹20 Under the old regime, the Indexed Cost would be ₹72.60, leading to a capital gain of ₹27.40 and a tax liability of ₹5.48. Under the new regime, the capital gain is ₹80 and taxed at 12.5%, resulting in a tax liability of ₹10.
These scenarios illustrate that while the simplified tax structure may reduce the effective tax rate for some transactions, it could result in a higher tax burden for assets with a longer holding period, where indexation previously offered substantial tax relief.
Amendments to Section 112 – Key Considerations
Section 112 has been comprehensively amended to incorporate the revised tax structure. The clauses defining the applicable tax rates and indexation provisions have been substituted with effect from July 23, 2024. While the optional regime of 20% tax with indexation remains available for certain resident taxpayers, the overall legislative intent is to gradually transition towards a simplified flat tax rate regime.
Tax experts have expressed concerns regarding the language of the amended provisions, particularly on the treatment of capital losses. There is a view that losses arising from the transfer of capital assets, especially under the new regime without indexation, may no longer be eligible for set-off or carry forward. This interpretation, if upheld, could have significant adverse implications for investors.
The government is expected to issue clarifications addressing these ambiguities. Until then, taxpayers and professionals must tread cautiously and plan their transactions with an understanding of the potential tax implications.
Impact on NRIs – Sale of Unlisted Shares
Non-Resident Indians will face a higher tax burden under the new capital gains taxation framework. For NRIs, long-term capital gains arising from the sale of unlisted shares will now be taxed at 12.5% without the benefit of indexation or foreign currency fluctuation adjustments.
Initially, the Finance Bill, 2024 proposed allowing NRIs to adjust capital gains for foreign exchange fluctuations, providing relief from currency depreciation effects. However, this provision was removed at the time of passing the Bill, reverting to the pre-amendment position in terms of foreign exchange adjustments but with an increased tax rate from 10% to 12.5%.
This change is expected to impact investment decisions by NRIs, as the lack of foreign currency adjustment could significantly inflate their taxable capital gains when converting proceeds into Indian Rupees.
Strategic Tax Planning Under New Regime
The restructured capital gains tax regime necessitates proactive tax planning by investors and corporations. Taxpayers should evaluate the implications of the new regime on their investment portfolios and consider the following strategies:
- Timing of Asset Sales: Taxpayers holding assets acquired before July 23, 2024, may benefit from opting for indexation and selling assets before the optional regime is phased out.
- Asset Reallocation: Investments in asset classes that offer favorable tax treatment, such as listed equity shares and mutual funds, may be considered to optimize post-tax returns.
- Capital Loss Harvesting: Taxpayers should strategically manage their capital gains and losses to ensure optimal utilization of capital losses under the revised set-off provisions.
- Professional Advisory: Given the complexities of the new regime, seeking professional tax advice is essential for accurate compliance and effective tax planning.
Compliance and Reporting
The new capital gains tax framework imposes additional compliance requirements on taxpayers. Accurate classification of assets, computation of holding periods, and application of the correct tax rates will be critical to ensure compliance.
Taxpayers must maintain comprehensive documentation, including acquisition and sale details, to substantiate their tax computations. Errors or misclassification in reporting capital gains could attract scrutiny from tax authorities and result in penalties. Professional assistance and the use of robust tax computation software will be invaluable in navigating the complexities of the revised capital gains tax regime.
Overview of Section 56(2)(viib) and Angel Tax
Section 56(2)(viib) of the Income-tax Act was introduced by the Finance Act, 2012, as an anti-abuse measure aimed at curbing the practice of unaccounted money being routed through share premiums in closely-held companies. The provision mandated that when a company, not being a company in which the public is substantially interested, receives any consideration from a resident for issue of shares that exceeds the fair market value (FMV) of such shares, the excess amount would be taxed as “Income from Other Sources” in the hands of the recipient company.
Popularly known as the “Angel Tax,” this provision was initially intended to target shell companies and prevent money laundering. However, it inadvertently impacted genuine startup investments, where valuations based on future growth potential often exceeded the FMV computed using prescribed methods.
Sunset Clause for Section 56(2)(viib)
Recognizing the adverse implications of Angel Tax on India’s startup ecosystem and the redundancy of the provision in light of other anti-abuse measures, the government has now decided to sunset clause (viib) of Section 56(2).
The Finance Act, 2024 amends Section 56 to provide that the provisions of clause (viib) shall not apply from Assessment Year 2025-26 onwards. This amendment effectively abolishes Angel Tax for share premiums received by closely-held companies on or after April 1, 2025.
Rationale for Sunset of Angel Tax
Several factors contributed to the government’s decision to sunset the Angel Tax provisions:
- Redundancy: With increased scrutiny by regulatory bodies such as SEBI, RBI, and stricter reporting norms under the Companies Act, the need for a separate tax provision targeting share premiums was deemed redundant.
- Impact on Startups: The provision adversely affected startups, which often raise funds at valuations exceeding traditional FMV methods due to their unique business models and growth potential.
- Ease of Doing Business: The removal of Angel Tax aligns with the government’s objective of improving India’s ease of doing business ranking and fostering a more conducive environment for startup funding.
Implications for Companies and Investors
The sunset of Angel Tax provisions is a welcome relief for startups, private equity investors, and venture capitalists. The key implications include:
- Enhanced Funding Flexibility: Startups can now raise funds at valuations agreed upon with investors without the fear of tax liabilities arising from Section 56(2)(viib).
- Simplified Compliance: Companies are relieved from the burden of complying with complex FMV determination methods and justifying valuations to tax authorities.
- Investor Confidence: The removal of Angel Tax is expected to boost investor confidence, facilitating increased flow of domestic and foreign capital into India’s startup ecosystem.
Transitional Provisions and Applicability
The amendment specifies that the sunset clause (viib) will take effect from April 1, 2025, applicable for Assessment Year 2025-26 onwards. Any share premium received by companies on or after this date will not attract tax under Section 56(2)(viib).
It is important to note that share premiums received prior to this date will continue to be governed by the existing provisions. Companies should ensure proper documentation and valuation reports for transactions executed before the sunset date to avoid disputes.
Broader Implications on Corporate Financing
The abolition of Angel Tax is expected to have a cascading positive impact on corporate financing in India. By removing regulatory friction in raising equity capital, companies, especially in the early stages, will find it easier to secure funding.
The decision is also likely to attract more foreign investment, as global investors often expressed concerns about India’s valuation norms and tax risks associated with Angel Tax.
Additionally, the amendment fosters a competitive funding landscape, where valuation negotiations between investors and startups can proceed without the overarching shadow of tax liabilities.
Interaction with Other Anti-Avoidance Measures
While Angel Tax has been sunsetted, the government continues to retain a robust framework of anti-abuse provisions to prevent tax evasion and money laundering through inflated valuations. Notable among these are:
- General Anti-Avoidance Rules (GAAR): Empower tax authorities to scrutinize transactions lacking commercial substance and deny tax benefits arising from impermissible avoidance arrangements.
- Transfer Pricing Regulations: Ensure that transactions between associated enterprises are conducted at arm’s length prices, preventing profit shifting and base erosion.
- Enhanced Reporting Requirements: Companies are required to disclose details of significant beneficial owners, related party transactions, and maintain documentation to justify share valuations.
Market Reactions and Industry Feedback
The decision to sunset Angel Tax has been widely welcomed by industry bodies, startup associations, and investor forums. Key takeaways from market reactions include:
- Positive Sentiment: Industry leaders view the move as a long-awaited correction that will stimulate entrepreneurial activity and ease capital access.
- Regulatory Clarity: The amendment reduces regulatory uncertainties that often led to protracted disputes between taxpayers and tax authorities over share valuation methodologies.
- Global Competitiveness: By aligning with global best practices, India enhances its attractiveness as a destination for venture capital and private equity investments.
Compliance Requirements Post-Amendment
While the abolition of Angel Tax simplifies capital raising for startups and private companies, companies must continue to ensure robust compliance with other regulatory requirements, including:
- Proper Maintenance of Share Allotment Records: Accurate documentation of share issuance, subscription agreements, and valuation reports remains critical.
- Adherence to Company Law Norms: Compliance with provisions of the Companies Act, 2013, including filing of returns and maintenance of statutory registers.
- Disclosure of Beneficial Ownership: Companies must disclose significant beneficial owners as per SEBI and Ministry of Corporate Affairs guidelines.
Amendments to Section 50AA and Its Implications
In addition to the sunset of Angel Tax provisions, the Finance Act, 2024 has also introduced amendments to Section 50AA of the Income-tax Act, impacting the taxation of certain debt instruments.
Section 50AA, which deals with the computation of capital gains on Market Linked Debentures (MLDs), has now been expanded to include unlisted bonds and debentures. Under the amended provisions, any capital gains arising from the transfer, redemption, or maturity of unlisted bonds or debentures on or after July 23, 2024, shall be treated as short-term capital gains, irrespective of the period of holding.
This amendment aims to curb tax arbitrage opportunities where investors structured their portfolios to convert interest income into capital gains taxed at concessional long-term rates.
Implications for Debt Market Investors
The reclassification of unlisted bonds and debentures as short-term capital assets irrespective of holding period will impact high-net-worth individuals (HNIs), family offices, and institutional investors who traditionally preferred these instruments for tax efficiency.
Investors will now be subject to taxation at applicable slab rates or corporate rates on gains arising from these instruments. Portfolio strategies will need to be realigned, taking into consideration the new tax implications and exploring alternative fixed income instruments that offer more favorable tax treatment.
Rationalisation of Period of Holding for Capital Assets
The Finance Act, 2024 has rationalised the period of holding for various capital assets, streamlining the classification of assets into short-term and long-term categories. The revised periods of holding are as follows:
Listed Equity Shares and Units of Equity-Oriented Mutual Funds: 12 months Units of Business Trusts: Reduced from 36 months to 12 months Bonds, Debentures, and Other Financial Instruments: Reduced from 36 months to 24 months Unlisted Shares and Immovable Property: Remain at 24 months Other Assets: Reduced from 36 months to 24 months
Market Linked Debentures (MLDs), Specified Mutual Funds (SMFs), and depreciable assets will continue to be classified as short-term capital assets irrespective of the period of holding.
Enhanced Reporting Norms for NRIs
The Finance Act, 2024 introduces stricter reporting norms for Non-Resident Indians (NRIs) investing in unlisted shares and debt instruments. With the removal of foreign currency fluctuation adjustments and the imposition of a flat 12.5% tax on long-term capital gains from unlisted shares, NRIs must ensure precise documentation of acquisition costs, remittance details, and adherence to the Liberalised Remittance Scheme (LRS) guidelines.
The lack of indexation and foreign currency adjustments will require NRIs to explore alternative tax planning strategies, including the use of Double Taxation Avoidance Agreements (DTAA) provisions where applicable.
Impact on Startup Ecosystem and Fundraising
The removal of Angel Tax is a significant catalyst for the startup ecosystem, as it eliminates a critical regulatory bottleneck that hindered fundraising efforts. Startups can now focus on growth and scaling operations without being bogged down by valuation disputes with tax authorities.
Venture capital funds and private equity investors are expected to increase their exposure to Indian startups, given the enhanced regulatory clarity. The amendment also levels the playing field, allowing startups to compete more effectively for capital on a global stage.
The Finance Act, 2024 marks a pivotal shift in India’s capital taxation landscape. By sunsetting the Angel Tax, rationalising capital gains tax rates, redefining holding periods, and amending the treatment of unlisted debt instruments, the government has taken decisive steps towards a more streamlined, equitable, and investor-friendly tax regime. These reforms are poised to invigorate capital markets, bolster the startup ecosystem, and align India’s tax policies with global standards.
The implications of these changes are profound, and taxpayers must undertake a comprehensive review of their investment strategies and compliance frameworks to navigate the evolving tax landscape effectively.
Conclusion
The amendment to Section 115QA under the Finance Act, 2024, marks a significant shift in the taxation landscape concerning share buy-backs by domestic companies. By moving the tax liability from companies to shareholders, the legislation aligns the taxation framework of buy-back proceeds with that of dividends, ensuring a uniform tax treatment for all forms of profit distribution. This change, while broadening the tax base, introduces new compliance and financial considerations for investors, who must now assess the personal tax implications of participating in buy-back offers.
One of the critical impacts of this amendment is the reclassification of buy-back proceeds as deemed dividends, taxable under the shareholders’ respective slab rates. Shareholders can no longer shelter such income through capital loss adjustments or expense deductions. Additionally, by deeming the buy-back consideration as NIL for capital gains calculation, the resulting capital loss becomes a latent tax shield, usable only against future capital gains but not immediately beneficial in offsetting ordinary income.
The concurrent rationalization of capital gains taxation further reshapes the investment environment. With the simplification of holding periods, increased tax rates on short-term and long-term capital gains, and the phased withdrawal of indexation benefits, investors must recalibrate their asset strategies. While Resident Individuals and HUFs retain limited indexation advantages for pre-amendment acquisitions, NRIs face a less favorable regime, especially with the removal of foreign currency fluctuation benefits on unlisted share transactions.
Amendments to Section 112 and Section 50AA signal the government’s intent to streamline capital gains computations, but also raise questions regarding the treatment of capital losses and carry-forwards. Until clarifications are issued by regulatory authorities or settled through judicial pronouncements, taxpayers must navigate these uncertainties cautiously, ensuring thorough documentation and professional advice.
The sunset of Section 56(2)(viib) marks a positive move, removing the contentious angel tax on share premiums, thereby promoting ease of doing business for startups and private companies. This measure aims to stimulate equity financing by alleviating undue tax scrutiny over share valuations.
For investors, tax planners, and corporate entities, these sweeping changes underscore the necessity of a proactive approach to tax compliance and investment planning. Shareholders must carefully evaluate the after-tax returns of participating in buy-backs versus holding shares, while companies might reconsider buy-back strategies as a tool for capital distribution. The new tax framework demands heightened vigilance and adaptive strategies to optimize tax outcomes within the evolving legislative context.