Multinationals with operations in India have only until May 31, 2013 to act before a newly proposed provision in India’s new Finance Bill will affect their tax planning.
Private companies (Pvt Cos) operating in India typically resort to a buyback of shares instead of payment of dividends to avoid dividend distribution tax (DDT), particularly where the capital gains arising to the shareholders are either not chargeable to tax or are taxable at a lower rate.
Under the proposal, which is likely to take effect from June 1, a private unlisted company would be taxed at the rate of 20 percent on the consideration paid by it as reduced by the amount received by it at the time of issue of such shares.
However, it is likely that the new Indian tax on the buyback of shares would not qualify for a direct foreign tax credit in the US, as it is a tax to be paid by the Indian company and not the recipient shareholder.
The proposed provision will also have a significant impact on foreign investors who have made investments from Mauritius, Singapore and Cyprus, where a buyback of shares would not have been taxable in India due to the availability of tax treaty benefits. Further, foreign investors may not be entitled to a foreign tax credit for such tax payments.
Under Indian company law provisions, a Pvt Co is permitted to buy back up to 25 percent of its total paid-up capital and free reserves, if it fulfills certain conditions. For instance, (a) the buyback does not exceed 25 percent of its total paid-up equity capital in that financial year; (b) the Pvt Co’s articles of association authorize a buyback of its shares; (c) the buyback is approved by passing a special resolution (i.e., by a 75 percent majority of the shareholders present and voting) at a general meeting of the Pvt Co; and (d) the ratio of the debt owed by the Pvt Co does not exceed twice its paid-up capital and free reserves after the buyback.
The consideration received by a shareholder on buyback of shares by a Pvt Co in India is taxable as capital gains in the hands of the shareholder. A Pvt Co having distributable reserves generally speaking has two options: (a) either to distribute the surplus funds to its shareholders by way of dividends; or (b) by purchasing its own shares at fair market value. In the first case, the dividend payout will suffer DDT at the rate of 16.22 percent and, generally, no tax credit is available for DDT in the home country. In the second case, the income is taxed in the hands of the shareholder as capital gains, either at (a) 15 percent if the shares are held for short term (less than 12 months); or (b) 20 percent, if the shares are held for long term (more than 12 months), depending on the period of holding; or (c) 0 percent, if the shareholder is located in a tax-friendly intermediary jurisdiction fulfilling commercial substance requirements.
Pvt Cos typically resort to buyback of shares instead of payment of dividends to avoid DDT particularly where the capital gains arising to the shareholders are either not chargeable to tax or are taxable at a lower rate.
In our view, all multinationals with Indian operations should deliberate this change, which is very likely to become effective on June 1. If it makes business sense, such multinationals should consider a buyback before May 31, 2013.