Rationale for Buy-Back Provisions
A cardinal principle of company law, incorporated in Section 67 of the Companies Act, 2013 (“the Act”), prohibits the purchase by the Company of its own securities for the protection of creditors. Section 68 is an exception to this general rule; hence, it starts with a non obstante clause laying down several conditions and restrictions for the companies undertaking a buy-back of its shares, primarily with a view to protect the creditors.
Buy-back of securities is used as a means for rationalization of capital. In the evolving business landscape, it also serves as a crucial avenue to offer an exit route to the investors. Traditionally, a buy-back was part of a capital reduction strategy as no specific provision was available for the company to purchase its own security. Moreover, when capital reduction was necessary, it involved a court-approved process, which is now sanctioned by the National Company Law Tribunal (“NCLT”). Subsequently, in response to changing circumstances, it was deemed necessary to introduce a provision enabling companies to conduct a buy-back in a more expedited and efficient manner, eliminating the need to approach the High Court (now NCLT). This approach also grants the company the flexibility to offer shareholders a convenient exit opportunity.
Section 77A of the Companies Act, 1956 (“CA 1956”), was introduced by the Companies (Amendment) Act, 1999. It was introduced after the report of the working group on the Companies Act, 1956, which stated, “Almost all OECD countries allow companies to buy back shares subject to certain regulations. Unfortunately, Section 77 (read with Section 100) of the Act prevents buy back. In today’s context, the Group strongly believes that this section is antiquated, and goes against the long-term interest of corporate sector growth and shareholder value. Hence, the Group recommends that the new Act should provide for buy back of shares subject to certain provisions.”[1]
Section 68 of the Act, which regulates buy-back of securities, outlines the sources and limits for buy-back and prescribes certain conditions for a company to purchase its own shares or other specified securities. In this article, the authors attempt to decode certain key issues under the provisions governing buy-back.
Key Issues
Reading between the lines – Proviso to Section 68(1) of the Act
Section 68(1) of CA 2013 governs the buy-back of securities and provides for sources for buy-back, such as (i) free reserves, (ii) securities premium account, and (iii) proceeds of issue of any securities. The proviso to Section 68(1) specifies that “no buy-back of any kind of shares or other specified securities shall be made out of the proceeds of an earlier issue of the same kind of shares or same kind of shares or same kind of other specified securities.”
The placement of the proviso to Section 68(1) of the Act creates some confusion as to whether the proviso is applicable to all the three limbs of Section 68(1) or only to clause (c) of Section 68(1), i.e., the proceeds of the issue of any shares or other specified securities as the source for buy-back.
The proviso under Section 68(1) prohibits using proceeds of the same kind of security which is being bought back. Clause (c) of Section 68(1) provides for “Proceeds” of the issue as a source of buy-back. It would mean that if a company wants to carry out the buy-back of securities but does not have free reserves and does not have any balance in the securities premium account, then buy-back is possible by issuing any other kind of security. Only if there is a nexus between the issue of securities and the buy-back of another kind of security should the proviso come in the picture and not otherwise, i.e., considering the securities premium account as proceeds of an earlier issue done without any nexus with the buy-back.
For a more appropriate perspective, it is also important to refer to Section 52 of the Act, which provides for permissible usage of the securities premium account generated on the issue of shares. One of the permissible usages under Section 52(2) is “Purchase of company’s own securities under Section 68”. Reading Sections 52(2)(e) and 68(1) in conjunction suggests that securities premium is a clear source for buy-back without having to give any regard to the kind of shares for which it is generated. Therefore, applying this restriction to the securities premium account would create an unworkable restriction.
Hence, the implication is that the proviso to Section 68(1) of the Act only applies to Section 68(1)(c) and not to a buy-back of securities out of the free reserves or the securities premium account.
Buy-back of securities under the Act – Limits on consideration or share capital?
Section 68 of the Act closely resembles its predecessor, Section 77A of CA 1956. Nonetheless, a subtle variation exists in the language concerning the limitations on buy-back specified in Section 68(2)(c) of the Act.
Comparison:
Section 77A(2)(c) of CA 1956
“The buy-back is or less than twenty-five per cent of the total paid-up capital and free reserves of the company:
Provided that the buy-back of equity shares in any financial year shall not exceed twenty-five per cent of its total paid up equity capital in that financial year”
68(2)(c) of CA 2013
The buy-back is twenty-five per cent or less of the aggregate of paid-up capital and free reserves of the company:
Provided that in respect of the buy-back of equity shares in any financial year, the reference to twenty-five per cent in this clause shall be construed with respect to its total paid-up equity capital in that financial year”
A careful reading of Section 77A(2)(c) implies that while the section refers to “consideration” for buy-back, the proviso refers to the “share capital”. Whereas, under Section 68(2)(c), the wording in the proviso “the reference to twenty-five per cent in this clause” suggests that the section as well as the proviso talk about “consideration”. An interpretation for this could be that the 25 per cent limit for buy-back applies only to “consideration” and not to “share capital”.
Operation of Proviso to Section 68(2)(c)
It can be implied that unlike Section 77A(2)(c), Section 68(2)(c) and the proviso talk about consideration. The proviso brings out a specific requirement in case of buy-back of equity shares. In conclusion, the proviso is relevant only and only if the company also has capital other than equity capital.
Buy-Back Pricing Conundrum
SEBI has prescribed elaborate regulations for the buy-back of shares of listed entities under the SEBI (Buy-Back of Securities) Regulations, 2018. However, Section 68 of the Act, which lays down substantive laws on buy-back for both listed and unlisted companies, has surprisingly not dealt with pricing for buy-back or a valuation report by a registered valuer despite the introduction of a specific section in the Act (Section 247 of the Act) for valuation by a registered valuer. Because of the large number of tech startups in India, there were several listed companies with hundreds of shareholders due to their employee stock option schemes. The only prescription under Rule 17(1) of the Companies (Share Capital and Debenture) Rules, 2014, is that the explanatory statement of the notice convening the meeting for approving the buy-back should specify the basis for arriving at the buy-back price. However, given that the provision requires that the basis or justification for arriving at the buy-back price should be disclosed, the requirement is effectively to ensure that there is an adequate justification for the buy-back price – which may be based on a valuation report from an independent valuer/ registered valuer.
FEMA Implications:
As per Rule 21 of the FEM (Non-Debt Instruments) Rules, 2019 (“NDI Rules”), if the shareholder tendering the shares in the buy-back is a non-resident, the fair value of the shares determined as per any internationally accepted methodology for valuation will act as a cap below which the Indian company is free to price the share for buy-back.
Taxation perspective
At present, companies are subject to 20% tax (plus surcharge/ cess) on the difference between the amount paid on buy-back of shares and the amount received by the company on the primary issuance of shares under Section 115QA of the Income Tax Act, 1961(“ITA”).
The Finance (No.2) Bill, 2024 seeks to amend this section to provide that the following:
- Any payment on the buy-back of shares shall be treated as deemed dividend in the hands of the shareholders under the proposed Section 2(22)(f) – irrespective of the “accumulated profits”, the entire consideration would be deemed to be dividend.
- Since the said amount would be considered as deemed dividend, the same amount of consideration would not be subject to capital gains tax under Section 46A of ITA.
- Given that there would be a cost of acquisition in the hands of the shareholders, the said cost of acquisition would be treated as capital loss in the hands of the shareholder. Such loss would be permitted to be set off and carried forward against capital gains subsequently accrued to the shareholder.
- Withholding tax on payment of the buy-back consideration will be applicable under Section 194 of the ITA.
- There shall not be any buy-back tax on the companies’ undertaking such buy-back under Section 115QA of the ITA.
- No deduction of any nature shall be available against the buy-back amount deemed as dividend in the hands of shareholders.
Concluding thoughts:
The recent ITA amendments by the Finance (No.2) Bill, 2024,[2] buy-back of shares as a method of compensating the shareholders has become unattractive for the shareholders because of the withdrawal of the currently available tax benefits. Nevertheless, the Government of India should revisit Section 68 of the Act in the next round of amendments to the Companies Act to remove all the drafting anomalies. As and when the tax regime becomes a little more favourable, the companies can use the buy-back of shares to reward the shareholders and provide an exit to the minority shareholders without going through the NCLT process. In the authors’ opinion, the buy-back of shares is a very useful provision and should be made more attractive from the tax angle to benefit all the stakeholders.
[1] Para 3.10 of the report of the working group on the Companies Act, 1956
[2] Bill No. 55 of 2024
