Buyback tax shift puts shareholders on notice: What has changed for investors

The Union Budget of July 2024 introduced a major change in India’s taxation framework for share buybacks -- a move that could reshape how companies return capital and how investors structure their portfolios. Effective from October 1, 2024, the tax liability for share buybacks has shifted from companies to individual shareholders. This marks a decisive departure from the earlier regime, where companies bore the tax burden and investors received buyback proceeds tax-free.

Until now, companies undertaking buybacks paid a tax at an effective rate of 23.3%, inclusive of surcharge and cess, under Section 115QA of the Income-Tax Act. Shareholders, in turn, received tax-free proceeds under Section 10(34A). But this has changed. CA Suresh Surana explains, “With effect from 01 October 2024, the buyback tax on companies is abolished, and the entire buyback proceeds are treated as 'deemed dividend' under Section 2(22)(f), taxable in the hands of shareholders at their applicable slab rates.”

This means high-net-worth individuals (HNIs) could now face a tax liability of up to 35.88% on buyback proceeds, far higher than the 23.3% previously paid by companies.

What does this mean for investors?

The change significantly reduces the tax efficiency of buybacks. Surana adds, “The cost of acquisition of shares is not deductible against the deemed dividend income. Instead, it will be treated as a notional capital loss under Section 46A, which can only be set off against future capital gains or carried forward for up to eight years.”

In simpler terms, shareholders now pay tax on the entire buyback amount, while any loss on the cost of the shares can only be adjusted against capital gains, which are taxed at much lower rates—12.5% for long-term gains.

This disincentivises buybacks, particularly for investors in higher tax brackets. Surana notes, “The new regime has certainly reduced the attractiveness of buybacks as a capital return mechanism.”

Dividends may regain popularity

With the erosion of buyback tax advantages, dividends are expected to become the preferred mode of profit distribution.

Surana points out, “Dividends may become a more preferred method for distributing profits as they do not involve the extinguishment of shareholder equity.” Moreover, dividend income is subject to withholding tax, typically 20% for residents, and lower for foreign investors under applicable tax treaties (5–15%), provided proper documentation is submitted.

For global investors, the foreign tax credit (FTC) mechanism further allows Indian taxes to be offset against home-country liabilities, subject to treaty provisions—another reason dividends may regain favor.

Changing investor strategies

The shift in taxation is likely to influence investor behavior and portfolio strategy. Many may now lean toward long-term capital appreciation rather than short-term gains through buybacks.

“The tax inefficiency of buybacks may push shareholders toward holding the shares rather than opting for such a scheme,” Surana says. “Long-term capital gains on listed shares are taxed at 12.5%, significantly lower than the slab rates of HNIs.”

This may encourage investors to stay invested longer, especially in high-quality companies with strong growth potential, to benefit from more favorable tax treatment.

Will it impact global competitiveness?

Despite initial concerns, the reform is unlikely to dent India’s competitiveness. Surana believes, “This move is expected to have a minimal impact on the global competitiveness of Indian companies,” citing India’s relatively competitive corporate tax rates—25.17% generally, and 17.16% for some manufacturing entities.

Moreover, he adds, “India’s treatment of dividends aligns with global norms and benefits foreign investors through DTAAs, which offer reduced tax rates and allow the claiming of foreign tax credits.”

The bigger picture

This policy change reflects the government’s intent to enhance tax compliance and align with global standards by shifting tax responsibility to shareholders. While it may bring more clarity and parity in taxation, it also adds complexity for investors managing their tax exposure.

As both companies and investors adapt to the new rules, we can expect a gradual shift in how profits are returned—and how portfolios are built—in India's capital markets.