Saturday, February 2, 2013

Amount paid for buyback of shares allowed as business expenditure


The ITAT, Mumbai has held1 that the premium paid by the company on buyback of shares of a warring shareholder group is deductible as business expenditure in the hands of the company. Thus, it allowed the premium of Rs. 6.82 crores (over the face value of Rs. 8.40 lakhs) paid for buying back 34% of the shares held by such group. Though the decision is similar to a few earlier decisions on similar set, it is still noteworthy. This is because, strangely, it allows the whole of the premium paid for buyback of shares deductible as business expenditure. It is submitted that this does not consider the nature of buyback of shares, particularly its accounting and legal implications and hence requires reconsideration.  At the very least, a grossly excessive amount is allowed as deduction. Nevertheless, the decision, even if diluted, would be useful in several situations that are commonly seen in case of unlisted companies and also seen recently in case of listed companies.

The essential ground for allowing deduction was that the buyback was in the interests of the company which otherwise was suffering because of internecine disputes. After the settlement/payment, the Company’s business saw a revival of fortunes in terms of significantly increased sales.

In doing this, it followed an earlier decisionof the same Tribunal, the appeal against which was dismissed by the Bombay High Court. In this case too, it was noted that on account of the disputes between two shareholder groups, the sales had gone down and the company faced other difficulties. After the settlement and buyback of shares, the company saw increased sales and profits, new confidence by the bankers by way of fresh loans, etc. 

There is another decision3 of similar ratio, though here, it is not clear whether and what part of the amount paid as settlement to shareholders was for buyback of shares.

However, when the Company buys back shares, it is generally returning the value of the shares in the form of face value as originally paid, accumulated reserves and value of assets like goodwill, etc. that is not recognized in the books. Such return can hardly be a business expenditure.

The accounting treatment under accounting principles and also under Section 77A (and related provisions) of the Companies Act, 1956, clearly supports this. The face value of shares bought back is reduced from the paid up capital and the surplus (premium) is debited to reserves such as securities premium account or other reserves (other than revaluation reserve). These provisions generally do not permit debiting the amount paid to profit and loss account for the year.

There is, however, merit in these decisions for a partial amount, to the extent the facts support them. There may be cases where shareholders may create such a nuisance value that it may seriously impact the working of the company (as what has happened in the above cited cases). The Company may end up buying back shares at a price higher than their fair value, just to get such hurdles out of the way so the Company can focus on its business. The excess may be deductible because it represents purely the amount paid on account of business expediency. But the fair value paid should, it is submitted, still not be deductible.

In the present decisions, the whole of the premium amount paid (the face value, incidentally, was very nominal) has been allowed as a deduction.

The fact that the shares constitute a very significant percentage of capital (34% in this case) should have also been a relevant factor for not allowing such deduction.

There is another way to look at this. Often, similar inter-shareholder group disputes are settled by one group buying out the other. In such a case, the amount paid would be treated as a cost of shares purchased which would be treated as a revenue expenditure. Only on eventual sale of the shares such amount would be deductible but even in such a case, only “excess”payment paid for removing nuisance would effectively be deductible. To take an example, if, say, the fair value of the shares is Rs. 100 but Rs. 120 is paid, then, assuming that the shares are sold the very next day at Rs. 100, the excess Rs. 20 (and not Rs. 120) would only be available as a deduction.

Nevertheless, these decisions would have relevance in cases of settlement of shareholder disputes. In particular, it would also be helpful in the several cases of buyout of minority/small shareholders during complete delisting since often the Company pays a higher price to get rid of small but litigative shareholders.

1Chemosyn Ltd. v. Assistant Commissioner of Income-tax, 8(3) (OSD), Mumbai (2012) 25 taxmann.com 325 (Mum.)
Echjay Industries Ltd. v. Dy. CIT [2004] 88 TTJ 1089
USV Ltd. JCIT ((2007) 106 TTJ 535 Bom-Trib

5 comments:

vswami said...

The write-up, as per one’s reading and understanding, suggests rather doubts the correctness or otherwise of the expenditure in issue having been allowed, in full, by the ITAT.
According to the applicable provisions of the IT act, and if strictly construed, once an expenditure is held to be admissible on the grounds that it has been incurred or laid out, “wholly and exclusively” for the purposes of the business, and in the relevant ‘previous year’. As such, there is no scope for going into the question of whether it is allowable in full or not.
One is, no doubt, aware, there was a view taken/also being followed, that even if expenditure is of a revenue nature and is fully admissible, it was still open to the Revenue to , if so called for, allow it in instalments, i.e. in more than previous year, should the benefit of the expenditure is found to spill over more than one year. If remembered right, that was an instance in which the payment was for acquiring ‘know-how’. That is besides and apart from those special provisions which permit allowance likewise spread over a period.
I remain to be enlightened by the writer after relooking into in the light of above.

Jayant Thakur, CA said...

@vswami...

The problem is that the ITAT did not bifurcate what amounts to return of capital/reserves which cannot be business expenditure and the extra amount paid purely for removing nuisance affecting business. The latter part may be, on facts, be of course wholly allowed.

To give an example, if shares are found to have value of Rs. 100 (fv Rs. 10) but they are bought back for Rs. 120, then the Rs. 100 is return of capital/reserves while Rs. 20 is, if facts demonstrate, paid for removing a nuisance impeding the business.

Of course, it is a separate issue for examination whether even any such excess money paid to shareholders, particularly a large group, is allowable at all.

vswami said...

The reasoning or hypothetical example given for explaining why the correctness of the itat decision came to be doubted may be something requiring to be gone into in-depth, calling for an independent study and scrutiny.

In pure theory, one may say, had all the REQUISITE / NECESSARY “facts and circumstances” been brought on record and also been argued out in a wholesome manner, by BOTH the sides,the itat’ s decision could possibly have been different. One is then talking of an ideal or the most desired situation; which, however, is not experienced many times or has been happening in real life.

Be that as it should, and subject to any additional input from anyone else who has gone into the entire matrix of facts brought on record, what is not still understood is the validity or rationale behind the observations: -
“The problem is that the ITAT did not bifurcate what amounts to return of capital/reserves which cannot be business expenditure and the extra amount paid purely for removing nuisance affecting business. .......”

Another recent itat case dealt with in the published article @
http://taxguru.in/income-tax/itat-order-shantikumar-majithia-dcit-itat-mumbai-critique.html,
despite being on altogether different issues, may help in understanding the foregoing viewpoints.

Anonymous said...

"Accordingly, the shares of Umesh Shah group were purchased and cancelled by the assessee company and the premium of Rs.6,81,60,200/- paid was claimed as expenditure incurred wholly and exclusively for the purpose of business as the same was to enable the assessee company to carry on this business smoothly, efficiently and profitably" says the ITAT

"The problem is that the ITAT did not bifurcate what amounts to return of capital/reserves which cannot be business expenditure and the extra amount paid purely for removing nuisance affecting business. The latter part may be, on facts, be of course wholly allowed." Notes Mr. Thakur.

But, perhaps, the claim was only in respect of the latter amount?

Jayant Thakur, CA said...

@Anonymous...

The ITAT decision reads in paragraph 18...

"...the assessee company purchased 8398 shares held by Umesh Shah group for a total consideration of Rs.6.90 crores as against their face value of Rs.8,39,800/- and the difference of Rs.6,80,60,200/- was claimed by it as expenditure incurred wholly and exclusively for the purpose of running its business."

That should be clear enough, I think.

p.s.:- The figure should read 6,81,60,200 in the decision - a typo, obviously, since it is corrected later.

The Echjay decision also reads:-

"After a period of over six years, good sense prevailed between the two warring groups and a consent terms were drawn by the shareholders and the Bombay High Court in its orders passed on 2nd May, 1991, decreed approving the consent terms, inter alia giving the direction that the company would purchase the shares of the family members of Shri Maganlal H. Doshi, Shri Hasmukhlal H. Doshi and Shri Manharlal H. Doshi, who were the shareholders of the company and to pay a sum of Rs. 1,000 per share of which Rs. 100 per share was return of its capital value and the balance of Rs. 900 as by way of premia. The total payment accordingly came to Rs. 1,02,35,900 by way of repayment of the capital sum and an amount of Rs. 9,21,23,100 by way of premia. The consequential reduction in share capital were approved by the High Court.

The assessee-company debited the premia amount paid to the P&L a/c for the year and has claimed the same as deductible in computing its total income."