BUYBACK OF SHARES ARE SIMILAR TO EXPENSES FOR ISSUE OF BONUS SHARES AND ARE REVENUE EXPENSES By: C.A.

DEV KUMAR KOTHARI : View Profile

In case of Brittania Industries Ltd the Kolkata ITAT while confirming the order of the CIT(A) and dismissing the appeal of revenue held that the expenses for buyback of shares are revenue expenses. In this write up salient feature about buyback of shares and the order of ITAT are discussed and the author has also provided some more important contentions which could have been raised to support the claim of assessee. It was worth to attempt to claim the sum paid to shareholders over and above the paid up value of share, as revenue expenditure - as an expenditure to provide service to shareholders and to maintain goodwill. The excess amount paid does not result in acquisition of a capital asset or benefit of enduring nature. Share in capital of company and some terms and conditions: Share in this context means share held by a shareholder in the capital of a company. The share may be equity share or preference shares or some other class of shares. The terms and conditions related to share are determined as per the Memorandum and Articles of Association of company, terms of issue and the provisions of The Companies Act, 1956. The same can be changed only by an appropriate resolution of shareholders of company or a class of shareholders when only the terms of that class is affected without adversely affecting other class of shareholder. Some time change may take place due to legislative changes. Buy back of shares: When buy-back of share is allowed under law, the Memorandum and Articles of Association of company also need to provide for buy-back of shares. In case of need the same need to be amended by appropriate resolutions. In case of buy back the company purchases shares from the shareholders and later cancel them. Why Buyback: The purchase of outstanding shares, that is shares already issued by a company by the company itself for cancellation is called buyback of shares by the company. Companies resort to buyback to reduce the number of shares issued to shareholders whether available or not in share market by way of listing. When company has surplus funds and the possible means of deploying funds for better returns to shareholders is not possible or in some cases company just want to reduce outstanding shares for better servicing in future, company may buy back its own shares. Companies buy back shares either to increase the value of shares by reducing supply of shares and improving EPS per share. Sometimes buyback is resorted to eliminate small shareholders or to eliminate any threats by shareholders who may be looking for avenues to extend support to competitors or who may be trying to acquire a controlling stake etc. In the course of buyback shareholders are given offer whereby they have the option to tender a portion or all of their shares within a certain time frame and at a prefixed price ( which is usually average market price or fair price fixed as per guidelines in this regard). Relevant provisions: There being frequent changes one should be careful to ascertain recent provisions, and procedure in relation to buyback of shares. Broadly speaking the provisions of contained in Section 77A, 77AA and 77B of the Companies Act,1956 , Rules and notifications or circulars issued in relation to them and also Rules framed by The Securities and Exchange Board of India (SEBI) that is SEBI(Buy Back of Securities) Regulations,1999 with their updates , the Rules framed by the Department of Company Affairs namely the Private Limited Company and Unlisted Public company (Buy Back of Securities) rules,1999 pursuant to Section 77A(2)(f) and (g) are important . Purpose of buyback: A company may buy back its own shares for variety of reasons. Some of practical reasons are as follows:

i. ii. iii. iv. v.

To increase promoters holding - to have stability of management. Increase CEPS and EPS. Improve breakeven value of shares and market value of shares. To pay surplus cash not required by business To eliminate small and marginal shareholders.

vi. To reduce number of shares with a view to make company a closely held company or a private company. All these purposes are purpose of business which is existing. Funding of buyback A Company can finance buyback of own shares in several ways however, the common and practical sources are (i) free reserves of company and (ii) securities premium account. Some times with a view of restructuring the capital structure proceeds of any shares or other specified securities can also be used. When a company purchases its own shares out of free reserves, a sum equal to the nominal value of the share so purchased shall be transferred to the capital redemption reserve and details of such transfer shall be disclosed in the annual reports including the balance-sheet. Some of preconditions of Buy Back are as follows: (a) The buy-back is authorised by the Articles of association of the Company; (b) company has power to reduce or increase capital in its capital clause. (c) A special resolution has been passed in the general meeting of the company authorising the buy-back. In the case of a listed company, this approval is required by means of a postal ballot. Also, the shares for buy back should be free from lock in period/non transferability. The buyback can be made by a Board resolution If the quantity of buyback is or less than ten percent of the paid up capital and free reserves; (d) The buy-back is of less than twenty-five per cent of the total paid-up capital and fee reserves of the company and 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; (e). Specified securities for buy-back should be fully paid-up. (f). After the buyback the ratio of the debt owed by the company will not be more than twice the capital and its free reserves. (e) There should not be default in any of the following: a. in repayment of deposit or interest payable thereon, b. redemption of debentures, or preference shares or c. payment of dividend, if declared, to all shareholders within the stipulated time of 30 days from the date of declaration of dividend or d. repayment of any term loan or interest payable thereon to any financial institution or bank; e. Certain procedural compliances for filing of documents and returns etc. f. Compliance of requirement of listing agreements, guidelines prescribed by stock exchange etc. g. other relevant rules in given circumstances and at the time of buyback are to be complied with and there should be no default in compliances within specified period before buy back. Disclosures in the explanatory statement The notice of the meeting at which special resolution is proposed to be passed shall be accompanied by an explanatory statement stating -

(a) a full and complete disclosure of all material facts; (b) the necessity for the buy-back; (c) the class of security intended to be purchased under the buy-back; (d) the amount to be invested under the buy-back; and (e) the time-limit for completion of buy-back Sources for purchase of own shares for cancellation: The securities can be bought back from (a) existing security-holders on a proportionate basis; Buyback of shares may be made by a tender offer through a letter of offer from the holders of shares of the company or (b) the open market through (i). book building process; (ii) stock exchanges or (c) odd lots, that is to say, where the lot of securities of a public company, whose shares are listed on a recognized stock exchange, is smaller than such marketable lot, as may be specified by the stock exchange; or (d) purchasing the securities issued to employees of the company pursuant to a scheme of stock option or sweat equity. Declaration of solvency After the passing of resolution but before making buy-back, company need to file a declaration of solvency with the Registrar of companies and SEBI in prescribed form and in prescribed manner. In case of unquoted share the declaration of solvency need not be filed with SEBI. Maintaining register of securities bought back Company need to maintain a register of the securities/shares bought and enter therein the prescribe information and particulars. Important time framework: Buy-back shall be completed within twelve months from the date of passing the appropriate resolution. Company which has bought back any security cannot make any issue of the same kind of securities in any manner whether by way of public issue, rights issue up to six months from the date of completion of buy back. A Company shall, after the completion of the buy-back file with the Registrar and the Securities and Exchange Board of India, a return in prescribed form containing relevant particulars relating to the buy-back within thirty days of such completion. In case of unlisted company this return is not required to be filed with SEBI.. Prohibition of Buy Back A company shall not directly or indirectly purchase its own shares or other specified securities (a) through any subsidiary company including its own subsidiary companies; or (b) through any investment company or group of investment companies; or Steps and major procedure for buy back: a. Public announcement at least in one English National Daily, one Hindi National daily and Regional Language Daily at the place where the registered office of the company is situated. b. The public announcement shall specify a date, which shall be "specified date" for the purpose of determining the names of shareholders to whom the letter of offer has to be sent. c. A public notice shall be given containing disclosures as specified in Schedule I of the SEBI

regulations. d. A draft letter of offer shall be filed with SEBI through a merchant Banker. The letter of offer shall then be dispatched to the members of the company. e. A copy of the Board resolution authorizing the buyback shall be filed with the SEBI and stock exchanges. f. The date of opening of the offer shall not be earlier than seven days or later than 30 days after the specified date g. The buy back offer must remain open for a period of not less than 15 days and not more than 30 days. h. A company opting for buy back through the public offer or tender offer shall open an escrow Account. Result of buyback of shares: In case of buyback of shares the results derived are: Reduction of outstanding shares and paid-up capital of company. Reduction of reserves and surpluses. Outflow of cash in form of payment made to shareholders and expenses in relation to buyback. There is no cash inflow to improve capital base of company. The result is that some surplus cash is taken out from the resources of company to enable the company to utilize its balance of cash resources in more effective manner. Expenses for buyback of shares: As noted above, there is lengthy procedure for buyback of shares. Complex legal provisions and formalities are involved. This require engagement of experts like CA,CS, Advocates, Registrars for buyback etc. There are costs of advertisement, filing fees, banking services and facilities, postage and stamps, courier services etc. Recent case before ITAT about expenses for buyback of shares: In ACIT -Vs- Britannia Industries Ltd. the "C" Bench of Kolkata ITAT considered several issues as the revenue was aggrieved by the order passed by the CIT(A). The Tribunal has confirmed the order of the learned CIT(A) on all issues and fully dismissed the appeal of revenue. This shows that many times the revenue prefer appeal only for sake of preferring appeals whenever there is substantial amount is involved. Even when the CIT(A) has followed law laid down by the Supreme Court, the revenue may prefer appeal before the ITAT and then before the high Court and Supreme Court. One of important and a new issue was about allowability of expenses incurred in relation to buyback of shares. The AO disallowed the same as capital expenses, the CIT(A) deleted the disallowance following the law laid down by the Supreme Court on principals about capital and revenue expenses. Still the revenue felt aggrieved and carried the matter before the ITAT. From the order of ITAT: We find the following from the order of ITAT in relation to expenses for buy back of shares: Relevant ground before the Tribunal reads as follows: "1. That the Ld. CIT (A) erred in holding that the expenses of Rs.28,21,321 on share buy back are revenue expenses and hence allowable." Authors comment: The revenue has challenged the order of CIT(A) only on the ground whether the expenses are 'capital expense or revenue'? Thus, it was not in dispute that the expenses are incurred wholly and exclusively for the purpose of business. Facts found by the Tribunal are analyzed below: a. The disallowance of Rs.28,21,321/- being expenditure on share buyback was delted by the CIT(A) and the revenue is aggrieved.

b. The assessee company incurred a sum of Rs.28,21,321/-(as capital expenditure)** for Buy Back of Shares) and claimed as revenue expenses. ** there seems some typing mistake in this statement- the words capital expenditure should be only expenditure- author). c. The assessee company submitted before the AO that "The share Buy Back Expenses have been debited to Profit &. Loss Account included in Miscellaneous Expenses. The Expenses incurred during the course of business of company and allowable as an expenditure within provision of Section 37(1) of Income-tax Act". d. The AO observed that the said explanation of assessee do not constitute any force as the increased or decreased of share capital of company is a lifelong benefit of company. When the increase of share capital of company is a capital expenditure as the benefit derived long term benefit. Similarly when the company offered for buy back of share for reduction of share capital for distribution of more income to the members of company in future it also a capital expenditure. e. There was no increase in profitability of business by reduction of share capital. But buy back of its own share the company is offering more distribution of profit amongst members in future. f. According to the AO, the expenditure incurred of Rs.28,21,321/- for buy back of its own share is not a revenue expenditure but capital expenditure. g. Therefore, the sum of Rs.28,21,321/- claimed by assessee company as revenue expenditure was disallowed by the AO . h. In appeal, the Ld. CIT(A) deleted the disallowance.

Contentions and arguments before the ITAT: On behalf of appellant / revenue Ld. D.R. relied on the order of the AO and prayed before the bench to confirm the same and set aside the order of the CIT(A). By the Counsel for the assessee: He reiterated his submissions before the Ld. CIT(A) and relied on his order and submitted that the AO was wrong in disallowing the sum of Rs.28,21,321/- being share buyback expenses on the ground that the same is capital in nature. Share buyback expenses have been included in Misc. Expenses and debited to the P & L Account. The expenses were incurred in the course of business of the assessee and are allowable as business expenditure in accordance with the provisions of section 37(1) of the I. T. Act. He lastly concluded that the order of the Ld. CIT(A) in this regard may be upheld. Observations and findings of Tribunal: Tribunal heard the rival submissions and perused the material available on record. Tribunal found that the Ld. CIT(A) while deleting the addition of Rs.28,21,321/- had passed a very well reasoned order. For the sake of brevity, Tribunal preferred to reproduce the relevant portion of the order of the CIT(A) which read as follows, with highlights provided by the author for analysis purpose: "13. I have considered the submissions of the A/R, perused the relevant provisions of the Companies Act and the decision on which the reliance was placed. In the impugned order the A.O. disallowed share buyback expenses because in his opinion buyback of shares resulted in permanent reduction in share capital. According to A.O. the same considerations should be applied in deciding the character of expenditure in case of increase and reduction in the share capital. In my opinion the A.O.'s proposition is not supported by the decision of the Supreme Court in the case of Punjab State Industrial Development Corporation Ltd (2008 -TMI - 5589 SUPREME Court). In this judgment the Supreme Court admitted that increase of share capital may certainly help the company in increasing its profit earning but because the benefit derived is of long term and enduring nature and there being permanent expansion of the capital base which results in capital inflow; the expenditure is capital in nature. In the case of buyback of shares however there is no permanent change in the capital structure of

the company. The company buys back its outstanding stock from the existing share holders and such purchase is effected out of company's free reserves which are otherwise capable of being freely distributable to the shareholders by way of dividend or can be used for declaration of bonus shares. On comparing provisions of Sec 77A and Sec 81 of the Companies Act it is found that many conditions for issue of bonus share are parameteria with provisions relating to buyback of shares. In both the cases i.e. buyback of shares and issue of bonus shares, the company can use its free reserves and share premium. In both the cases the company utilizes its existing reserves for enhancing the share holder's investment value.The decisions regarding issue of bonus share or buyback of shares are taken by the directors on business consideration. No benefit of enduring nature is derived by the company. In buyback of shares there is temporary reduction in the capital base because prohibition on issue of shares of that kind is for temporary period of 24 months. The Supreme Court in the case of CIT Vs. General Insurance Corporation (2008 -TMI - 6547 SUPREME Court) has held that expenditure on bonus share is not a capital expenditure as there is no increase in the capital base of the company because existing free reserves of the company are utilized for issue of bonus shares. Applying the ratio laid down in this decision I find that existing free reserves and share premium account are used for buyback of shares which does not result in permanent reduction of the share capital and no benefit of enduring nature is derived. In the appellant's case the buyback of shares was effected by utilizing its free reserves. In my considered opinion therefore the expenditure incurred on buyback of shares was not a capital expenditure as there was neither permanent change in the capital structure of the company nor benefit of enduring nature was received by the appellant. The A.O. is therefore directed to deleted the disallowance of Rs.28,21,321 Tribunals finding and order: The Tribunal took view that in view of the above (findings of CIT(A) and in the absence of any contrary material brought on record by the revenue at the time of hearing before Tribunal , Tribunal did not find any infirmity in the order of the Ld. CIT(A) and therefore, the same was upheld by the Tribunal and the ground of revenue was dismissed. Observations of author and conclusion: It appears that there is some typing is take in order of Tribunal whereby words 'capital expenditure' has been used instead of word 'expenditure'. As noted earlier, in case of buyback, there is no inflow of cash as is in case of further issue of shares. Rather there is cash outflow on account of payment made to shareholders and expenses for buy back. Thus buy back does not result into improving capital structure or capital base by infusion of funds which company has in case of further issue of shares for consideration. Therefore, the rule applicable in case of rights issue, public issue etc. are not at all applicable in the case of buyback of shares. This aspect has not been touched upon by the CIT(A) and ITAT. Applying judgments of the Supreme Court on the issue of expenses on issue of further shares (for consideration) and issue of shares by way of bonus shares we find that the proposition laid down in case of bonus issue expenses is applicable to the expenses for buyback of shares as applied by the CIT(A) and ITAT. The following contentions could also be raise don behalf of assessee: a. Buyback of shares is for the servicing of existing capital base and existing shareholders.

b. Buyback is not to create a new capital base. Maintaining or improving existing capital base or capital structure is definitely for the purpose of business and is a revenue expenditure. c. Buyback of shares is also a measure of maintaining goodwill of company amongst shareholders and in the financial markets. d. Buyback of shares provide a platform for the company to increase its visibility in the market and that is important for carrying business in competition. Further possible claim: In case of buyback usually the amount paid to the shareholder is more than the amount paid up on the share tendered in buyback. For example suppose a share of face value and paid up value of

Rs. 10/- each is tendered and bought back by the company at a price of Rs.100/-. The company has not purchased the share as an investment to hold but to cancel the same. Company pays Rs. 100/- Rs. 10/- is deducted from share capital and Rs. 90/- from reserves. Thus capital reduced is Rs.10/-. The permanent capital base affected is by Rs.10/The purposes of buyback are to provide service to existing shareholders and for existing capital base. It is to reduce number of outstanding shares to improve CEPS and EPS on shares and to reduce paid up capital of company. Therefore the payment of Rs.10/- only is on capital account and the balance amount of Rs.90/- per share can be considered as revenue expenditure because it is incurred for the purpose of carrying an existing business, and to service the existing shareholders and existing capital base and not to create a new one. Therefore, author wonders as to why an attempt was not made to claim the sum paid to holders over and above the paid up value of share, as revenue expenditure as an expenditure to provide service to shareholders and to maintain goodwill. The excess amount paid does not at all, result in acquisition of a capital asset or benefit of enduring nature therefore, there appears chances of same being allowed as revenue expendituremore brain storming is required. Readers are requested to send feed back. A fit case for awarding costs: In the appeal preferred by the Revenue several other issues were also raised. In fact the issues on which the AO made disallowances the legal position is well settled but just for sake of making variation in income some disallowances were made. Therefore, in the first place the disallowances were wrongly made ignoring settled legal position and then the appeal against the order of the CIT(A) was made by revenue. By this way the taxpayer was put to harassment. Therefore this was a fit case for awarding costs in favor of the assessee.