Introduction

A shareholders’ agreement, from a tax perspective, involves several critical considerations under the Income Tax Act, 1961 and related regulations. These considerations can significantly influence the financial outcomes for both the shareholders and the corporation involved.

Specifically, the tax implications of these agreements in India hinge on various factors such as the distribution of dividends, capital gains tax, and withholding taxes on transactions between the corporation and its shareholders.

• Dividend Distribution and Taxation (DDT): Under the Finance Act, 2020 India moved to the classical system of taxation, where dividends are taxed in the hands of the shareholders instead of the distributing company. This shift has profound implications for shareholders’ agreements, especially concerning the structuring of dividend distribution policies to optimize tax liabilities.
• Capital Gains Tax (CGT): Shareholders’ agreements often include clauses for the transfer of shares among shareholders. The CGT implications of these transfers are a vital consideration, especially distinguishing between short-term and long-term capital gains. The tax rates and exemptions available under the Income Tax Act, 1961, for long-term capital gains (LTCG) and short-term capital gains (STCG) can influence the structuring of share transfer clauses in these agreements.
• Withholding Taxes: The obligation to withhold tax at source (TDS) on certain payments to resident companies and non-resident entities is outlined under the Income Tax Act, 1961. For transactions contemplated under shareholders’ agreements, understanding the withholding tax obligations is essential.

Essential Tax Considerations in Shareholders’ Agreements

The implications of CGT and securities transaction tax (STT) is crucial for shareholders and investors. The Income Tax Act, 1961, outlines the framework for capital gains tax, which is levied on the profit derived from the transfer of a capital asset. Capital assets are classified into two categories: short-term capital assets and long-term capital assets, with the distinction based on the period of holding.

• STCG arise from the sale of a capital asset held for a period of not more than 36 months. However, for listed shares, listed securities, mutual funds, and zero-coupon bonds, this period is shortened to 12 months. The tax rate for STCG is as per the applicable income tax slab rates for the individual.
• LTCG, on the other hand, result from the sale of a capital asset held for more than 36 months (or more than 12 months for the assets mentioned above). LTCG is taxed at 20% with the benefit of indexation, which adjusts the purchase price of the asset for inflation, thereby reducing the taxable gain.

The STT is a direct tax levied on the value of securities transacted through a recognized stock exchange. The STT was introduced to curb tax evasion by making the taxation process straightforward and non-evasive. The rates for STT vary based on the type of security and the nature of the transaction (sale or purchase), with the current rate for delivery-based equity transactions set at 0.1% on the turnover.

Impact of Stamp Duty on Share Transfers and Agreements

Stamp duty is another significant consideration in shareholders’ agreements. It is a tax, similar to a legal fee, levied on the transfer of shares and is governed by the Indian Stamp Act, 1899, and various state legislations. The rate of stamp duty varies from state to state within India and depends on the nature of the transaction and the value of the shares being transferred.

For share transfers, stamp duty is typically a small percentage of the total value of the shares transferred. The introduction of electronic stamping has made the process of paying stamp duty more efficient and accessible. It is imperative for parties involved in shareholders’ agreements to account for stamp duty costs in their financial planning, as it affects the overall cost of transactions involving share transfers.

Dividend Tax Considerations for Shareholders

Dividend Income Taxation

Prior to the Finance Act, 2020, dividends distributed by Indian companies were subject to DDT, which was paid by the distributing company. With the introduction of the Finance Act, 2020, DDT was abolished

Post-abolition of DDT, dividends are now taxed in the hands of the shareholders at their applicable income tax rates. This applies to both domestic and foreign shareholders, aligning with the classical system of dividend taxation. For domestic shareholders, this means dividends are added to their total income and taxed according to the slab rates under the Income Tax Act, 1961, without any basic dividend tax exemption limit.

For Non-Resident Indians (NRIs) and foreign shareholders, dividend income from Indian companies is subject to a withholding tax of 20% (plus applicable surcharge and cess), which can be reduced under applicable Double Taxation Avoidance Agreements (DTAA). This provision aims to avoid double taxation and provide relief based on bilateral agreements between India and the shareholder’s country of residence.

Dividend Distribution Tax: Rates, Slabs, and Exemption Strategies

The transition from DDT to taxing dividends in the hands of shareholders has introduced new considerations for both individual and corporate shareholders. Individuals are taxed at their income tax slab rates, with opportunities to optimize tax liability through investments and deductions available under sections 80C to 80U of the Income Tax Act, 1961.

For corporate shareholders receiving dividend income from another Indian company, a deduction under section 80M of the Income Tax Act, 1961, is available. This deduction is designed to mitigate the cascading effect of taxes on dividends distributed across multiple layers of companies, provided certain conditions are met, including the distribution of dividends by the recipient company within a specified timeframe.

NRIs and foreign shareholders can benefit from lower tax rates under DTAAs, subject to obtaining a Tax Residency Certificate (TRC) and meeting other conditions stipulated in the agreement.

Withholding Tax and Its Implications on Shareholders

Withholding Tax Requirements in Shareholders’ Agreements

Withholding Tax (WHT) in India plays a crucial role, especially concerning payments made to shareholders in the form of dividends or the sale and purchase of shares. The Income Tax Act, 1961, mandates the deduction of TDS on various payments, including dividends paid to shareholders by companies.

The rate of WHT on dividends paid to residents is currently set at 10%, provided the amount exceeds INR 5,000 in a financial year. This requirement aligns with the broader objective of ensuring tax compliance and collection at the source, minimizing tax evasion risks.

In addition to dividends, significant transactions such as the purchase of goods exceeding a threshold of INR 5 million require a WHT deduction at the rate of 0.1%. Similarly, payments for professional services, technical services, and royalty or Fee for Technical Services (FTS) attract a WHT rate of 10% if the payment exceeds specified thresholds.

Seeking Dividend Tax Relief and Exemptions

The Finance Act, 2020, introduced a significant change by abolishing the DDT, making dividends taxable in the hands of shareholders. This shift places a renewed emphasis on the applicability of WHT on dividend payments and the potential for claiming tax relief.

Shareholders, especially those in higher tax brackets, may seek relief through the DTAAs India has with various countries. These agreements often provide a lower WHT rate on dividends than the domestic rate, subject to the fulfilment of conditions outlined in the respective DTAA.

Furthermore, the Finance Act, 2021, prescribed higher TDS and TCS rates for non-filers of income tax returns, including on interest and dividend income. This measure underscores the importance of timely tax return filing to avoid higher tax deductions.

Structuring Shareholders’ Agreements for Tax Efficiency

Tax Planning Strategies for Shareholders’ Agreements

Structuring shareholders’ agreements with tax efficiency involves a nuanced understanding of the Income Tax Act, 1961, and amendments introduced by subsequent Finance Acts. Shareholders’ agreements must consider various tax obligations including, but not limited to, capital gains tax, dividend distribution tax, and stamp duty implications on share transfers.

1. Capital Gains Tax Considerations: When structuring exit mechanisms within the agreement, consider the provisions under the Income Tax Act, 1961, for capital gains. Utilize the benefits under Section 112A for long-term capital gains and Section 111A for short-term capital gains, ensuring the agreement provisions align with the holding period requirements and tax rates applicable.
2. DDT Strategy: Following the Finance Act, 2020, DDT is abolished, and dividends are taxable in the hands of the shareholders at their applicable income tax rates. The agreement should detail the method of dividend distribution, keeping in mind the tax liability for shareholders and providing for a mechanism that optimizes the overall tax burden.
3. Incorporating Buyback Provisions: Consider the tax implications of share buyback under Section 115QA. Structuring buyback provisions can serve as a tax-efficient exit strategy for shareholders, given the buyback tax is lower compared to the individual tax rates on dividends for higher income shareholders.
4. Stamp Duty Considerations: Clearly outline the process for share transfers within the agreement to manage stamp duty costs effectively. Since stamp duty rates may vary across states, the agreement should specify the governing state’s law to ascertain the applicable rates.

Avoiding Common Tax Pitfalls in Agreement Drafting

1. Ambiguity in Share Valuation Methods: A clear, agreed-upon share valuation method is crucial. Ambiguity in this area can lead to disputes and unfavorable tax assessments, especially in forced buy-outs or exits. Incorporate a valuation mechanism that is fair, transparent, and recognized by tax authorities.
2. Failure to Address Indirect Transfers: The Income Tax Act, 1961, has provisions under Sections 9(1)(i) and 195 related to the taxation of indirect transfers of shares. The agreement must address the implications of these provisions to prevent tax liabilities arising from indirect share transfers, especially in cross-border transactions.
3. Neglecting the Impact of International Taxation: For companies with foreign shareholders or those making foreign investments, understanding the DTAA between India and other countries is essential. Ensure the agreement’s provisions do not lead to adverse taxation consequences under the applicable DTAA.
4. Overlooking Regulatory Compliance: Ensure the shareholders’ agreement complies with the Companies Act, 2013, and SEBI regulations, if applicable. Non-compliance can lead to penalties that negate any tax planning benefits envisioned by the agreement.

Regulatory Framework and Compliance

The Income Tax Act, 1961 and Shareholders’ Agreements

The Income Tax Act of 1961 is the cornerstone of income tax law in India, providing the legal framework for the taxation of income, including that which arises from shareholders’ agreements. Specifically, this Act outlines how dividends are taxed, which is crucial for shareholders under such agreements. Sections 2(22)(e) and 56(2)(x) are particularly relevant, as they detail the conditions under which dividends and other distributions to shareholders can be considered income and thus subject to taxation.

Additionally, the Act includes provisions for the avoidance of double taxation, crucial for foreign shareholders. These provisions ensure that shareholders who are residents outside India and are subject to tax in their resident countries for income received from Indian companies can avail themselves of relief either under the DTAAs that India has signed with various countries or under the Act itself.

Recent Changes in Tax Law Affecting Shareholders’ Agreements

Recent amendments to the Income Tax Act, 1961, have had a significant impact on shareholders’ agreements, particularly concerning the taxation of dividends. The Finance Act 2020 introduced a major change by abolishing the DDT, shifting the tax burden from companies distributing dividends to the recipients of such dividends. Previously, companies were required to pay DDT on the dividends paid to their shareholders, but post-amendment, dividends are taxed in the hands of the individuals at their respective income tax rates.

This amendment necessitates careful planning and consideration in drafting shareholders’ agreements, especially in terms of structuring dividend payouts and understanding the tax liabilities for shareholders.

Given the breadth and complexity of the Income Tax Act, 1961, and its amendments, it is essential for shareholders and companies alike to stay informed and seek expert advice when drafting or revising shareholders’ agreements. This ensures not only compliance with current tax laws but also efficient tax planning and management of potential liabilities.

Conclusion: Best Practices and Future Outlook

Tax planning for shareholders’ agreements in India is intricately tied to the provisions of the Income Tax Act, 1961, and subsequent Finance Acts, guiding the taxation on dividends and capital gains derived from share transactions.

India’s tax legislation necessitates that shareholders remain vigilant about changes in dividend tax rates, dividend tax slabs, deductions, and exemptions, as well as regulatory adjustments from SEBI and corporate governance norms. Future tax legislation changes could significantly impact the net returns from share investments, making it imperative for shareholders to stay informed and adapt their tax planning strategies accordingly.

Leveraging professional advice for these changes can optimize investment returns and ensure compliance with the evolving tax framework in India, ultimately benefitting shareholders through strategic investment planning and tax liability optimization.

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