1. What Is a Buyback and Why Companies Use It
A buyback of shares is a transaction in which a company repurchases its own shares from existing shareholders, resulting in a reduction of the company's share capital. For Indian startups and growth-stage companies, buybacks are commonly used for:
- Providing an exit to early investors, angel investors, or ESOP holders where no external buyer is readily available
- Returning surplus cash to shareholders in a tax-efficient manner (historically, though this has changed — see Section 5)
- Consolidating ownership by buying out departing co-founders or dissenting shareholders
- Cleaning up the cap table ahead of a fresh fundraising round or before a strategic transaction
A buyback is fundamentally different from a share transfer — in a transfer, shares move between two shareholders; in a buyback, the company itself is the counterparty, and the shares bought back are extinguished, reducing the total outstanding share capital.
2. Companies Act, 2013 — The Governing Framework (Section 68)
Buyback of shares by an Indian company is governed by Section 68 of the Companies Act, 2013, read with the Companies (Share Capital and Debentures) Rules, 2014. The key conditions are:
Source of funds. A buyback can be funded out of: (a) free reserves, (b) the securities premium account, or (c) proceeds of any shares or other specified securities. Importantly, a buyback cannot be funded through borrowed funds — the company cannot take a loan to finance a buyback of its own shares.
Quantum limits. The total value of the buyback in any financial year cannot exceed 25% of the aggregate of paid-up capital and free reserves of the company. Additionally, the buyback of equity shares in any financial year cannot exceed 25% of the total paid-up equity capital of the company.
Approval requirements. A buyback of up to 10% of the total paid-up equity capital and free reserves can be approved by the Board of Directors through a board resolution. A buyback exceeding 10% (up to the 25% overall cap) requires approval by shareholders through a special resolution passed at a general meeting.
Debt-equity ratio. Post-buyback, the company's debt (secured and unsecured) cannot exceed twice its paid-up capital and free reserves — though for certain classes of companies, a higher ratio may be permitted by the Central Government.
Solvency declaration. Before the buyback, the company must file a declaration of solvency with the Registrar of Companies and (for listed companies) SEBI, signed by at least two directors (one of whom must be the Managing Director, if any), affirming that the company will be able to pay its debts and will not be rendered insolvent within one year.
3. Procedural Steps for a Private Company Buyback
For a private limited company (the typical structure for Indian startups), a buyback generally follows these steps:
Step 1 — Board approval. The Board approves the buyback proposal, including the price, the number of shares, and the source of funds, and (if the buyback exceeds 10% of paid-up capital + free reserves) recommends a special resolution to shareholders.
Step 2 — Shareholder approval (if required). A special resolution is passed at a general meeting, with the explanatory statement disclosing full details of the buyback as prescribed under the Rules.
Step 3 — Filing of letter of offer. The company files a letter of offer with the Registrar of Companies in the prescribed form (Form SH-8), along with the declaration of solvency (Form SH-9).
Step 4 — Offer to shareholders. The letter of offer is dispatched to shareholders, who can choose to tender their shares for buyback. For unlisted companies with multiple shareholders, the buyback should generally be offered to all shareholders on a proportionate basis (subject to the company's articles and any shareholder agreement provisions).
Step 5 — Verification and payment. The company verifies the offers received, accepts shares for buyback, and makes payment to shareholders within the prescribed timeline (typically within 7 days of verification, and the buyback process must be completed within 1 year of the special resolution).
Step 6 — Extinguishment of shares. The bought-back shares are extinguished and physically destroyed (for physical shares) or cancelled in the demat system within 7 days of completion of the buyback. Form SH-11 (return of buyback) is filed with the Registrar within 30 days.
Step 7 — Cooling-off period. The company cannot make a further issue of the same kind of shares (including by way of bonus or rights) within a period of one year from the completion of the buyback, except for ESOPs, sweat equity, or conversion of existing instruments.
4. FEMA Implications — Where Foreign Shareholders Are Involved
Where a buyback involves a non-resident shareholder (e.g., a foreign VC fund or a non-resident individual investor), the transaction must additionally comply with the FEMA framework under the NDI Rules, 2019.
Pricing. Although a buyback is not strictly a "transfer" between two parties, the consideration paid to a non-resident shareholder for shares bought back must be determined in accordance with the applicable FEMA pricing guidelines — i.e., the buyback price for a non-resident shareholder should not exceed the Fair Market Value (FMV) as determined by a SEBI-registered Merchant Banker, consistent with the "Non-Resident to Resident" pricing principle (since economically, the shares move from the non-resident to the company, which is a resident entity).
Reporting. Since the buyback results in a reduction of the foreign investment held in the company, the company should report this through the appropriate FEMA filings — typically reflected in the company's updated FC-GPR/FLA records to ensure the outstanding foreign investment position is accurately maintained. Companies should consult with their Authorised Dealer (AD) bank on the specific reporting form applicable, as practice in this area has evolved with the FIRMS portal.
Repatriation. The buyback consideration payable to the non-resident shareholder can be remitted abroad through normal banking channels, subject to the AD bank's standard compliance checks — including a Form 15CA/15CB certificate from a Chartered Accountant confirming the applicable tax has been accounted for (see Section 5 below for the tax treatment post-October 2024).
Sectoral conditions. If the company operates in a sector with FDI conditions (e.g., minimum capitalisation, lock-in periods for certain sectors like NBFCs), the buyback should not result in a breach of those conditions — for instance, certain regulated entities have minimum capital requirements that a large buyback could inadvertently breach.
5. Income Tax Treatment — The Section 115QA Framework and the 2024 Shift
The income tax treatment of buybacks has historically been one of the most tax-efficient ways to return capital to shareholders — but this changed significantly with amendments effective 1 October 2024.
Pre-October 2024 position (Section 115QA): Under the erstwhile framework, the company was liable to pay "buyback tax" under Section 115QA at a rate of approximately 23.296% (including surcharge and cess) on the "distributed income" — broadly, the difference between the buyback consideration and the amount received by the company at the time of issue of those shares. Critically, the amount received by the shareholder on account of the buyback was exempt from tax in their hands under Section 10(34A).
Post-October 2024 position: The Finance (No. 2) Act, 2024 fundamentally restructured this. With effect from 1 October 2024:
- Section 115QA (company-level buyback tax) has been removed for buybacks undertaken on or after this date
- The entire amount received by a shareholder on a buyback is now treated as a dividend in the hands of the shareholder, taxable at the shareholder's applicable slab rate (for individuals) or applicable rate (for companies/other entities)
- The cost of acquisition of the shares bought back is treated as a capital loss in the hands of the shareholder, which can be set off against other capital gains (subject to the usual set-off and carry-forward rules for capital losses)
- For non-resident shareholders, the dividend portion is subject to withholding tax (TDS) under Section 195 at rates prescribed under the Act or the applicable Double Taxation Avoidance Agreement (DTAA), whichever is more beneficial
This is a material shift: previously, a buyback was attractive because the shareholder received the proceeds tax-free (with the company bearing a flat-rate tax). Now, the entire proceeds are taxed as dividend in the shareholder's hands at their marginal rate — which, for individuals in the highest tax bracket, can be significantly higher than the erstwhile 23.296% company-level rate. The capital loss generated can only be used against capital gains, and cannot offset the dividend income itself — creating a potential tax mismatch in timing and character.
6. Practical Implications of the 2024 Change
The October 2024 change has meaningfully altered the calculus for using buybacks as an exit or capital return mechanism:
For resident individual shareholders in higher tax brackets, a buyback now attracts dividend taxation at slab rates (up to ~39% effective with surcharge and cess for the highest bracket), compared to capital gains rates (typically 12.5% long-term post the 2024 capital gains restructuring) that would apply on a share transfer. This makes a secondary share transfer (to another investor) potentially more tax-efficient than a buyback for shareholders seeking exit, where a willing buyer exists.
For non-resident shareholders, the dividend characterisation means withholding tax under Section 195 applies, and the rate under the relevant DTAA (often 5-15% for dividends, depending on the treaty and shareholding percentage) needs to be evaluated — this may, in some treaty scenarios, still result in a lower effective rate than the resident slab-rate outcome, making jurisdiction-specific analysis important.
For companies, the removal of Section 115QA means the company itself no longer bears a direct tax cost on the buyback — but the company must now undertake TDS compliance under Section 194 (dividend distribution) for resident shareholders and Section 195 for non-residents, adding a compliance layer that did not exist in quite the same form previously.
Choice between buyback and other exit mechanisms. Given this shift, companies and shareholders evaluating an exit or capital return should compare the after-tax outcome of a buyback (dividend treatment + capital loss) against alternatives such as a secondary sale to a new or existing investor (capital gains treatment) or a capital reduction (which may have its own characterisation, generally also now aligned with dividend treatment for the distributed portion under amended provisions). The right structure is highly fact-specific and depends on the shareholder's tax residency, holding period, and overall portfolio of gains/losses.
7. Restrictions and Common Pitfalls
Beyond the quantum and procedural requirements, Section 68 imposes several restrictions that are frequently overlooked:
No buyback if defaults exist. A company cannot undertake a buyback if it has defaulted in repayment of deposits, interest on deposits, redemption of debentures/preference shares, or payment of dividend to any shareholder — unless the default has been remedied for a period of at least three years.
No buyback through subsidiaries. A company cannot buy back its shares through any of its subsidiary companies, including its own subsidiaries, or through any investment company (or group of investment companies).
Filing compliance status. The company must not be in default of filing its annual return, financial statements, or other returns under the Companies Act at the time of the buyback.
ESOP and sweat equity carve-out. While the one-year cooling-off period restricts fresh issuance of the same kind of shares post-buyback, this does not apply to issuance pursuant to a stock option scheme, sweat equity, or conversion of warrants/debentures/preference shares into equity — an important carve-out for startups that continue to operate ESOP pools alongside a buyback.
Valuation documentation. Even though the Companies Act itself does not mandate an independent valuation for unlisted company buybacks (unlike for preferential allotments), obtaining a valuation report is strongly advisable — both to support the FEMA pricing compliance (where non-residents are involved) and to defend the transaction price for income tax purposes.
8. Summary — A Three-Lens Checklist
Before executing a buyback, companies should run through a checklist across all three regimes:
Companies Act lens: Is the buyback within the 25% caps? Is board or special resolution approval required and obtained? Is the solvency declaration in place? Does the post-buyback debt-equity ratio remain compliant? Are the SH-8, SH-9, and SH-11 filings planned?
FEMA lens (if non-resident shareholders involved): Is the buyback price aligned with FEMA pricing guidelines (FMV ceiling for non-resident exits)? Is a valuation report from a SEBI-registered Merchant Banker in place? Has the AD bank been consulted on the reporting mechanism and remittance documentation (15CA/15CB)?
Income Tax lens: Has the post-October 2024 dividend characterisation been factored into the shareholder's after-tax analysis? Is TDS under Section 194/195 (as applicable) being correctly withheld and deposited? Has the capital loss treatment for the shareholder been documented for their future capital gains computations?
(if non-resident shareholders)
Given the interplay between these three regimes — and the significant tax shift introduced in October 2024 — a buyback should not be approached as a purely procedural Companies Act exercise. Early involvement of tax and FEMA advisors alongside corporate counsel is essential to ensure the transaction achieves its intended commercial outcome.
This article is for informational purposes only and does not constitute legal, tax, or financial advice. Please consult with a qualified professional for advice specific to your situation. Maroon Advisors would be delighted to assist — get in touch.