NRI exit from shares of unlisted companies: Check the hidden tax traps to navigate before repatriation

Non-resident Indians (NRIs) have long been active investors in Indian businesses, particularly unlisted companies and startups. As such options grow, one critical decision they face is exiting their investments while optimising tax liability as well as ensuring smooth repatriation of returns and other income to their country of residence.

Here, understanding income tax rules, Foreign Exchange Management Act (FEMA) provisions, Reserve Bank of India (RBI) regulations, and other norms becomes vital. Let’s examine the taxation framework governing such transactions and practical challenges NRIs encounter in the repatriation process.

Exit routes

1. Direct share sale

Transfer of unlisted shares by an NRI directly to a buyer is taxed under the head capital gains. The capital gain is computed as the difference between the sale consideration received and the total cost of acquisition. It includes the original purchase price along with allowable expenditure related to the transfer. Section 115F of the Income Tax Act provides NRIs exemption from long-term capital gains (LTCG) tax if the original investment was made in convertible foreign exchange and the sale proceeds are reinvested in specified assets—shares in Indian companies, debentures or deposits in public companies, government securities, and other notified assets— within six months from the date of transfer. The newly acquired asset must be held for at least three years to retain the exemption.

2. Company liquidation
Liquidation is governed by Section 2(22)(c), read with Section 46 of the Act. Any amount distributed to shareholders is treated as a deemed dividend to the extent of accumulated profits available in a company. Any amount distributed in excess of both paid-up capital and accumulated profits is treated as a capital gain. For instance, if an NRI invested Rs.1.82 crore as paid-up capital, the company has garnered profits of Rs.30 lakh, and the total distribution at liquidation to the NRI shareholder is Rs.2.2 crore, then Rs.30 lakh would be treated as deemed dividend and the remaining Rs.8 lakh (i.e. `2.2 crore - Rs.30 lakh - Rs.1.82 crore) as LTCG.

3. Share buyback
Under the now amended provisions, buyback proceeds are taxed in the hands of shareholders as ‘deemed dividend’ under Section 2(22) (f). The entire consideration a shareholder receives on buyback is treated as dividend income taxable at 20% under Section 115A.

The original acquisition cost of the shares repurchased by the company is treated as the cost of acquisition for computing capital gains. Any resulting capital loss may be set off against other capital gains or carried forward in accordance with the tax provisions.

4. Regular dividend distribution
When a company distributes dividends to shareholders, such income is taxable at 20% (plus applicable surcharge and cess) under Section 115A. Double taxation avoidance agreements (DTAAs) prescribe different concessional tax rates on dividend income, depending on the NRI’s nation of residence.

Tax rates

DTAA beneficial rates: Across all exit routes listed above, NRIs may avail of the DTAA beneficial tax rate, if any, by furnishing a tax residency certificate, Form 10F, a no-PE (permanent establishment) declaration, and by meeting the applicable conditions under the DTAA of India and the said country.
Tax rate and period of holding: LTCG on unlisted shares are taxed at 12.5% without indexation benefits. Shares held for 2 years or less qualify as short-term capital assets and taxed at applicable slabs; those held for over 2 years are treated as long-term capital assets.

Issues and challenges

Impact of 2024 amendment on buybacks
The shift from company-level to shareholderlevel taxation since 2024 means NRIs face the same 20% tax rate on buyback proceeds as on regular dividends. Moreover, treating buyback proceeds as dividends instead of capital gains has many implications. Unlike capital gains, dividend income does not qualify for the Section 115F exemption, even if the shares were initially acquired in foreign exchange.

FEMA compliance and RBI regulations
NRIs must also comply with RBI rules and FEMA provisions before repatriating funds from India. Each exit route has different documentation and repatriation conditions. Full FEMA compliance ensures smooth funds transfer without delays or regulatory issues.

Feasibility of liquidation
Liquidation may seem tax-efficient but is often impractical. Many unlisted companies, especially those in the real estate sector or with ongoing operations, have contingent liabilities that hinder timely winding up. The process is lengthy, costly and may lead to stakeholder disputes.

Section 115F eligibility
The exemption under Section 115F, while attractive, requires strict compliance with many conditions. The original shares must have been bought using convertible foreign exchange. Identifying suitable specified assets for reinvestment within the six-month window, especially for large amounts, can be challenging. Additionally, the 3-year lock-in period for new investments may not align with an investor’s strategy or liquidity needs.

Double taxation and foreign tax credits
Even after paying taxes in India, NRIs may be taxed in their country of residence on the same income. Most nations offer foreign tax credit for taxes paid in India, but the mechanics of claiming it involve additional compliance, documentation, and potential timing mismatches. To avoid double taxation by availing the correct tax credits, NRIs should engage professionals in both jurisdictions.

Withholding tax and TDS compliance
No matter the exit route a remitter chooses, proper tax withholding compliance is mandatory. Additionally, in the case of foreign remittances, Form 15CA is to be furnished along with Form 15CB, which is required to be certified by a chartered accountant.

End note

NRIs must ensure that their chosen route of exit aligns with regulatory conditions, documentation needs, and broader financial objectives. Given the multiple compliance layers, planning and professional guidance are vital.

Disclaimer: This article is based on the authors’ understanding of the law as on the date of publication. Readers should consult advisers before acting on the information herein.

The author (Hitesh Kumar) is direct tax specialist
The author (Rajiv Nabar) is a retired principal chief commissioner, income tax