Capital Reduction: Tax Conundrums

[Sumit Bansal (Partner), Shivani Chhabra (Associate) and Taranjeet Singh (Associate) are with S&R Associates, Advocates]

Capital reduction refers to the technique of reducing a company’s share capital in any form. It is a mechanism usually adopted by companies for re-modelling their capital structure, amongst other means (viz., buy-back of shares and redemption of preference share capital). The need for reducing share capital may arise due to several reasons, such as returning excess funds to the shareholders, eliminating share capital not represented in the form of assets, adjustment of accumulated losses appearing in the books of accounts, minority exit, producing a more efficient capital structure, and the like.

Section 66 of the Companies Act, 2013 governs the law for capital reduction, which provides that for a company to reduce its share capital it should possess the power under its articles of association (“AOA”) to do so by following the procedure laid down under such provisions. Unlike buy-back of shares provided under section 68 of the Companies Act, an application needs to be filed before the jurisdictional bench of the National Company Law Tribunal (“NCLT”) by the company seeking such reduction in share capital and consent is required from the shareholders and creditors.

Depending upon the objectives and attendant circumstances, a company can undertake a share capital reduction either with or without making any payment to its shareholders (to return their surplus capital). The following are the most likely modes by which a reduction in share capital is undertaken:

1. Reduction in the face value of all shares without cancelling the shares in toto; or
2. Reduction in full of a selective number of shares leading to a cancellation of such shares.

Reduction in the Face Value of Shares

In the Hands of the Shareholders

Deemed dividend implications

When a company returns cash to its shareholders by way of capital reduction, it amounts in essence to a distribution of profits to shareholders. In other words, the amount distributed to shareholders pursuant to a capital reduction is akin to dividend distribution and consequently attracts dividend taxation to the extent the company undertaking capital reduction possess accumulated profits (viz., accounting profits).

Section 2(22) of the Income Tax Act, 1961 provides for taxation of such distribution or payments which are in the nature of dividends, although not explicitly distributed in the form of dividend. Clause (d) of the said section deals with the taxation of amount distributed pursuant to capital reduction. It provides that any distribution by a company to its shareholders on the reduction of its capital to the extent of accumulated profits, whether capitalized or not, would be treated as deemed dividend.

With effect from April 1, 2020, dividend distribution tax (“DDT”) was abolished in the hands of the company and dividend has become taxable in the hands of the shareholders. Therefore, such deemed dividend is taxable in the hands of the shareholders as ‘income from other sources’ and tax is levied at the rates applicable to such shareholders depending upon the category of the assessee (e.g., individual, domestic company, foreign company, etc.)

Capital gains implications

Capital gains tax implications shall arise only if the proceeds received upon capital reduction exceed the amount of accumulated profits. Shares of a company are typically held as a ‘capital asset’ referred to in section 2(14) of the Income Tax Act by the shareholders. By virtue of capital reduction, shares are cancelled and shareholders’ interest in a company gets extinguished. Therefore, this constitutes ‘transfer’ in the hands of shareholders within the meaning of section 2(47) of the said legislation. Although there is no specific provision in the Act dealing with taxability of consideration received by shareholders in excess of accumulated profits, Supreme Court held in Commissioner of Income Tax v. G. Narasimhan [1999] 236 ITR 327 that any distribution over and above the accumulated profits would be chargeable to capital gains tax in the hands of the shareholders.

The amount chargeable to tax would be computed as under:

There is no guidance under the Income Tax Act on determination of the cost of acquisition in case of a partial reduction in the face value of the shares. It is possible to take the view that cost proportionate to the face value of the share being reduced should be the cost of acquisition. Therefore, if the shareholder acquired the share having a face value of INR 10 for a purchase price of for INR 200, in case of 70% reduction in the face value of share, the cost of acquisition for the purpose of calculating capital gains shall be INR 140. However, in the absence of any specific provision, this could be challenged by the tax authorities.

In case there is no distribution on capital reduction, a view can be taken that the proportionate cost of acquisition may be considered as ‘capital loss’ in the hands of shareholder. However, in this regard, Mumbai Tribunal (Special Bench) in Bennett Coleman & Co. Ltd. [2011] ITR(T) 97 (Mumbai) has held that no transfer is involved in case of capital reduction: it is merely a substitution of one kind of shares with another kind of shares, and the loss arising on account of capital reduction is not an allowable capital loss. Note that this case dealt with reduction of the face value of shares without any payout to the shareholders.

In the Hands of the Company

Finally, note that no tax implications arise in the hands of the company for a reduction in the face value of shares it has issued.

Reduction in the Number of Shares (Cancellation of Shares)

While the underlying basic principles remain the same, capital reduction under this method involves extinguishment of the shares, like that undertaken in a buy-back procedure. Since there exists separate code for tax treatment of cancellation of shares, it has given rise to differing and contentious opinions.

There is an argument that the proceeds from capital reduction undertaken pursuant to cancellation of shares would be liable to tax under section 115QA of the Income Tax Act, which contains “special provisions relating to tax on distributed income of domestic company for buy-back of shares”, as the capital reduction by way of cancellation of shares tantamount to the company purchasing its own shares.

Section 115QA was inserted in the Income Tax Act by the Finance Act, 2013. This provision starts with a non obstanteclause and provides that the company (listed/unlisted) undertaking capital reduction is liable to pay tax at the rate of 20% (plus applicable surcharge and cess) on the amount of distributed income (hereinafter referred to as the ‘buy-back tax’). The term ‘distributed income’ means the consideration paid by the company on buy-back of shares as reduced by the amount which was received by the company for issue of such shares, determined according to the mechanism provided in the Income Tax Rules, 1962.

Further, the explanation to section 115QA of the Income Tax Act defines the term ‘buy-back’ as a ‘purchase by a company of its own shares in accordance with the provisions of any law for the time being in force relating to companies.’ This is a revised definition which was amended by the Finance Act, 2016. Prior to this amendment, the term buy-back was defined to mean “purchase by a company of its own shares in accordance with the provisions of Section 77A of the Companies Act, 1956.” However, the Memorandum explaining the Finance Bill 2016 (‘Memorandum’) clarified that the provisions of this section shall apply to any buy-back undertaken by the company in accordance with the provisions of the law relating to the Companies and not necessarily restricted to section 77A of the Companies Act, 1956.

Therefore, it is clear from the Memorandum that the amendment in section 115QA of the Income Tax Act was brought in to widen the scope of section 115QA so as to include in its ambit any purchase of its shares undertaken by a company under any provision of the Companies Act which has the effect of distribution of income by the company to its shareholders. In other words, what is relevant is the substance of a transaction involving distribution of income by the company to the shareholders and not the governing section/provision of the Companies Act under which such a transaction/arrangement is undertaken. The Memorandum bringing such amendment itself recognizes that it is possible for a company to undertake purchase of its own shares through means and mode other than buy-back mechanism prescribed under section 77A of the Companies Act, 1956 (or the corresponding section 68 of the Companies Act, 2013). Accordingly, the definition of term “buy-back” under section 115QA of the Act is no longer restricted to only cover a transaction of purchase of its own shares by the company under section 77A of the Companies Act, 1956 (or the corresponding section 68 of the Companies Act, 2013) but any transaction involving purchase of its own shares by the company in accordance with the provisions of Companies Act.

In light of the above explanation, since the reduction of capital by way of cancellation of shares (which shall be undertaken under section 66 of the Companies Act, 2013) involves purchase of its own shares by the company from the shareholders (followed by subsequent cancellation and extinguishment of those shares since the company is not permitted to hold its own shares) and also carries an important element of distribution of income to the shareholders pursuant to reduction, such a transaction may get covered within the purview of section 115QA of the Income Tax Act after the aforesaid amendment.

In the Hands of the Company

Section 115QA of the Income Tax Act may become applicable and, accordingly, the company will be required to pay buy-back tax at the rate of 20% (plus applicable surcharge and cess) on the amount of distributed income (as discussed above).

In the Hands of the Shareholders

No tax implications should arise in the hands of the shareholders as section 10(34A) of the Income Tax Act provides a specific exemption if the shareholders receive any income on account of buy-back of shares by a company referred to in section 115QA of the Act.

Way Forward

Capital reduction has, over the years, proved to be an effective mechanism for alignment of capital to address corporate needs. Though the timeline may be a crucial aspect considering that it involves various approval requirements for undertaking a capital reduction (including approval of NCLT), it could have the potential to attain certain key business objectives such as repatriation of surplus cash, cleaning of the balance sheet by writing off accumulated losses, enabling exit to minority shareholders, and repaying whole or a part of the capital. Note that the capital reduction process can be carried out along with a scheme of merger/demerger or any compromise or arrangement as the procedure specified in a capital reduction is similar to the one specified for corporate re-arrangements as provided in section 230 to 232 of the Companies Act, 2013. However, one needs to be mindful of the tax implications that could arise in the hands of the company undertaking such capital reduction and its shareholders under different situations.

– Sumit Bansal, Shivani Chhabra & Taranjeet Singh