Share Capital Reduction – The Income Tax Angle

In the recent past, a few companies like Syngenta India Limited, Atlas Copco, etc. have, after their delisting from the stock exchanges, followed the Sec 66 of Companies Act, 2013 route to selectively reduce their non-promoter capital and provide a means of exit to minority shareholders.[1] Sec 66 allows a company to distinguish between shareholders of the same class by compulsorily extinguishing their holding without affecting others within the same class. This is one form of Share Capital Reduction.

Share Capital Reduction is the trimming of issued, subscribed and paid-up capital of a company. Companies reduce their existing share capital for a variety of reasons some of which include making the capital structure more efficient or eliminating losses or providing returns to the shareholders. Since, the shareholder is receiving some form of income/return on the investment he/she has made, there is bound to be a liability to pay income tax.

In this article we shall explore the income streams created along with its tax implications from the shareholder’s point of view.

The following provisions and case laws apply in the event of capital reduction:

1. Section 8 of the Income Tax Act, 1961 [2]

2. Sec 2(22)(d) of the Income Tax Act, 1961 [2][3]

3. Section 56 of the Income Tax Act, 1961 [2]

4. CIT v Jai Hind Investment Industries (P) Ltd (1993) 202 ITR 316 (Cal)

5. Proviso to Section 57 of the Income Tax Act, 1961 [2]

6. Kartikeya V. Sarabhai v CIT (1997) Supreme Court [4]

7. G Narasimham (Supreme Court) 1998 [4]

A brief analysis of each is as follows:

Part 1 – Dividend Income

1. Section 8 states that the total income of an assessee shall be deemed to include:

a. Any dividend declared by a company or distributed or paid u/s 2(22)(a)/(b)/(c)/(d)/(e) in the year of declaration, distribution or payment, as the case may be.

b. Any interim dividend in the year in which it is unconditionally made available by the company to the member who is entitled to it.

2. Sec 2(22)(d) exclusively deals with deemed dividend arising in the event of reduction of share capital. It states that any distribution to its shareholders by a company on the reduction of its capital, to the extent to which the company possesses accumulated profits which arose after the end of the previous year ending next before the 1st day of April, 1933, whether such accumulated profits have been capitalised or not. It thus seeks to tax distribution of accumulated profits under the guise of returning/reducing capital.

When a company has an excess of accumulated profits over and above its requirement, it may use such accumulated profits to reduce its share capital instead of capitalising it. In other words, the company may, out of its accumulated profits, pay off any share capital which is in excess of what it wants. In such cases there is evidently a release of assets.

Any such distribution by a company on reduction of its capital is ‘dividend’ to the extent to which the company possesses accumulated profits which arose on/after 01-04-1933, whether capitalised or not.

However, where the reduction is greater than the accumulated profits, then it is a case of genuine reduction of capital. Any capital so returned is genuinely a capital receipt in the hands of the shareholders and is accordingly exempt from tax.

3. Section 56 states that dividend income is chargeable to tax under the head ‘Income from Other Sources’ (IFOS).

4. In the case of CIT v Jai Hind Investment Industries (P) Ltd (1993) 202 ITR 316 (Cal) it is stated
that when the amount paid by the company has been treated as dividend, there is no scope for reduction of face value of shares from such dividend.

5. Proviso to Section 57 additionally states that the only deduction allowable from such dividend income is the interest expense to the extent of 20% of the total dividend income.

PART 2 – Capital Gains

1. In Kartikeya V. Sarabhai v CIT (1997) Supreme Court it was held that reduction of share capital by a company and paying off the balance to the shareholders would result in extinguishment of rights in the shares held by the shareholder and would amount to transfer. On reduction of share capital the rights of the shareholders in the dividend and net assets are extinguished. Therefore, capital gains would arise.

2. In G. Narasimham (Supreme Court) 1998, it was held that the amount distributed by the company on reduction of its share capital has two components, namely:

a. Distribution attributable to accumulated profits and

b. Distribution attributable to the capital

The Supreme Court held that out of the amount received on reduction of share capital, the amount attributable to accumulated profits will be deemed as dividend u/s 2(22)(d) and balance amount is the sale proceeds of the shares so reduced.

Part 3 – Conclusion

In simple words, the income of the shareholder, in the event of reduction of share capital by a company, is to be computed as follows[4]:

The taxation of the above incomes is as follows:

References:

1. https://corporate.cyrilamarchandblogs.com/2021/07/exit-to-minority-is-selective-reduction-of-capital-a-viable-option/

2. https://www.incometaxindia.gov.in/pages/acts/income-tax-act.aspx

3. Sampath Iyengar’s Law of INCOME TAX, Volume 1

4. CA Vinod Gupta’s Module 4 ‘Income from capital gains and other sources’, 36th Edition