Aditya Narwekar*
The COVID-19 pandemic has compelled even prolific investors to re-examine their investment strategies and exit from companies that seem to have no path to profitability. This has resulted in several companies looking for alternative ways to readjust their capital structures, capital reduction being one of them.
Capital reduction is a scheme of corporate restructuring wherein the existing share capital of a company is reduced by lowering the face value of shares, cancelling part of the face value of shares or by cancelling shares entirely. Capital reduction may be with or without cash pay-out.
There are multiple tax and regulatory issues surrounding capital reduction. In this article, we have highlighted a few of the tax issues.
The taxability of capital reduction is divided into two parts:
1. Dividend – to the extent of accumulated profits
2. Capital gains – over and above the amount of dividend
As per section 2(22) of the Income-tax Act, 1961 (Act), any distribution of accumulated profits to the shareholders, whether capitalised or not, pursuant to capital reduction, is considered as dividend.
However, the wording of the above section open up questions regarding what constitutes accumulated profits: whether the term includes securities premium and capital redemption reserve (CRR)?
As per the Supreme Court ruling in the case of PK Badiani,[1] accumulated profits can be interpreted as profits made by the company in a real and true sense and not merely assessable profits or profits liable to tax, as a company distributes dividend out of its business profits and not out of its assessable income. Further, in the case of Shree Balaji Glass Manufacturing Pvt. Ltd.,[2] the High Court of Calcutta held that securities premium should not be considered as accumulated profits for the purposes of capital reduction. This view has been upheld subsequently in other cases as well and is thus a settled view. However, CRR is created out of a company’s profits under certain circumstances like buybacks, as per the provisions of the Companies Act, 2013. Essentially, a transfer to CRR is merely a book entry to comply with the provisions of the law. The wording of section 2(22) of the Act reads as “accumulated profits, whether capitalised or not”. From this, it appears that CRR forms a part of accumulated profits.
Capital reduction is an alternative method to distribute accumulated profits. However, an interesting question is the quantum of accumulated profits in case of selective capital reduction. Selective capital reduction is a scheme wherein only the share capital held by a particular shareholder is reduced to the exclusion of the capital held by other shareholders. As all the shareholders have an equal right over the accumulated profits, a logical position would be to consider accumulated profits only to the extent of pro-rata shareholding being reduced. However, there is no specific provision in the Act to allow for this. Further, there are multiple judicial precedents which also hold that total accumulated profits should be considered. Based on the above, even in case of selective capital reduction, the entire amount of accumulated profits may have to be considered as dividend. Pursuant to the amendment in the Finance Act, 2020 on dividend taxation, this may lead to higher tax (as high as 30%) in the hands of the shareholders, making this option unattractive.
There is also ambiguity around whether capital reduction can be considered as buyback of shares. Under section 115QA of the Act, the buyback of a closely held company attracts buy-back tax (BBT) at 20.56% on the difference between the buyback proceeds and issue price of shares by the company. Therefore, if capital reduction is classified as buyback, the company may be required to pay BBT on the same.
The following arguments could be considered for capital reduction not to be considered as buyback:
1. As per the Companies Act, 2013, when a company purchases its own shares, it is considered a buyback. But in case of capital reduction, the shares get cancelled on the day of sanction of the scheme by NCLT.
2. If capital reduction is also to be taxed under section 115QA, then section 2(22)(d) will become redundant, which cannot be the intention of law.
3. According to section 67 of the Companies Act, 2013, no company has the power to buy back its own shares, unless there is a consequent reduction of share capital. Indirectly, section 67 indicates that buyback is one of the ways of capital reduction and not the other way around.
The above view has been upheld in the case of Goldman Sachs (India) Securities (P.) Ltd v. ITO.[3] However, it is not free from litigation.
Let us move to the capital gains tax treatment of capital reduction.
There is no specific provision in the Act dealing with this. However, the matter was settled by the decision of the Supreme Court in the case of G. Narasimhan[4], wherein it was held that any distribution over and above the accumulated profits would be chargeable to capital gains tax in the hands of the shareholders. It was also held that reduction in capital will be construed as a transfer within the meaning of section 2(47) of the Act.
Now, the application of deemed income provisions to capital reduction should be analysed.
Section 50CA provides for the replacement of the fair market value (FMV) of shares as the full value of consideration in case of transfer of shares for inadequate consideration.
Section 50CA would not apply in case of capital reduction without a pay-out, as no consideration is received. However, in case of capital reduction with a pay-out, in the absence of any specific carve-out, section 50CA should apply. The question is whether the entire FMV of the shares shall be considered or only the FMV over and above the accumulated profits. On a plain reading of the section, it appears that the entire FMV must be considered, resulting in double taxation to the extent of accumulated profits.
Section 56(2)(x) of the Act provides for taxation in the hands of the recipient in case of receipt of property for inadequate consideration.
However, in case of capital reduction, the shares are cancelled immediately on the scheme becoming effective. Therefore, in essence, the company does not receive any property and therefore, should not be subjected to tax. This view has been upheld in the context of buyback by the Mumbai Tribunal in the case of Vora Financial Services Pvt. Ltd.[5] as well. Further, the cost of the property which has been subject to taxation under section 56 has been specifically provided under section 49. This implies that for section 56 to apply, the property should remain in existence even after receipt, which necessitates providing for a cost for such properties in section 49. Based on the above arguments, one might possibly argue that section 56 should not apply to capital reduction.
Considering all the issues enlisted above, it is evident that capital reduction is easier said than done. Therefore, companies planning to undertake capital reduction should consider all the tax and regulatory implications carefully before proceeding.
*Author: Aditya Narwekar –Partner and Hemanth Danda–Associate Director, M&A Tax, PwC India
The views expressed in this article are personal. The article includes input from Aaditi Kulkarni – Assistant Manager and Heishwariya Sureka – Associate, M&A Tax, PwC India.
Notes:-
[1] 105 ITR 642 (1976) (SC)
[2] [2016] 72 taxmann.com 118 (Calcutta)
[3] [2016] 70 taxmann.com 46 (Mumbai – Trib.)
[4] [1999] 102 Taxman 66 (SC)
[5] ITA No. 532/Mum/2018
