Hiten Kotak, Leader – M&A Tax, PwC India and Saurabh Kothari, Director – M&A Tax, PwC India
Capital reduction is a commonly adopted tool by companies for re-engineering their capital structure. The need for reducing share capital may arise owing to a number of reasons, such as returning excess funds to the shareholders, adjustment of accumulated losses, minority squeeze out, improving EPS, producing a more efficient capital structure, etc. Capital reduction may be with or without cash payout and the process would require sanction by the National Company Law Tribunal.
It is important to understand the key tax aspects related to capital reduction. Section 2(22)(d) of the Income-tax Act, 1961 (Act) provides that any distribution by a company to its shareholders, on the reduction of its capital, to the extent of accumulated profits, whether capitalised or not, would be treated as deemed dividend.
The first important aspect to determine taxability would be to determine what would be covered by the term “accumulated profits.” The term “accumulated profits” is not defined in the Act and the courts have interpreted the term in various judicial precedents. It is important to consider the judgement of the Apex Court in the case of P.K. Badiani v. CIT, in which the court has held that accumulated profits are profits made by the company in the real and true sense and not merely assessable or profits liable to tax as a company distributes dividend out of its business profits and not out of its assessable income.
The courts have ruled in specific facts of the case, amounts transferred to general reserves, tax free profits, amounts transferred to building reserve funds and development rebates should be included while computing accumulated profits and depreciation incurred in normal course of business on regular basis, amounts set aside for payment of taxes and dividends, funds set aside for replacement of specific machineries are to be excluded while computing the accumulated profits.
Another important aspect is whether the face value of shares should be reduced while computing accumulated profits. The matter has been examined by the Calcutta High Court in CIT v. Jai Hind Investments Industries (P) Ltd and it has been held that the entire amount of distribution to its shareholders by a company to the extent it possesses accumulated profits would be treated as dividend. Thus, the face value of shares cannot be deducted in computing deemed dividend. Further, the Apex Court in the case of CIT v. G. Narasimhan has held that any amount that has already been taxed as deemed dividend under section 2(22)(e) of the Act will have to be reduced from accumulated profits in arriving at dividend under section 2(22)(d) of the Act.
The next important consideration is the date on which the accumulated profits should be considered. The Explanation to section 2(22) of the Act provides that accumulated profits up to the date of distribution or payment should be considered.
Once the amount taxable as dividend is ascertained, the next important point for consideration is the taxability of proceeds received in excess of accumulated profits. There is no specific provision in the Act dealing with taxability of consideration received by shareholders in excess of accumulated profits. The matter has been settled by the Apex Court’s ruling in the case of G. Narasimhan, wherein it has been held that the amount distributed by a company on capital reduction has two components: distribution attributable to accumulated profits and distribution attributable to capital. Any distribution over and above the accumulated profits would be chargeable to capital gains tax in the hands of the shareholders. Reference can be drawn from the judgement of the Apex Court in the case of Kartikeya v. Sarabhai, in which the court, while dealing with a case of taxability of proceeds received on reduction in the face value of preference shares, held that the same amounts to reduction in the right of shareholders proportionately and would amount to transfer, and is thus, liable to capital gains tax.
From the shareholder’s perspective, the impact of newly inserted section 50CA of the Act would also need to be considered. In case of capital reduction without payout, it can be argued that section 50CA should not be applicable, as there is no consideration. Further, when the distribution does not exceed accumulated profits, relying on the principles of the Apex Court in the case of G.Narasimhan, it can be argued that there should be no tax implications under section 50CA. However, when the payout on capital reduction exceeds accumulated profits and the payout price of a share is less than the price determined as per the rules, there can be additional potential tax implications for shareholders.
Further, there is no clarity on whether the entire price as per section 50CA would be taxable, which could lead to double taxation or only excess over accumulated profits. It would be interesting to see how the courts interpret the matter.
(Views expressed are personal to author. Article includes inputs from Hiral Vageriya – Assistant Manager, M&A Tax, PwC India and Khushbu Shah – Associate, M&A Tax, PwC India)