TAX ISSUES IN REDUCTION OF SHARE CAPITAL

[Mr. M. GOVINDARAJAN]

REDUCTION OF SHARE CAPITAL:

Section 100 of the Companies Act, 1956 (‘Act’ for brevity) deals with the reduction of share capital. Sec. 100(1) provides that subject to the confirmation by the Court, a company limited by shares or a company limited by guarantee and having a share capital, may, if so authorized by its articles, by special resolution, reduce its share capital in any way; and in particular and without prejudice to the generality of the foregoing power, may-

(a)  extinguish or reduce the liability on any of its shares in respect of share capital not paid up;

(b) either with or without extinguishing or reducing liability on any of its shares, cancel any paid up share capital which is lost, or is unrepresented by available assets; or

(c)  either with or without extinguishing or reducing liability on any of its shares, pay off any paid-up share capital which is in excess of the wants of the company;

and may, if and so far as is necessary, alter its memorandum by reducing the amount of its share capital and of its shares accordingly.

The need for reducing the capital may arise for various reasons such as trading losses, heavy capital expenses, and assets of reduced or doubtful value.   The reduction of share capital, by any mode, has the effect of reducing the liability of the company to its shareholders.   It relieves the company from its liability to pay to the shareholders in future to the extent of the capital reduced, in the event of the winding up of the company; and also to pay dividend on such amount of share capital during the subsistence of the company. The company should be given such power in articles of association. If the articles do not contain such provision the same must be first altered so as to give the power.

The process for reduction of share capital is enunciated by the Supreme Court in ‘Indian National Press (Indore) Limited In re - 1986 (11) TMI 338 - HIGH COURT OF MADHYA PRADESH as follows:

• there will be a resolution by the general body of a company for reduction of capital by distribution of the accumulated profits amongst the shareholders;
• the company will file an application in the court for an order confirming the reduction of capital;
• after its confirmation, it will be registered by the Registrar of Companies;
• after the registration, the company will issue notices to the shareholders inviting applications for refund of the share capital;
• on receiving the applications the company will distribute the said profits.

In exercising the power the Court will have due regard to the interests of the creditors, who may consent or object to the resolution. The court is concerned to see that whether the reduction of share capital is fair and equitable and not concerned to consider the motive for the reduction of share capital. Likewise the court is only concerned to confirm the proposed reduction and cannot go into the validity of the resolutions passed by the company. The court has inherent power to rectify petty mistakes in the resolution.

Reduction of capital in the following ways is permissible under this Act:

• diminishing the nominal amount of the shares so as to leave a less sum unpaid;
• diminishing the nominal amount of any shares by writing off or repaying paid up capital;
• diminishing the nominal amount by combining both above two;
• diminishing the number of shares by extinguishing the existing liability on certain shares, writing off or repaying the whole amount paid up thereon and canceling them.

There will be no reduction of share capital in the following cases:

• Where redeemable preference shares are redeemed in accordance with the provisions of Sections 80 and 81;
• Where any shares are forfeited for non payment of calls, though the forfeiture as a fact amounts to reduction of capital;
• Where there is a surrender of shares or a gift is made to a company of its own shares. (The gift may be accepted in the name of a nominee of the company);
• Where the nominal share capital of a company is reduced by canceling any shares which have been taken or agreed to be taken by any person;
• Where company purchases its own shares in pursuance of the provisions in Section 77A.

TAX ISSUES:

Definitely there are tax implications in case of reduction of share capital. The shareholders may get compensation for such reduction of share capital. In some cases there will be a loss also to the shareholders. Whether the amount received by the shareholders in respect of reduction of share capital will attract capital gains tax? Likewise another question arises. Whether the shareholders who get loss due to the reduction of share capital are entitled to claim the long term capital loss. These two issues are discussed in this article with reference to decided case laws.

Section 45 (1) of the Act provides that any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in sections 54, 54B, 54D, 54E, 54EA, 54EB, 54F, 54G and 54H, be chargeable to income-tax under the head "Capital gains", and shall be deemed to be the income of the previous year in which the transfer took place.

The Gujarat High Court in ‘Commissioner of Income Tax V. Mohanbhai Pamabhai’ – 1971 (9) TMI 56 - GUJARAT High Court gives the requirement for charging of capital gains tax. The Court held that section 45 is the charging section, undoubtedly provides that any profits or gains arising from the transfer of a capital asset shall be chargeable to income tax under the heading ‘capital gains’   But Section 48 shows that the transfer that is contemplated by Section 45 is a transfer as a result of which consideration is received by the assessee or accrues to the assessee.   Section 48 provides the mode of computation of capital gains by enacting that the income chargeable to tax as capital gain shall be computed by deducting from the ‘full value of the consideration received or accruing as a result of the transfer of capital asset’ the following amounts, namely:-

• Expenditure incurred wholly and exclusively in connection with such transfer; and
• The cost of acquisition of the capital asset and the cost of improvement thereto.

The amounts specified above are to be deducted from the ‘consideration received or accruing as a result of the transfer of capital asset’ for the purpose of determining the profits or gains chargeable to tax.   It is, thus, clear that the transfer as a result of which consideration is received by the assessee or accrues to the assessee.   If there is no consideration received or accruing to the assessee as a result of transfer, the machinery section enacted in section 48 would be wholly inapplicable and it would not be possible to compute profits or gains arising from the transfer of the capital asset. The transaction in order to attract the charge of tax as capital gains must, therefore, clearly be such that consideration is received by the assessee or accrues to the assessee as a result of the transfer of the capital asset.   Where transfer consists in extinguishment of a right in the capital right, there must be an element of consideration for such extinguishment, for then only it would be eligible to capital gains tax.

In ‘Kartikeya V. Sarabhai’ – 1997 (9) TMI 2 - SUPREME Courtthe assessee purchased 90 non cumulative preference shares each of the face value of Rs.1000 at a price of Rs.420 per share of a company called Sarabhai Limited.   In 1965 a sum of Rs.500 per preference share was paid off to the assessee upon reduction of the share capital of the company.   This was done by reducing the face value of each share from Rs.1,000 to Rs.500 by paying off Rs.500 in cash.   Further reduction in the face value of the shares took place in the year in question.   The company paid off Rs.450 per share which reduced the liability on the preference share from Rs.500 to Rs.50 per share.   The Income Tax Officer formed the view that the sum of Rs.450 per share received by the assessee in the year was liable to capital gain tax. The assessee’s contention is that there was no ‘transfer’ within the meaning of Section 2(47) did not find favor with him.   The High Court held that the assessee made capital gain on reduction of preference share capital and the same was eligible to capital gains tax.   It was contended on behalf of the assesseee before the Supreme Court that there was no ‘transfer’ within the meaning of Section 2(47) as the assessee continued to be a shareholder of the company even after the receipt of the amount.   The Supreme Court rejected the contention of the appellant and observed that the reduction in the face value of shares amounted to ‘extinguishment’ within the meaning of Section 2(47) and hence the amount received on such reduction was taxable as capital gain.

In the case ‘G. Narashimhan (Decd.)’ – 1998 (12) TMI 5 - SUPREME Court the assessee was a shareholder in a private company holding 70 shares with the face value of Rs.1000 each.   The company passed resolution to reduce its capital. With that the face value of shares in the company was reduced from Rs.1000 each to Rs.210 each.   There was pro-rata distribution of some properties of the company and payment of money to the shareholders.   The Tribunal held that no capital gain was assessable in the hands of the assessee as there was no extinguishment of any right of the assessee and consequently there was no transfer within the meaning of Section 2(47) of the Act by the assessee of any capital asset.   The Supreme Court considered the provisions of Section 45(1) read with Section 2(47) and also Section 2(22)(d) of the Act.   It was observed that on the reduction in the face value of the share, the share capital stood reduced; the right of the shareholder to the dividends and his right to share in the distribution of the net assets upon liquidation were extinguished proportionately to the extent of reduction in the capital.   The Supreme Court noticed that in this case there were two factors in the amount distributed to the assessee on reduction of the share capital viz., distribution attributable to accumulated profits and distribution attributable to capital (except capital profit).   It was finally held that no extent of the accumulated profits in the hands of the company, the return to the assessee on reduction of his capital was taxable as dividend under Section 2(22)(d) and the balance as capital gain.

In ‘Bennett Coleman and Co. Limited V. Additional Commissioner of Income Tax’ – 2011 (9) TMI 1 - ITAT MUMBAI the assessee made an investment of Rs.2,484.02 lakhs in equity shares of a group company viz., Times Guarantee Limited (TGL).   The TGL was running into loss of Rs.42.96 crores. This loss was sought to be written off by reducing the paid up share capital to the extent of Rs.8.99 crores and the balance amount of Rs.33.97 crores by utilizing the share premium accounts of the company. As such the company passed special resolution for reduction of share capital under Section 100 of the Companies Act and the High Court approved the resolution in annual general meeting.   The reduction in the share capital in this case is covered under Section 100 (1) (b) of the Companies Act by which TGL cancelled its paid up share capital to the extent it was lost and was unrepresented by available assets. The High Court approved the company by reducing the face value of each equity share from Rs.10/- to Rs.5/-.   After that two equity shares of Rs.5 each were consolidated into one equity share.

The assessee’s investment in TGL got reduced from Rs.2484.02 lakhs to Rs.1,242.01 lakhs. After applying the indexation a sum of Rs.22,21,85,693/- was claimed as long term capital loss by the assessee. The Assessing Officer noticed this claim of capital loss issued a notice to the assessee for exclusion of the same.   The assessee contended that reduction in the face value of shares would amount to transfer such loss was available. For this purpose he relied on the judgment of ‘Kartikeya V. Sarabhai’ (supra) and ‘CIT V. G. Narasimhan’ (supra).   The Assessing Officer held with reference to ‘Kartikeya’ case that this was merely a case involving in face value of preference shares and accordingly the same should not be applied particularly because the Supreme Court had also observed that in terms of Section 87(2) (i) the voting rights were also reduced proportionately on the resolution which effected the rights of preference shareholders whereas in case of equity shares, there is no reduction in the rights of such equity shareholders.   The Assessing Officer further observed that the assessee has not received any consideration for reduction in the value of shares, nor any part of the shares have been passed to any one else.   This means, there was no change in the rights of the assessee vis-à-vis other shareholders and, therefore, no transfer had taken place and, thus, the assessee was not entitled to the claim of long term capital gain.

On appeal, the Commissioner of Income Tax (Appeals) upheld the findings of the Assessing Officer on similar reasoning.   The assessee filed appeal before the Tribunal. The Special Bench has been constituted by the President to consider the following question:

“Whether, on the facts and in the circumstances of the case, the Commissioner of Income Tax (Appeals) was justified in declared long term capital loss of Rs.22, 21, 85,693/- on account of reduction of paid up equity share capital?”

The assessee submitted the following before the Tribunal:

• The assessee’s holding in TGL has been reduced and the same has been credited in demat account of the assessee;
• The ISIN (International Security Identification Number) number has been changed from INE289C01025 to INE289C01017, which basically means that new shares are different shares because different ISIN INE Number has been allotted;
• Old shares have been replaced with new shares which is a reduced number and this should be treated as exchange of shares which is clearly covered by the definition of ‘transfer’ and once the shares have been transferred it is a basic condition for attracting Section 45, then the loss incurred on the same should be treated as capital loss;
• The case ‘G. Narasimhan’ (supra) squarely applies to his case since the issue there was regarding the reduction of equity shares. The Supreme Court following the decision of ‘Kartikeya’ (supra) held that reduction in equity share capital would amount to transfer; by applying this decision the loss claimed by the assessee is allowable because the same has arisen from reduction of equity share capital;
• Even extinguishment of right in a capital asset would amount to transfer and in his case his right got extinguished proportionately to the reduction of capital, it would amount to transfer;
• The capital loss has been disallowed by the Assessing Officer is only on the ground it did not amount to transfer but mainly on the point that the assessee had not received any consideration. The consideration in his case is assessable, in the sense that same should be taken as zero;

The Department submitted the following before the Tribunal:

• In this case the capital has been reduced by the company in two phases.   The face value of the shares was reduced from Rs.10 each to Rs.5 each which means the capital was reduced by 50% and then such two shares of Rs.5 each were consolidated into one share and such new share has been allotted to the company.   However the value of the assets of the company remained the same before and immediately after such reduction and therefore no loss was caused to the assessee;
• Section 84 of the Companies Act defines that a share certificate shall be prima facie evidence of the members to such share.   Since share of the assessee in the company’s assets have not gone down, no loss can be said to have been incurred by the assessee;
• The assessee is holding proportionate share in assets of the company which have not gone down and therefore no loss has been suffered.   Mere reduction of share capital at best can lead to a notional loss;
• Section 55(2)(v) defines cost of acquisition in case of shares in the event of consolidation, division or conversion or original shares; as per this clause, original cost has to be taken as cost of present acquisition. In this case the cost of acquisition would remain same to the assessee in terms of this provision and if the loss on reduction of share capital is allowed at this stage and in future if such shares are sold, then the assessee can take the original cost as cost of acquisition which would mean double benefit to the assessee which is not permissible under the law;
• Whenever a company issues bonus shares no capital gain is chargeable on the same on mere receipt of such bonus shares and capital gain, if any, can be charged only at the stage when such bonus shares are sold by such assessee.   Similar principle needs to be applied in the case when the assessee’s shareholding is reduced on reduction of such capital;
• In the assessee’s case the value of reduced share holding can be increased, i.e., cost of acquisition can be increased but the loss cannot be allowed because at the stage of reduction of capital it is only a notional loss.

The assessee filed a rejoinder in which gives computation of capital loss incurred on reduction of share capital of TGL shares and pointed out that cost has been taken on the basis of cost to the assessee which has been indexed as per the provisions of Section 48 and therefore, no double benefit had been obtained by the assessee and such cost has been further reduced from the value of investment as pointed out earlier. He again reiterates that it is a simple case of transfer.

Among the three members two members unanimously have taken a decision and the third member has taken a different view.   By virtue of majority the decisions of two members will prevail.   The Tribunal observed as follows:

• If the earlier shares have been replaced or substituted by new shares then the same would not amount to transfer at all.   It would be merely a case of substitution of one kind of share with another kind of share which has been received by the assessee because of the rights to the original shares on the reduction of capital;
• The Supreme Court in ‘CIT V. Rasiklal Maneklal (HUF)’ - 1989 (3) TMI 3 - SUPREME COURT held that in case of exchange that one person transfers a property to another person in exchange of another property the property continues to be in existence. Similarly in the case of the assessee the old shares with different ISIN number ceases to exist and new shares with a different ISIN numbers have been issued and, therefore, it cannot be called as a case of extinguishment or relinquishment and it is a mere case of substitution of one kind of share with another. The assessee got the new shares on the strength of its rights with the old shares and therefore, the same would not amount to transfer;
• The transfer of a capital asset, in order to attract the capital gains tax, must be a transfer of the capital asset for the purpose of determining the profits or gains chargeable to tax.   It is, therefore, clear that the transfer of a capital asset, in order to attract the capital gains tax, must be a transfer as a result of which consideration is received by the assessee or accrued to the assessee.   If there is no consideration received or accruing to the assessee as a result of the transfer, the machinery section enacted in Section 48 would be wholly inapplicable and it would not be possible to compute profits or gains arising from the transfer of the capital asset;
• Where transfer consists in extinguishment of a right in the capital asset, there must be an element of consideration for such extinguishment, for then only it would be a transfer eligible to capital gains tax;
• The assessee has not received any consideration for reduction of share capital. What has happened is that ultimately the number of shares held by the assessee has been reduced to 50% and nothing has moved from the side of the company to the assessee;

The Tribunal, on the above discussions, held that the loss arising on account of reduction in share capital cannot be subjected to the provisions of Section 45 read with Section 48 and accordingly such loss is not allowable as capital loss.   At best such loss can be described as notional loss and it is settled principle that no notional loss or income can be subjected to the provisions of income tax act.

CONCLUSION:

From the above discussions the following inferences can be made:

• To attract capital gains tax there must be a transfer of capital asset;
• Consideration must be received or must accrue as a result of the transfer and the consideration must be capable of being determined in monetary term in order that the computation of capital gains may be made as required by section 48;
• Profits or gains must arise from the transfer and must be embedded in the consideration;
• If there was no change of the assessee vis-à-vis other shareholders and therefore no transfer had taken place and thus there would be no claim of term capital loss is available for the assessee. The loss will be only the notional loss.