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Taxsutra Eye Share: Capital Reduction - The Story on Allowability of Capital Loss
Continues

Aug 10,2020

Taxsutra Eye Share: Capital Reduction - The Story on Allowability of Capital Loss Continues

Deepak Manoharan Abhishek Singhvi

(Chartered Accountants)

Taxability of capital reduction under the provisions of the Income-tax Act, 1961 (‘the Act’) has been a subject
of continued litigation, with the positions not settled even after multiple occasions of the Supreme Court
dealing with the issue with different set of facts. In this article, we have discussed the tax implications
arising on account of capital reduction, including the treatment of capital loss arising on such instance for tax
purposes in light of some recent rulings of the Tax Tribunal.

Background

Capital reduction is a tool used by the Companies looking to revamp their balance sheet and increase the
shareholders’ wealth.

Capital reduction is a process where a company reduces the amount of its share capital. A company may
opt various means to reduce its share capital. It may cancel some of its paid-up shares or repay any paid-up
shares. It may reduce its share capital by reducing the number of shares in issue, the face value of shares in
issue or the amount paid up on the shares in issue.

A company opts to exercise capital reduction for various reasons, which may include to create distributable
reserves to pay dividends; to reduce or eliminate accumulated losses in order to be able to make
distributions in the future; to return surplus capital to shareholders; etc.

A company can reduce its share capital by a special resolution of its shareholders supported by the approval
of National Company Law Tribunal (‘NCLT’). The exhaustive steps of capital reduction are covered by
section 66 of the Companies Act, 2013 which gives power to the NCLT to sanction the scheme of capital
reduction on an application made by the company.

Deemed dividend

Section 2(22)(d) of the Act provides that any amount distributed by the company on reduction of capital to
the extent it possesses accumulated profits (whether capitalized or not) shall be taxable in the hands of the
shareholders as dividend.

Though the term distribution is not defined under the Act, the Apex Court in case of Punjab Distilling
Industries Ltd[1] has held that the term means something actual and not notional. Hence, any
consideration to the shareholders paid in actual terms on account of capital reduction shall be treated
as dividends to the extent of accumulated profits held by the company.
The term accumulated profits in this regard is defined to include all the profits of the company up to the
date of distribution, and as held by the Apex Court in the case of P.K. Badiani [2], the accumulated
profits should be given the meaning of profits in commercial sense and not taxable income of the
company.

It may be interesting to note that the amounts distributed in respect of shares issued for full cash
consideration, and where such shareholders are not entitled to surplus assets during liquidation are excluded
from the definition of dividend. Since preference shareholders are not entitled to surplus assets during
liquidation, it may be reasonably inferred that preference shares are excluded from the taxation of capital
reduction under the head dividends.

Considering the amount paid is construed as dividend, the companies undertaking capital reduction were

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hitherto liable to pay dividend distribution tax (‘DDT’) as per section 115-O of the Act (to the extent of
accumulated profits). However, with the amendments brought in with effect from April 1, 2020, the tax
incidence for dividends have been shifted back to shareholders.

As per the amended provisions in respect of dividends, a company paying any amount in the nature of
dividend to resident shareholder shall withhold tax under section 194 of the Act at the rate of 10%. In case
of distribution to a non-resident shareholder, the company shall withhold tax at the rate of 20% as per
section 115A of the Act or the applicable Tax Treaty whichever is more beneficial.

Capital gains in the hands of shareholder

The moot question to determine capital gains tax in the case of capital reduction is whether the transaction
could be construed as transfer of a capital asset under the provisions of section 2(47) of the Act. While it
may be argued that there is no sale of the shares by the shareholder in this case, the term ‘transfer’ has
been defined widely to include not only sale, but also exchange or relinquishment of asset, or the
extinguishment of any right therein.

The meaning of the term ‘extinguishment of rights in an asset’, and whether the asset needs to be in
existence after extinguishment of rights has been subject matter of interpretation by the Supreme Court in
multiple cases[3]. In the context of capital reduction, the Apex Court[4] went on to hold that reduction in
face value of shares amounts to extinguishment of rights in the shares, attracting the provisions of capital
gains.

Given that the shareholder may be subject to capital gains taxation, a question arises as to whether the
shareholder is liable to pay tax twice, i.e., under the head ‘Income from Other Sources’ on deemed dividend,
and under the head ‘Capital Gains’ respectively. The Apex Court in the case of G Narasimhan [5] resolved
this conflict holding that the amount taxed as dividend shall be reduced from full value of consideration
received in determining the capital gains.

Given the above, it can be inferred that the amount received over and above the accumulated profits
possessed by the company shall be treated as full value of consideration (‘FVC’) for the purpose of section 48
of the Act, and the same shall be reduced by Cost of acquisition and cost of indexation in arriving at the
capital gains / losses.

The taxability of capital gains in the hands of a non-residents shall be governed by the provisions of the Act
or applicable Tax Treaty whichever is more beneficial.

Key rulings on allowance of loss on capital reduction in the hands of shareholders

While certain profitable companies may use capital reduction as a tool to optically enhance the wealth of
shareholders, the capital reduction exercise is generally undertaken by companies incurring losses to facelift
their financial outlook. Hence, from a shareholder’s perspective, it may result in a loss more often than not,
especially after indexing the cost of acquisition of such shares to the present date.

While reduction of capital construes transfer and is chargeable to capital gains, a question arises as to what
would be the tax implications if the activity of capital reduction results in a capital loss in the hands of
shareholders, i.e., where the amount received over and above accumulated profits is lower than the cost of
acquisition & indexation. The taxpayers generally look forward to claim such capital loss arising on capital
reduction, and utilize the same to offset against potential gains arising on other transactions.

Despite some rulings of the Apex Court on taxability of capital reduction under the head ‘Capital Gains’, it
continues to be a matter of controversy on whether there is a transfer invoking capital gains provision in
every kind of capital reduction. The Special Bench of Tax Tribunal in the case of Bennett Coleman Ltd [6]
reignited this issue denying the taxpayer long-term capital loss arising on account of capital reduction.

Earlier this year, Mumbai Tax Tribunal distinguished the ruling of the Special Bench allowing capital loss on
capital reduction in the case of Carestream Health Inc[7] bringing cheers to the taxpayers. However, in yet
another recent case of Mahindra & Mahindra Limited[8] the Mumbai Tax Tribunal swerved back to follow the
Special Bench ruling.

In this context, we have briefly captured the points of difference considered by the Tax Tribunal in the above
rulings.

Particulars Bennett Coleman Ltd Carestream Health Inc

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Facts of the The taxpayer made The taxpayer, a USA resident

case investment in Times made investment in its wholly
Guarantee Limited (‘TGL’). owned subsidiary (‘WOS’)
Carestream Health India Pvt Ltd.

Out of the total

investment, certain portion Out of total investments, certain
of investment was portion of investment was
cancelled owing to losses cancelled for a consideration.
made by TGL

To the extent of accumulated

Given the fact that no profits, the same was considered
consideration was paid, the as dividend under section 2(22)
Assessee offered to tax the (d) of the Act and balance was
long-term capital loss as considered as FVC under section
computed under section 48 of the Act and capital loss was
48 of the Act computed

Contention Reliance on Karthikeya V The right of shareholder is diluted

of taxpayer Sarabhai[9] to contend to the extent of reduction and
that reduction of capital hence the same would construe
involves transfer extinguishment

Submission of Demat
statement evidencing
cancellation and change in
ISIN number
Contention No consideration was paid The Tax Officer stated that there
of lower and the computation was no transfer as per section
authorities mechanism fails 2(47) of the Act as it was a
holding subsidiary relationship, as
post reduction the rights are not
extinguished as the Indian
There was no reduction in company is still a WOS and hence
rights of the taxpayer as disallowed the loss
the taxpayer continued to
hold equity shares and
hence, it cannot be held as
transfer It was argued that the case was
squarely covered by Special
Bench ruling of Mumbai Tax
Tribunal in the case of Bennett
Coleman

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Ruling of Substitution of new shares Placing reliance on Apex court

the Tax with old shares does not ruling in case of Karthikeya V
Tribunal amount to transfer Sarabhai, it was held that
reduction of capital amounts to
transfer u/s 2(47) of the Act.
The Tax Tribunal
distinguished the case of
Karthikeya V Sarabhai and The percentage of holding has no
held that unless and until a relevance in determining the
consideration is received, whether a transaction is transfer
the same would not attract or not.
the provisions of capital
gains by placing reliance
on Apex court ruling of
Mohanbhai Pamabhai[10] Bennett Coleman ruling was
distinguished stating that
consideration was received in
current scenario unlike the former
The effective share of case.
assessee in the assets of
the company would remain
the same immediately
before and after reduction
of such capital, as there
was no change in the
percentage of
shareholding.

As may be noted above, while the Special Bench of Tax Tribunal in the case of Bennet Coleman Ltd held that
the reduction of capital is not a transfer, the Mumbai Tax Tribunal in case of Carestream Health Inc has taken
a completely contrary view. Further, the Mumbai Tax Tribunal, by relying on Bennet Coleman Ltd, in the
recent case of Mahindra & Mahindra Limited held again that where no consideration is received by
shareholder on capital reduction, such loss shall not be allowable.

Receipt of consideration on capital reduction has been construed as one of the most important factors to
attract capital gains provision. Given that a loss-making company opting for capital reduction would
generally not pay out consideration on such reduction, a shareholder might not be able to take the benefit of
loss arising on such reduction.

Points to ponder

Given that section 48 of the Act uses the term FVC accruing as a result of transfer, whether a view can
be taken that the accrual of FVC in case of capital reduction is nil if no consideration is received?
Should a loss-making company mandatorily pay a minimum amount to shareholders on capital
reduction to treat the same as transfer?

Well….!!! The doors to litigation are still open!!

The views expressed in this article are the personal views of the authors

[1] [1965] [TS-5001-SC-1965-O] (SC)

[2] [1976] [TS-5044-SC-1976-O]

[3] Rasiklal Maneklal [1989] [TS-9-SC-1989-O] (SC); Vania Silk Mills [TS-3-SC-1991-O] (SC); Anarkali Sarabhai
[1997] [TS-1-SC-1997-O] (SC); Mrs Grace Collis [2001] [TS-5-SC-2001-O] (SC)

[4] Kartikeya V Sarabhai [1997] [TS-24-SC-1997-O] (SC)

[5] [1999] [TS-5067-SC-1998-O]

[6] [TS-5095-ITAT-2011(AGRA)-O]

[7] ITA No 826/Mum/2016 / [TS-5270-ITAT-2020(MUMBAI)-O]

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[8] ITA No 1449 / Mum/ 2016

[9] [1997] [TS-24-SC-1997-O]

[10] [1973] [TS-9-HC-1971(GUJARAT)-O]

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