As a process of Internal Reconstruction, capital reduction is undertaken for various reasons, such as eliminating losses, simplifying capital structure, writing off fictitious assets, to make the balance sheet look healthy and many others.
There is a recent judgement by Income Tax Appellate Tribunal ("ITAT"), Mumbai in the case of M/s. Carestream Health INC dealing with the issue of whether the loss arising on the cancellation of shares pursuant to capital reduction should be allowed as long-term capital loss and whether such loss can be carried forward to subsequent years.
As a part of the capital reduction scheme, the assessee, a tax resident of the United States of America, received consideration from its Indian subsidiary on account of cancellation of its shares. There was capital reduction by way of reduction in the number of shares. The total consideration received by the assessee up to the extent of accumulated profits of the Indian subsidiary was treated as deemed dividend, and DDT(“Dividend Distribution Tax”) was paid. The balance consideration was treated as sale consideration, and capital loss was calculated on the same after availing indexation benefit under the Income Tax Act, 1961(“Act”). The assessee's claim for long-term capital loss was disallowed by the Assessing Officer (AO) and the Dispute Resolution Panel on the ground that there was no change in the rights of the shareholder vis-à-vis the other shareholders as well as the Company. The conditions for transfer under section 2(47) of the Income Tax Act, 1961 were not satisfied as the assessee held 100% shares in the Indian subsidiary even after the scheme of capital reduction.
As per the Act, capital reduction to the extent of accumulated profits is treated as deemed dividend under section 2(22)(d). Consequently, DDT under section 115-O was paid by the company. Accumulated profits for this purpose shall include all profits of the company upto the date of such distribution or payment whether capitalised or not.
Thus, the capital reduction to the extent of accumulated profits was treated as deemed dividend under section 2(22)(d) and the assessee claimed such deemed dividend as exempt under section 10(34).
Now the question arises whether capital reduction over and above the accumulated profits, exceeding the original cost of acquisition would be taxed as capital gain?
The charging section 45 read with section 48 of the Act requires the following for taxability of profits or gains from transfer of a capital asset as capital gains:
- The existence of a 'capital asset';
- There should be a 'transfer' of such a capital asset; and
- Consideration should be received or receivable on transfer of such a capital asset.
The issue which was required to be analysed was whether reduction of share capital tantamounts to “transfer” of a capital asset under section 2(47)?
Section 2(47) “transfer” in relation to a capital asset includes:
- the sale, exchange or relinquishment of the asset; or
- the extinguishment of any rights therein;
- …
The AO and DRP were of the view that only the number of shares have been reduced but the assessee's percentage of holding vis-a-vis the company and shareholders are the same. There is no change in the intrinsic value of the shares and rights of the shareholders. Thus, there is no extinguishment of rights of the shareholders as they are still the shareholders of the company post the capital reduction scheme without any change in percentage of holding. Consequently, they disallowed the LTCL claimed by the assessee.
The case was then taken to the tribunal by the assessee. The tribunal placed reliance on the decision by the Bangalore ITAT decision in Jupiter Capital Pvt. Ltd [ITA No. 445/Bang/2018] which stated that reduction in the number of shares would amount to extinguishment of rights in the capital asset.
Further, the following judgements were being referred to support that reduction in share capital amounts to 'transfer' chargeable to tax as capital gains:
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Kartikeya V Sarabhai and Anr vs CIT reported in 228 ITR 163 (SC) that reduction in the face value of non-convertible preference shares amounts to extinguishment of rights in those shares. Sale is not necessary for capital gains to arise. Extinguishment of rights in the capital asset also amounts to 'transfer' and taxable under capital gains. And the provisions of section 2(22)(d) had not been considered by the court in this case.
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CIT vs G Narasimhan reported in 236 ITR 327 (SC) that reduction in the face value of the equity shares would amount to extinguishment of rights in those shares.
- CIT vs Mrs Grace Collis reported in 248 ITR 323 (SC) that the rights of assessees in the capital asset, being shares in the amalgamating company got extinguished upon amalgamation of the amalgamating company. But due to the effect of section 47(vii), this transaction was not regarded as 'transfer'.
However, in the case of Bennett Coleman, the issue was that the share capital was reduced to set off accumulated losses and no consideration was being paid by the company to its shareholders. The assessee received new shares as a result of its rights to the original shares on the reduction of capital which was merely a case of substitution of one kind of share with another kind of share. Thus, the special bench held that as there was no extinguishment of the rights in the shares and it does not amount to 'transfer'.
Considering the aforesaid judicial precedents, the ITAT Mumbai held that even though the share of holding of the assessee in company remained same but the rights of assessee got extinguished as a result of the reduction of capital, thus, it would qualify as transfer under the provisions of the Income Tax Act, 1961. Resultantly, capital gain can be computed by the assessee on the basis of available cost of acquisition and sale consideration. Therefore, capital loss claimed by the assessee was allowed and eligible to be carried forward to subsequent years.
Considering the applicability of Section 50CA on such transaction:
Section-50CA of the Act deals with the full value of consideration for transfer of unquoted shares.
It states where the consideration for the transfer of unquoted shares of a company is less than the FMV(“Fair Market Value”) of such share then the FMV to be deemed as full value of consideration for the purpose of calculation of capital gains under section 48.
Further, rule 11UUAA refers to rule 11UA for the determination of fair market value of unquoted shares.
Another doubt revolves around whether the capital reduction of unquoted shares are covered under the ambit of this section?
If the capital reduction of capital assets i.e., unquoted shares qualify as 'transfer' as per the facts of the case then the applicability of this section would depend upon the involvement and ascertainment of consideration in the transaction.
Conclusion: The amount distributed by a company on reduction of its share capital has two components - distribution attributable to accumulated profits and distribution attributable to capital (except capitalised profits). The distribution attributable to capital is a capital receipt and taxed under the head capital gains subject to certain conditions. The transaction must qualify as 'transfer' is one of them and it includes relinquishment of a capital asset or extinguishment of rights in the capital asset. In the case of capital reduction, the rights of the shareholders to the dividend on share capital and the right to share in the distribution of the net assets upon liquidation is extinguished proportionately to the extent of reduction in the capital, thereby, qualifying as 'transfer' by way of extinguishment of the rights in the capital asset i.e., shares.
If the capital reduction is done to write off accumulated losses and no consideration is received by the shareholders then in that case there is no reduction in any rights of the shareholders to the assets of the company as it is just an adjustment of losses with the capital and nothing is flowing from company to the shareholders to compensate such capital reduction. Thus, there is no 'transfer' in that case.
Also, zero or nil consideration does not mean non-applicability of Section 45 for taxability of the capital receipts in accordance with the computational provisions in section 48. Where the full value of consideration or other components as required by section 48 are unascertainable then the computational provisions under section 48 fail leading to non-applicability of charging section 45. Considering this in view, the applicability of section 50CA would depend on the possibility of ascertainment of the consideration.
Disclaimer: The analysis presented above solely relates to the interpretation of case laws by author which may differ from case to case. The above analysis has been done only for informational purpose, there is no intention of recommendation. The author is not responsible for any damages caused to anyone.
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