Selective capital reduction – Applicability of section 50CA and section 56(2)(x) of Income-tax Act, 1961
Capital reduction refers to corporate reorganization activity in which the existing share capital is extinguished. Companies consider utilizing this route for various business reasons, such as returning excess capital to shareholders, distributing assets to shareholders, loss of original share capital due to accumulated business losses, etc.
The process of capital reduction might affect all shareholders or certain shareholders, depending upon business requirements. When the capital reduction process targets specific shareholders or a class thereof, the process is known as selective capital reduction. One example of such capital reduction is minority buyouts.
It would be pertinent to examine the relevant provisions of the Income-tax Act, 1961 (ITA), as shall be applicable in case of selective capital reduction. Under section 45 of the ITA, any profits or gains arising from the transfer of a capital asset shall be chargeable to income tax under the head “capital gains.” Considering that the shares, in this case, shall be considered capital assets and the definition of “transfer” includes extinguishment of any right, it may be inferred that reduction of share capital may be considered as the transfer of capital asset and appropriate capital gains tax may be applicable.
The Finance Ministry, in its 2017 budget, introduced section 50CA to the ITA (effective from Assessment Year 2018-19), which provides that where the consideration received or accruing as a result of transfer of an unquoted share is less than the fair market value (FMV) as on the date of transfer, the FMV shall be treated as the full value of consideration for the purpose of computation of capital gains under section 48.
Thereby, section 50CA may be applicable to selective capital reduction to determine the full value of consideration, which shall be the amount payable by a company pursuant to a reduction of share capital for the purposes of computing capital gains.
Additionally, it would be worthwhile to delve into a case of selective capital reduction, wherein capital reduction undertaken by the company does not result in any payout to the shareholders, i.e., a capital reduction without payment of any consideration.
As per section 50CA, there should be consideration “received” or “accruing” as a result of a transfer of unquoted shares. In this regard, judicial precedents discussing the meaning of “accrue” and “receive” are provided below:
In the case of CIT v. Annamalais Timber Trust,[1] on the meaning of the terms “accrue” and “receive,” the Court opined that “accrue” is “to arise or spring as a natural growth or result” and may be interpreted as present enforceable right to receive income, profits or gains and is capable of “being enforced or converted into money by actual receipt.” On the other hand, the word “receive” means actual receipt income, profits or gains.
Further, in the case of CIT v. Ashokbhai Chimanbhai,[2] with respect to the meaning of the said terms, the Court observed that income is said to be received when it reaches the assessee, whereas when the right to receive the income becomes vested in the assessee, it is said to accrue or arise.
Accordingly, it may be inferred from judicial precedents that the term “accrue” conveys the idea of a presently enforceable right to receive and the term “received” means that there is an actual receipt of consideration.
Thus, one may contend that the terms “received or accruing” in section 50CA do not envisage a situation of “no consideration” and section 50CA may not be applicable where no consideration is envisaged.
Another aspect to be considered is the applicability of section 56(2)(x) of ITA in the hands of other shareholders who did not participate in capital reduction. Section 56(2)(x) provides that where any person receives in any financial year, any shares and securities without consideration, the FMV of which exceeds INR 50,000, the whole FMV of such shares and securities shall be chargeable to tax under section 56(2)(x) in the hands of the transferee.
In the case of Sudhir Menon HUF v. ACIT, [3] the Tribunal held that a proportionate issue of shares at a price below the FMV to all shareholders of the company may not lead to any tax implications under section 56(2)(via)). One wonders whether any disproportionate issue of shares, i.e., issue of shares to a particular shareholder or a group of shareholders at a price lower than the FMV may lead to taxability under section 56?
However, in a capital reduction scenario, vis-à-vis the remaining shareholders, what happens is merely an enlargement of rights and interests of other shareholders and there is no “receipt” of shares or assets, and hence, section 56(2)(x) may not apply. However, the jury is however still out on this interpretation and one should wait for some precedents before any conclusions.
