(First published on Linkedin)
In one of the NCLT decisions earlier this year, the NCLT approved a selective capital reduction involving the distribution of equity shares in its investee companies in lieu of cash payouts. This distribution was against selective cancellation of shares held by foreign investors. While this structure provided a practical mechanism for shareholder exits, it requires careful consideration of various tax and regulatory laws.
Key Considerations:
1. Income Tax: Any capital reduction is considered as deemed dividend in the hands of the exiting shareholder, to the extent of the accumulated profits of the company. Any value distributed over and above the accumulated profits is considered as capital gains.
2. FEMA Implications: While “swap” of equity instruments is permitted for primary issuances, it does not seem that distribution of equity shares against cancellation of shares is permitted under the FEMA NDI Rules. In the given case, however, RBI approval was sought.
3. Criticality of Valuation: Valuation of the shares so distributed assumes critical importance – this is so because it is only basis the valuation that the value of assets distributed would be determined in INR terms; consequently, the proportion of value attributable as dividend and capital gains would be determined accordingly. Further, especially because this is a case of distribution to foreign shareholders, full taxes would have had to be withheld and deposited with the government, requiring proper valuation computation. Lastly, given that this would be a transfer of Indian equity shares to a foreign shareholder, computing capped valuation so that excess value of shares is not distributed on cancellation becomes critical.
4. IndAS: Appendix A to IndAS 10 mandates that non-cash distributions, such as the distribution of assets during capital reduction, be accounted for at their fair market value. The fair value of the distributed assets is recognized as a liability at the date the distribution is approved. Upon settlement, the difference between the carrying amount of the assets and their fair value is recorded as a gain or loss in the P&L Account.
5. SEBI Delisting Framework: While the given case was in the context of capital reduction by an unlisted company, recently, SEBI had also introduced a similar mechanism for delisting of listed holding companies. The said framework provides that listed holding companies deriving 75% of their value from underlying listed companies may delist itself through distribution of distributing underlying listed shares and cash in lieu of other assets.
Conclusion
Capital reduction through asset distribution presents a pathway for shareholder exits, particularly when investee companies face liquidity constraints, or companies with valuable investments, which are not intended to be liquidated.