(First Published on Taxsutra: https://www.taxsutra.com/dt/experts-corner/corporate-liposuction-capital-reduction-et-al)
In the realm of corporate finance, one form of internal restructuring is for companies to occasionally undergo a strategic restructuring of its balance sheet, which is akin to a “liposuction” targeting the balance sheet of the company involved, by eliminating the unnecessary elements dragging the size of the balance sheet, and reflecting the true financial position of the company involved. This process, known as capital reduction, involves the pruning the unwarranted excesses, such as reduction in assets not representing its true value, set off of negative reserves against other reserves or share capital which would otherwise drag the overall depiction of balance sheet, reduction of share capital whose original value may have been lost due to persistent losses, restructuring preference shares of a company as a form of debt restructuring due to an inability of the company involved to service such redemption, and so on and so forth. Much like liposuction that aims to refine the physical contours of a human body, capital reduction seeks to refine the financial contours of a balance sheet of a company. This write-up aims to explore some of the modes of capital reduction by analysing regulatory and tax implications on account of a capital reduction in the backdrop of the underlying commercial considerations.
Scenario 1: Cancellation of Convertible Preference Shares
Consider a scenario of a loss-making company (unlisted), where the shareholders of the company had sought to fund the losses through compulsorily convertible preference shares (“CCPS”). Commercially, and from an accounting perspective, CCPS would be treated as quasi-equity under IndAS 109 read with IndAS 32, and therefore, would not leverage the balance sheet of an already loss-making entity. Therefore, rather than a mere debt funding which would result in year-on-year interest accrual, thereby, hitting the statement of profit and loss of the loss-making entity, CCPS would not impact the PBT/ PAT of the loss-making entity. Separately, from a banking perspective, given that CCPS would be considered as quasi-equity, especially given the fact that there is no obligatory repayment/ redemption on such company, this instrument would be more suited to fund losses as against debt funding.
if the company under consideration does not recoup its losses, the value of CCPS invested earlier is not represented by the underlying value of the company, hence the company may consider cancelling the said CCPS, and offsetting the losses incurred against such cancellation of CCPS.
The manner in which the said company would undertake the said cancellation of CCPS through a petition for capital reduction under section 66 of the Companies Act, 2013 requiring jurisdictional NCLT approval. The question is whether capital loss on account of the said cancellation of preference shares would be available to the shareholders or not.
In this context, it could be contended that cancellation of shares amounts to a “transfer” as defined u/s 2(47) of the Income-tax Act, 1961 (“Act”) and therefore, the consequent impact of computing capital gains (or loss) should follow. Therefore, irrespective of the post-facto shareholding of the taxpayer in the company undertaking the capital reduction remaining the same (given that it would be a proportionate reduction across board), capital loss should be allowable as such u/s 45 of the Act. The Supreme Court in the case of Kartikeya Sarabhai[1], and subsequent decisions including the decision of Mumbai Tribunal in the case of Carestream Health Inc.[2] and decision of the Bangalore Tribunal in the case of Jupiter Capital Private Limited[3] had upheld that capital reduction is tantamount to an extinguishment of an asset (including right to that asset) and therefore, a “transfer” within the meaning of section 2(47) of the Act, and therefore, capital loss should be available to the shareholders. Recently, the decision of Mumbai Tribunal in the case of Tata Sons Limited[4] also established the said principle. A reference to the decision of the Supreme Court in the case of Grace Collis[5] would not be unwarranted, where the Supreme Court held that transfer under section 2(47) includes “extinguishment of rights” in a capital asset, in the context of an amalgamation.
Distinguishing from the judgement of the Mumbai Tribunal in the case of Bennett Coleman & Co. Ltd.[6], where the Mumbai Tribunal had held that if there is a mere reduction in the face value of shares, if there is an actual cancellation of shares, the said cancellation should result in a “transfer” of shares under section 2(47) of the Act. The said principle was also established vide the decision of the Supreme Court in the case of G. Narsimhan[7], wherein it was held that consideration to the extent of accumulated profits should be taxable as dividend u/s 2(22)(d) of the Act (not applicable in case of loss making companies), while consideration over and above the accumulated profits should be taxable as capital gains.
The next question, therefore, is whether mere cancellation, which results in a “transfer” would result in deemed capital gains tax implications under section 50CA of the Act. Section 50CA of the Act provides that if consideration received on account of a “transfer” (which is so in case of cancellation of shares) of equity shares is less than the fair market value of the unlisted company, i.e., net book value as adjusted for the reckoner value of underlying immovable properties, market price of underlying listed companies, and underlying net book value of underlying unlisted companies under Rule 11UAA read with Rule 11UA of the Income-tax Rules, 1962 (“Rules”) or in case of transfer of CCPS or other instruments, the underlying actual fair market value so computed, then the said adjusted net book value or the underlying fair market value so computed would be deemed to be the full value of consideration for the purposes of computation of capital gains. However, if, there is no consideration payable on account of a capital reduction, then the provisions of section 50CA should not apply since the basic premise of applicability of section 50CA is that there should have been a consideration payable.
Without prejudice, if there is a valuation report obtained for CCPS which establishes a fair market value, even though the same is nominal (since it represents the underlying losses), the difference between the cost of acquisition (i.e., the indexed cost of investment) and the valuation as per the Rules, should be available as capital loss under the Act in the hands of the shareholders of the loss-making company. This principle was also upheld by the Mumbai Tribunal in Mahindra & Mahindra Ltd[8]. Commercially, the fact of the matter is that the shareholders invested an amount as CCPS in the loss-making company, and that the shareholders did in-turn incur a loss on account of the losses of the said company – if one were to logically align the principles of taxation with the commercial undertones, the said loss should be available as a capital loss in the hands of the shareholders, irrespective of the manner in which the said loss arose; if the said capital loss arose as a result of actual sale at a loss, then then Act would have permitted availing capital loss in the hands of the shareholders; by the same yardstick, why would the Act intend to not permit the said capital loss on account of a capital reduction, which merely seeks to represent the commercial reality, especially in the backdrop of ease of doing business in India? An express clarification from the Central Board of Direct Taxes (“CBDT”) is warranted to align commercial realities with tax in this regard.
Scenario 2: Cancellation of Equity Shares
While the underlying rationale and principles are the same in case of cancellation of equity shares as well, the key difference lies vis-à-vis applicability of section 50CA of the Act. As established earlier, even if there is no consideration “paid” on account of cancellation of shares, any loss, being the indexed cost of acquisition itself should be allowed as a capital loss in the hands of the shareholders, since it is, indeed, a commercial loss, arising out of an investment made. In any case, if there is an actual consideration paid on the basis of a fair market valuation report. Valuation principles under the Rules warrant that the minimum valuation at which the equity shares shall be “transferred” is the adjusted net book value (which would be adjusted for the net book value of the underlying subsidiaries/ market value of listed companies and reckoner value of immovable properties). If the Rules themselves provide for a valuation mechanism, and if the capital reduction is undertaken at the said valuation, while the principle of “transfer” through extinguishment of an asset is established through the provisions of the Act and various judicial precedents, then the capital loss arising on cancellation of such equity shares in the hands of the shareholders is a natural consequence of such a cancellation, and not a tax consideration driving such accrual of capital loss in the hands of the shareholders.
Scenario 3: Capital Reduction in case of Distressed Companies
Distressed companies, which may not be able to service redemption of any redeemable preference shares (“RPS”) due to lack of profits, or due to restrictions in raising additional capital, may look at restructuring the said RPS as debt securities. RPS is considered as a part of share capital and this effective conversion of RPS into debt securities will be construed as capital reduction. This is given that RPS could only be redeemed out of profits or proceeds from issue of fresh shares, and has more restrictions in terms of source of redemption as opposed to a debt instrument which could be refinanced through fresh debt as well, and therefore, any conversion of RPS into a debt security would be considered as a capital reduction, requiring NCLT approval. Assuming that there would obviously be no profits in the company which has issued such RPS, and that the value of debt securities proposed to be issued against the RPS would either be of the same amount or lower since it is a part of debt restructuring, there should not be any dividend tax or capital gains in the hands of the shareholders. From an IndAS perspective, IndAS 109 would consider this as an extinguishment of financial liability (RPS is considered as a financial liability under IndAS 109) and the fair market value of new debt securities issued would have to be recorded in the books of the issuer, with the difference between the face value of RPS and the fair market value (presumable lower than the face value of RPS cancelled) being credited to the P&L account of the issuer
Scenario 4: Buyback versus Capital Reduction
While Scenario 1, Scenario 2, and Scenario 3 above represent capital reduction in case of a gloomy situation, it need not be so. In lieu of dividend which would be restricted to the amount of free reserves, either a buyback or capital reduction could be considered to distribute surplus cash.
A buyback is a special form of capital reduction, permitted under section 68 of the Companies Act, 2013, subject to various conditions such as maximum buyback permissible is up to 25% of the net worth and 25% of the total number of shares, source of funding should be from reserves/ securities premium, and not from monies raised by issuance of similar kind of shares earlier, maintenance of a debt equity ratio post buyback, cooling off period for issuance of same kind of shares (upto 6 months), and restriction on any further buyback for a period of 12 months. Typically, a buyback would only require board approval (if the buyback is less than 10%) and shareholders’ approval (if the buyback is in excess of 10% but lower than the statutory limit of 25%). A buyback would not require an NCLT approval. However, given that buyback can only be out of free reserves/ securities premium, lack of such reserves could impede a buyback.
Further, from a tax perspective, buyback tax is chargeable at ~23% as a transaction tax in the hands of the company on the difference between the consideration for buyback and the amount received by the company upon issuance of shares. Therefore, in case where a shareholder had acquired shares of a company through secondary acquisition, the cost of acquisition would not be available as deduction in the hands of the shareholder, thereby making buyback prohibitive in case of shareholders with high cost of acquisition. Further, given that a buyback is a transaction tax, and therefore, exempt in the hands of the shareholders, such buyback tax would not be available as a tax credit in the host country of a non-resident shareholder, and could potentially result in double economic taxation.
As against this, a capital reduction, which albeit would require an NCLT approval (i.e., approx. 5-6 months), would be taxable as dividend in the hands of the shareholders as dividend tax to the extent of free reserves in the hands of the company, and balance as full value of consideration for computation of capital gains. This could mean that non-residents could avail lower rate of tax in case of dividend (say, 10% in case of UAE, 5% in case of Mauritius, etc.), and the capital gains for non-residents would be restricted to ~11% in India (unless in case of shareholders who had invested in India prior to 1 April 2017, and had entered through Mauritius, Singapore or Cyprus). Further, in absence of free reserves, capital reduction could be undertaken through debt funding, which would not be so in case of dividend or buyback.
Scenario 5: Capital Reduction in kind
Similar to capital reduction which involves a cash payout, a company may undertake cancellation of shares or redemption of preference shares by way of distribution of assets to the shareholders instead of cash. Given that this is also a form of cancellation of shares, this would require an NCLT approval. From the perspective of the shareholders, to the extent of accumulated profits, the fair market value of assets distributed would be considered as dividend, and the balance fair market value would be considered as full value of consideration for the purposes of computing capital gains. From a FEMA perspective, capital reduction in kind may not be possible since FEMA does not specifically permit discharge of consideration in kind to non-residents.
Scenario 6: Capital Reduction against Reserves
Typically, Scenario 5 would cover cases of balance sheet right sizing whereby debit balances of free reserves would be set off against other available reserves such as capital reserve, capital redemption reserve, securities premium, etc. Given that the Companies Act, 2013 do not permit dividend distribution out of the said reserves, any utilisation of such reserves to offset debit balances of free reserves would be considered as capital reduction and would require NCLT approval. From a tax perspective, since this is merely a balance sheet right sizing, and there is no consideration to the shareholders, there should not be any dividend tax or capital gains tax implications in the hands of the shareholders.
Procedural Matters and Stamp Duty
From a process standpoint, any capital reduction would require an NCLT approval under section 66 of the Companies Act, 2013. Firstly, the board of directors and shareholders (through special resolution) of the company undertaking the capital reduction would approve the capital reduction, and thereafter, a petition would be filed with the jurisdictional NCLT to seek such approval. As a part of the process, a notice to the company’s creditors would be required to be sent to seek objections, if any, to the capital reduction – the rationale behind this is that capital reduction may result in alteration of share capital of the company, and therefore, the interests of the creditors of the company should not be prejudiced.
In case of a listed company, prior approval of the stock exchanges/ SEBI would also be required under SEBI Master Circular dated 20 June 2023.
Separately, the effective date i.e., the date of approval by the NCLT and filing of requisite forms with the MCA to make the order effective is treated as the date on which capital reduction has occurred – however, if a company intends to undertake capital reduction with effect from a specific date (i.e., Appointed Date), then a full Scheme of Arrangement u/s 230-232 of the Companies Act, 2013 would be required to be undertaken, which is a more elaborate process than the process u/s 66 of the Companies Act, 2013.
From a stamp duty perspective, unless in case of capital reduction through distribution of assets, there is no conveyance of assets from the company to a shareholder, and therefore, no stamp duty should be applicable. In case of distribution of assets, stamp duty will be required to be paid on the assets so distributed, and the rate of stamp duty would depend on the nature of assets so distributed i.e., either immovable property or movable property.
Summing Up
While capital reduction as a concept may seem straight forward, the said concept can be explored to address various scenarios in order to prune the excesses or unwarranted values in a balance sheet. Depending on various scenarios in which capital reduction is used, it would entail an interplay between various tax considerations for the shareholders on the one hand, and regulatory (NCLT v/s SEBI/ stock exchange, FEMA, corporate law, etc.) and accounting implications (i.e., mainly IndAS 109) from the perspective of the company undertaking such capital reduction.
[3] [TS-9102-ITAT-2018(BANGALORE)-O]