Reduction of capital – an alternate to buyback and minority exit?
Buyback was considered as one of the most effective means of scaling down of capital by a company and distribution of accumulated profits, until the tax law changes pursuant to the Finance Act, 2024 effective 1st October, 2024. With buybacks becoming ineffective, one may want to look at reduction of capital u/s 66 of the Companies Act, 2013 (‘Act’) as an alternate route for scaling down capital. In fact, the section has been worded in a manner that seems to suggest that the capital reduction procedure u/s 66 can serve various objectives, as also highlighted in various rulings of NCLT and NCLAT, including the Supreme Court.
Manner of capital reduction u/s 66
Section 66 of the Act reads as:
- Subject to confirmation by the Tribunal on an application by the company, a company limited by shares or limited by guarantee and having a share capital may, by a special resolution, reduce the share capital in any manner and in, particular, may—
XXX
Thus, the opening sub-section of the section seems to suggest that the share capital may be reduced in any manner, as the company may approve by a special resolution, upon confirmation by the NCLT.
However, the section is further followed by clauses specifying the manner in which the capital reduction may be effected.
(a) extinguish or reduce the liability on any of its shares in respect of the share capital not paid-up; or
(b) either with or without extinguishing or reducing liability on any of its shares,—
(i) cancel any paid-up share capital which is lost or is unrepresented by available assets; or
(ii) pay off any paid-up share capital which is in excess of the wants of the company,
alter its memorandum by reducing the amount of its share capital and of its shares accordingly:
(a) Extinguishment of uncalled capital
Clause (a) deals with extinguishment of uncalled capital. Hence, if a company has issued shares at a face value of say, Rs. 10 each, of which Rs. 8 per share has been paid-up, the company may reduce the share capital, by extinguishing the liability towards the uncalled and unpaid capital of Rs. 2 per share.
This results in a reduction in the face value of the share capital, although, no reduction in the voting rights or shareholding percentage of the shareholders, if effected proportionately for all the shareholders.
(b) (i) Cancellation of deteriorated capital
Clause (b)(i) deals with the capital that gets deteriorated on account of the deterioration in the value of the assets. This assists in reflecting the true value of the company by cancelling such value of the capital that is not represented by assets of equivalent value.
For instance, the face value of each share of the company is Rs. 100, represented by assets worth Rs. 80, for each share. In this case, the company may write-off its share capital to the extent of Rs. 20 per share.
(b) (ii) Payment of the excess paid-up capital available with the company
Clause (b)(ii) deals with the payment of capital that is in excess of the requirement of the company. This is similar to Clause (a), except that in case of the former, the capital was unpaid, and hence, there is no cash outflow in the hands of the company. In case of the latter, that is, under Clause (b)(ii), the capital having already been paid by the shareholders, the cancellation of the same requires payment on the part of the company to the shareholders.
Sources of payment for capital reduction
Where capital reduction is on account of the loss in the value of assets, the same would technically, not result in any payment from the company to its shareholders. In other cases, however, there is a cash outflow on the part of the company, and hence, it becomes relevant to understand the sources from which such payment can be made.
Capital reduction essentially means a reduction in the capital of the company, being excess than required, and hence, remaining unutilised. Further, in terms of Section 52 of the Act, the application of securities premium, except for the purpose as specified in sub-section (2) or (3) thereof, as applicable, constitutes a reduction in share capital.
Capital reduction as a means of profit distribution?
A part of the consideration may also be payable from the accumulated profits of the company, thereby, also leading to distribution of profits through capital reduction. However, the same is considered as deemed dividends, for income tax purposes, attracting tax implications, as discussed in later paragraphs below.
Capital reduction for consideration other than cash
The consideration payable on account of capital reduction need not necessarily be paid in cash, the same may also be paid through other means, that is, by distributing property owned by the company. In re Aavishkaar Venture Management Services Private Limited, the NCLT Mumbai affirmed the permissibility of capital reduction for consideration other than cash, against an observation of the Regional Director, Western Region, having reference to other judicial precedents.
Capital reduction by creation of liability in any other form
An extended and striking version of capital reduction for consideration other than cash is the creation of resultant liability in the hands of the shareholders against capital reduction. In Ulundurpet Expressways Private Limited, the NCLT Mumbai rejected the scheme of capital reduction, proposing capital reduction through creation of resultant loan to be repaid to the shareholders over a period of time. It was stated that:
“…the scheme of section 66(1)(b)(ii) of the Companies Act, 2013 only enables a company to pay off excess capital to its shareholders, which is considered in excess of wants of the company. The facts of the case clearly shows that such reduced share capital can not be said to be in excess of wants of the company on the date of passing of special resolution. Accordingly, such reduction is not permissible under the terms of Section 66(1)(b)(ii) of the Companies Act, 2013.”
The matter was put to appeal before NCLAT, that reversed NCLT’s order, thereby allowing such a scheme of capital reduction. The appellant had referred to two similar cases where the consideration was to be discharged over a period of time and was kept outstanding as a loan between the Company and its shareholders, and such a scheme had been approved by the NCLT Mumbai. NCLAT referred to various rulings in the context of capital reduction, and concluded that the same is permissible under section 66 allowing capital reduction “in any manner”, being a domestic issue. In Indian National Press (Indore) Ltd (1989) 66 Comp Cas 387 (MP), the High Court held:
“The need for reducing capital may arise in various ways, for example, trading losses, heavy capital expenses, and assets of reduced or doubtful value. As a result, the original capital may either have become lost or a company may find that it has more resources than it can profitably employ. In either case, the need may arise to adjust the relation between capital and assets. The company has the right to determine the extent, the mode and incidence of the reduction of its capital. But the court, before it proceeds to confirm the reduction of capital, must see that the interests of the minority and that of the creditors are adequately protected and there is no unfairness to it, even though it is a domestic matter of the company. The power of confirming or refusing to confirm the special resolution of a company to reduce its capital is conferred on the court in order to enable it to protect the interest of person who dissented or even of persons who did not appear, except on the argument and hearing of the petitioner.”
Other cases where the capital reduction has been effected through creation of liability to be discharged over a period of time include Tamil Nadu Newsprint & Papers Ltd (CP No. 17 of 1995) wherein redeemable non-convertible debentures were issued in consideration for reduction of capital, Dewas Bhopal Corridor Private Limited (CP No. 252 of 2022) and Godhra Expressways Private Limited (CP No. 254 of 2022) etc. NCLAT also cited various judgements stating capital reduction as a matter of domestic concern, discussed in the paragraph below.
Proportionate rule or selective reduction?
A question that has been raised time and again in the context of capital reduction is, whether the same needs to be effected in a proportionate manner for all the shareholders, or whether it can also be structured in a manner so as to selectively reduce/ extinguish the rights of some shareholders, thereby, reducing their overall holding in the company, including a complete buy-out of the minority shareholders.
Ruling disallowing minority buy-out through capital reduction
A recent ruling by NCLT Kolkata (pronounced on 19th September, 2024) in the matter of Philip India Ltd answers the aforesaid question of selective reduction in negative. The judgement considers the two clauses u/s 66(1) to conclude that Section 66 cannot be invoked for buying out the minority stake, and that the petition is liable to be dismissed since “…share capital reduction is only incidental to the main objective of buy back of shares…”
| Relevant clause of section 66 | Application to the case |
| Sec 66(1)(a) | Not applicable as the capital reduction is not sought for extinguishing or reducing the share capital that has not been paid-up |
| Sec 66(1)(b)(i) | Not applicable since nothing has been pleaded to show that the the reduction in share capital is for cancellation of paid-up capital, which is lost or unrepresented by available assets |
| Sec 66(1)(b)(ii) | Not applicable since it is not pleaded that they wanted to pay off capital which is in excess of the wants of the Company. In fact, there are borrowings/ liabilities in the balance sheet of the petitioner |
The matter has been appealed for and currently pending before the NCLAT.
Rulings allowing minority buy-out through capital reduction
While NCLT Kolkata disallowed selective capital reduction, there is a plethora of rulings – both under the existing 2013 Act and the erstwhile 1956 Act, as well as English rulings allowing selective capital reduction, where the same is not unfair or inequitable.
In British and American Trustee and Finance Corporation v. Couper, (1894) AC 399, the House of Lords of England held that:
“…if there is nothing unfair or inequitable in the transaction, I cannot see that there is any objection to allowing a company limited by shares to extinguish some of its shares without dealing in the same manner with all other shares of the same class. There may be no inequality in the treatment of a class of shareholders, although they are not all paid in the same coin, or in coin of the same denomination.”
The principle was reiterated in Poole v. National Bank of China, 1907 AC 229 and Westbern Sugar Refineries Ltd., (1951) 1 All. E.R. 881 (HL) etc.
“…the general rule is that the prescribed majority of the shareholders is entitled to decide whether there should be a reduction of capital, and, if so, in what manner and to what extent it should be carried into effect”
The principle has been followed and restated in various rulings of the Indian courts from time to time.
In Reckitt Berickiser (India) Ltd (2005) 122 DLT 612, the Delhi High Court approved the scheme of capital reduction resulting in paying off the minority public shareholders based on the aforesaid judicial dicta, while also laying down the principles for capital reduction in the following manner:
(i) The question of reduction of share capital is treated as matter of domestic concern, i.e. it is the decision of the majority which prevails.
(ii) If majority by special resolution decides to reduce share capital of the company, it has also right to decide as to how this reduction should be carried into effect.
(iii) While reducing the share capital company can decide to extinguish some of its shares without dealing in the same manner as with all other shares of the same class. Consequently, it is purely a domestic matter and is to be decided as to whether each member shall have his share proportionately reduced, or whether some members shall retain their shares unreduced, the shares of others being extinguished totally, receiving a just equivalent.
(iv) The company limited by shares is permitted to reduce its share capital in any manner, meaning thereby a selective reduction is permissible within the framework of law (see Re. Denver Hotel Co., 1893 (1) Chancery Division 495).
(v) When the matter comes to the Court, before confirming the proposed reduction the Court has to be satisfied that (i) there is no unfair or inequitable transaction and (ii) all the creditors entitled to object to the reduction have either consented or been paid or secured.”
The aforesaid has been referred to in various judgements such as in RS Livemedia Pvt Ltd, and Bombay Gas Company Ltd, thereby answering the question of permissibility of selective capital reduction in affirmative.
On the question of whether the special resolution which proposes to wipe out a class of shareholders (through capital reduction) after paying them just compensation can be termed as unfair and inequitable, the Bombay High Court, in Sandvik Asia Ltd. vs. Bharat Kumar Padamsi (2009) SCC Online Bom. 541 has answered in negative, having reliance on the judgment of the House of Lords in the case of British and American Trustee and Finance Corpn (supra). The Bombay High Court also referred to the judgment of the SC in Ramesh B. Desai v/s. Bipin Vadilal Mehta, (2006) 5 SCC 638 for the same.
“As the Supreme Court has recognised that the judgment of the House of Lords in the case of British & American Trustee and Finance Corporation Ltd. is a leading judgment on the subject, we are justified in considering ourselves bound by the law laid down in that judgment. As we find that there is similarity in the facts in which the observations were made in the judgment in the case of British & American Trustee and Finance Corporation, we will be well advised to follow the law laid down in that case.”
In Brillio Technologies Pvt Ltd. vs ROC & RD, referring to various judgements including the ones cited above, the NCLAT held that:
“…Section 66 of the Companies Act, 2013 makes provision for reduction of share capital simpliciter without it being part of any scheme of compromise and arrangement. The option of buyback of shares as provided in Section 68 of the Act, is less beneficial for the shareholders who have requested the exit opportunity.”
The aforesaid ruling does not only permit selective reduction of capital, it expressly puts capital reduction u/s 66 as an alternative to buyback of shares u/s 68 where the former is more beneficial to the shareholders than the latter. The ruling has also been referred to by NCLT Mumbai in Reliance Retail Ltd.
Tax implications on capital reduction
Capital reduction qualify as “transfer” u/s 2(47) of IT Act
In order to qualify for taxability as capital gains, or claiming set-off of capital losses pursuant to a capital reduction, it is necessary that the transaction falls within the meaning of “transfer” u/s 2(47) of the IT Act. The term “transfer” has been defined in the following manner:
“transfer”, in relation to a capital asset, includes,—
(i) the sale, exchange or relinquishment of the asset ; or
(ii) the extinguishment of any rights therein ; or
XXX
The question of whether reduction of capital amounts to ‘transfer’ has been a matter of discussion before courts, including the Supreme Court in several instances. The Supreme Court has, recently (pronounced on 2nd January, 2025), in the matter of PCIT v. Jupiter Capital Pvt Ltd 2025 INSC 38 considered the matter at length and answered in affirmative. In the facts of the case, while the number of shares held by the shareholder assessee had reduced on account of capital reduction, the shareholding pattern remained the same, due to which the Assessing Officer concluded that there is no “extinguishment of rights”, thereby the capital reduction cannot amount as ‘transfer’ u/s 2(47) and no capital losses can be booked by the assessee on the same.
The Supreme Court, having regard to its judgement in previous matters concerning the question of whether capital reduction amounts to transfer, dismissed the petition filed by Revenue, thereby, allowing the assessee to claim capital loss.
Reference was made of the decision of Supreme Court in Kartikeya V. Sarabhai v. Commissioner of Income Tax, (1997) 7 SCC 524, where, on account of capital reduction, the face value of shares were reduced although the number of shares remained the same. The SC, having regard to its another decision in Anarkali Sarabhai v. Commissioner of Income-Tax, Gujarat 138 I.T.R. 437 (pertaining to redemption of preference shares) held that:
“Section 2(47) which is an inclusive definition, inter alia, provides that relinquishment of an asset or extinguishment of any right therein amounts to a transfer of a capital asset. While, it is no doubt true that the appellant continuous of a share capital but it is not possible to accept the contention that there has been no extinguishment of any part of his right as a share holder qua the company. It is not necessary that for a capital asset. Sale is only one of the modes of transfer envisaged by Section 2(47) of the Act. Relinquishment of the asset or the extinguishment of any right in it, which may not amount to sale, can also be considered as a transfer and any profit or gain which arises from the transfer of a capital asset is liable to be taxed under section 45 of the Act.”
The views expressed in Kartikeya V. Sarabhai (supra) was reiterated in the matter of CIT v. G. Narasimhan, 1999 (1) SCC 510.
In Anarkali Sarabhai (supra), it was held that both reduction of share capital and redemption of shares involve the purchase of its own shares by the company and hence will be included within the meaning of transfer under Section 2(47) of the Income Tax Act, 1961. Relevant excerpts are reproduced below:
The view taken by the Bombay High Court accords with the view taken by the Gujarat High Court in the judgment under appeal. In the judgment under appeal, it was pointed out that the genesis of reduction or redemption of capital both involved a return of capital by the company. The reduction of share capital or redemption of shares is an exception to the rule contained in Section 77(1) that no company limited by shares shall have the power to buy its own shares. When it redeems its preference shares, what in effect and substance it does is to purchase preference shares. Reliance was placed on the passage from Buckley on the Companies Acts, 14th Edn., Vol. I, at p. 181: “Every return of capital, whether to all shareholders or to one, is pro tanto a purchase of the shareholder’s rights. It is illegal as a reduction of capital, unless it be made under the statutory authority, but in the latter case is perfectly valid.”
In Commissioner of Income Tax v. Vania Silk Mills (P.) Ltd, (1977) 107 ITR 300 (Guj) the expression “extinguishment of any right therein” has been interpreted in a wider fashion.
14. The word “extinguishment” is the kingpin of this expression. It is a word of ordinary usage having the widest import. Usually it connotes the end of a thing, precluding the existence of future life therein (see Black’s Law Dictionary, fourth edition, page 696). It has been variously defined as meaning a complete wiping out, destruction, annihilation, termination, cancellation or extinction and it is ordinarily used in relation to right, title, interest, charge, debt, power, contract, or estate (see Corpus Juris Secundum, volume 35, page 294). In Rawson’s Pocket Law Lexicon, the meaning assigned to it is : “the destruction or cessation of a right either by satisfaction or by the acquisition of one which is greater”. In Ramanlal Gulabchand Shah v. State of Gujarat AIR 1969 SC 168 at page 175, the word “extinguishment”, which is employed in conjunction with the expression “of any such rights” in Article 31A of the Constitution, was interpreted as meaning ” complete termination of the rights “.
15. The word “extinguishment” is here used in a similar context, namely, in combination with the expression “of any rights therein”. This expression again has a wide ambit and coverage. The word “therein” refers to “capital asset” mentioned earlier in the definition. So far as the expression “any rights” is concerned, it was observed by this court in Commissioner of Income-tax v. R.M. Amin [1971] 82 ITR 194 at page 201, while interpreting this very provision :
” ……the word ‘ any ‘ is a word which ordinarily excludes limitation or qualification and it should be given as wide a construction as possible, unless, of course, there is any indication in the subject-matter or context to limit or qualify the ordinary wide construction of that word……There being no contrary intention in the subject-matter, or context, the words ‘any rights’ must include all rights……”
16. It was there pointed out that where the capital asset consists of incorporeal property, such as a chose-in-action, the bundle of rights which constitutes such incorporeal property would be comprehended within the meaning of the words “any rights”. It would thus appear that the expression. “any rights therein ” is wide enough to take in all kinds of rights–qualitative and quantitative–in the capital asset.
In view of the judgements cited above, the SC held that:
“…the reduction in share capital of the subsidiary company and subsequent proportionate reduction in the shareholding of the assessee would be squarely covered within the ambit of the expression “sale, exchange or relinquishment of the asset” used in Section 2(47) the Income Tax Act, 1961.”
Distribution of accumulated profits taxable as “dividend”
Reduction of capital results in extinguishment of some rights on the part of the shareholders, and hence, can be construed as “transfer” within the meaning of sec 2(47) of IT Act, resulting in the tax implications u/s 54 (capital gains or loss, as the case may be).
However, as stated above, some part of the consideration may be paid out of the accumulated profits of the company. To that extent, the consideration received by the shareholders is taxable as dividend u/s 2(22)(d) of the IT Act. The section reads as below:
(22) dividend includes –
XXX
(d) any distribution to its shareholders by a company on the reduction of its capital, to the extent to which the company possesses accumulated profits which arose after the end of the previous year ending next before the 1st day of April, 1933, whether such accumulated profits have been capitalised or not;
Thus, to the extent the consideration for capital reduction is paid from the accumulated profits of the company, the same would be taxable as dividend in the hands of the shareholders. In Commissioner of Income-Tax v. Urmila Remesh, 230 ITR 422, the Supreme Court clarified that:
Section 2(22) of the Act has used the expression `accumulated profits’ Whether capitalised or not”. This expression tends to show that under Section 2(22) it is only the distribution of the accumulated profits which are deemed to be dividends in the hands of the share-holders. By using the expression “whether capitalised or not” the legislative intent clearly is that the profits which are deemed to be dividend would be those which were capable of being accumulated and which would also be capable of being capitalised. The amounts should, in other words, be in the nature of profits which the company could have distributed to its share-holders. This would clearly exclude return of part of a capital to the company, as the same cannot be regarded as profit capable of being capitalised, the return being of capital itself.
This was further reiterated in the matter of G. Narasimhan (supra).
Whether the new buyback taxation rule applies on capital reduction?
In various rulings, capital reduction has been employed as a means to buy back the shares of the minority investors. Therefore, a question arises on whether the new taxation rule on buyback (refer our article here) would apply to capital reduction as well.
Here, reference may be made to the language of Section 2(22)(f) of the IT Act, that reads as:
(f) any payment by a company on purchase of its own shares from a shareholder in accordance with the provisions of section 68 of the Companies Act, 2013 (18 of 2013)
The provision, thus, clearly refers to buyback u/s 68 of the Act, whereas, capital reduction is effected u/s 66 of the Act. On the other hand, distribution of profits on capital reduction is explicitly covered u/s 2(22)(d) of the IT Act. Hence, there is no reason one should take a view that the new rules on taxation of buyback also extends to capital reduction.
Illustration showing tax implications upon capital reduction
The below table contains a few illustrations with respect to the tax implications upon reduction of capital.
| Sl. No. | Particulars | Part consideration from accumulated profits & Capital gains | Capital loss on account of capital reduction | No consideration paid on capital reduction |
| Amount (Rs.) | Amount (Rs.) | Amount (Rs.) | ||
| A. | Consideration received on capital reduction | 1,00,000 | 10,000 | – |
| B. | Amount paid out of accumulated profits | 30,000 | – | – |
| C. | Amount taxable as deemed dividends u/s 2(22)(d) [(B)] | 30,000 | – | – |
| D. | Cost of acquisition of shares | 20,000 | 20,000 | 20,000 |
| E. | Amount taxable as capital gains/ (loss) [(A) – (C) – (D)] | 50,000 | (10,000) | (20,000) |
Conclusion
The aforesaid discussion reveals how capital reduction has been given the widest possible meaning by the courts and tribunals, in the interpretation of the expression “in any manner”. Capital reduction can be used in scaling down the capital in any manner, so long as the same is (i) not unfair or inequitable to the shareholders and creditors, and (ii) duly approved by the shareholders through a special resolution. Though the process requires an approval of NCLT, the role of the Tribunal is supervisory in nature, since the matter is one of “a domestic affair”.
Our other resources on the subject:
[1] Read a detailed article on the same at Bye Bye to Share Buybacks
Leave a Reply
Want to join the discussion?Feel free to contribute!