Reduction of share capital amounts to ‘transfer’ of capital assets

Reduction of share capital is a strategic move undertaken by companies for a variety of reasons such as, to set off losses through one-time adjustment, to return surplus share capital, or to optimize the capital structure. This process involves cancellation of shares, repayment of capital or buy-back of shares. In these instances, when the company returns cash to the shareholders, in essence it amounts to distribution of profits to shareholders. Accordingly, it will be akin to dividend distribution and will attract dividend taxation. Additionally, if the consideration received by the shareholders exceeds the amount of accumulated profits, then it will also attract capital gains tax implications. Now, in relation to the imposition of capital gains tax or allowability of capital loss in the context of reduction of share capital, courts/ tribunals have been taking divergent views.  

Recently, the Hon’ble Supreme Court in the case of Principal Commissioner of Income-tax v. Jupiter Capital (P.) Ltd.^[i] has dealt with the issue whether reduction of share capital could be considered ‘transfer’ of capital assets under section 2(47) of the Income-tax Act, 1961 (IT Act), and whether the resultant capital loss should be allowed.

Facts

The taxpayer i.e., Jupiter Capital (P.) Ltd. was engaged in the business of investing in shares, leasing, financing and money lending. It had invested in an Indian media company by purchasing 14,95,44,130 (Fourteen Crore Ninety-five Lakhs Forty-four Thousand One Hundred Thirty) shares of INR 10 (Indian Rupees Ten) each and later increased its shareholding to 15,33,40,900 shares which constituted 99.88% of the total number of shares of the company. However, the company incurred losses and filed a petition for reduction of its share capital to set off the losses against the paid-up equity share capital. Pursuant to the reduction, the number of shares held by the taxpayer reduced from 15,33,40,900 (Fifteen Crore Thirty-three Lakh Forty Thousand Nine Hundred) shares to 9,988 (Nine Thousand Nine Hundred Eighty-eight) shares. Although, the face value of shares remained the same and the taxpayer received INR 3,17,83,474 (Indian Rupees Three Crore Seventeen Lakh Eighty-three Thousand Four Hundred Seventy-four) as a consideration for such reduction.

In furtherance to this, the taxpayer claimed long term capital loss incurred on the reduction of share capital from the sale of shares of the company. The Assessing Officer (AO) and CIT (A) was of the view that reduction in shares of the subsidiary company will not result in the transfer of a capital asset under section 2(47) of the IT Act. This is because there was no change in face value of the shares and shareholding pattern. Then, the Income-tax Appellate Tribunal (ITAT) reversed the order passed by the CIT(A) and allowed the taxpayer’s claim for the capital loss. The Karnataka High Court upheld the order of ITAT. Aggrieved by this order, the Revenue filed this appeal before the Supreme Court.

Background

Prior to this, in the case of Kartikeya V. Sarabhai v. Commissioner of Income-tax,^[ii] similar issues in relation to claim of capital loss incurred on account of reduction in share capital, came up for consideration. The Supreme Court observed that the definition of the ‘transfer’ under section 2(47) is an inclusive definition, wherein sale is only one of the modes of transfer. 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.

Moreover, the Hon’ble Gujarat High Court in Anarkali Sarabhai v. CIT,^[iii] relied on this case under appeal and interpreted the term ‘transfer’ under Section 2(47) of the IT Act. Based on the interpretation, it was held that the redemption of preference shares by a company is essentially a sale by the shareholder to the company. The Court held that this transaction falls under the terms ‘sale, exchange, or relinquishment’ of an asset under section 2(47) and that any gain from parting with a capital asset is taxable under Section 45.

Based on the aforesaid decision, it can be discerned that if the taxpayer continues to be a shareholder of the company after the reduction of share capital, it will be considered extinguishment of any part of the right of the shareholder qua the company.

Ruling of the Supreme Court

The Supreme Court observed that “Every return of capital, whether to all shareholders or to one, is pro tanto a purchase of the shareholder’s rights…”. Accordingly, relying on the aforesaid judgements held that the reduction in share capital of the subsidiary company and subsequent proportionate reduction in the shareholding of the taxpayer would fall within the ambit of the expression ‘sale, exchange or relinquishment of the assets’ under section 2(47) of the IT Act. Therefore, the taxpayer’s claim for capital loss incurred due to reduction in capital was allowed as extinguishment of rights of the shareholder.

Similarly, it was observed that when there is a reduction in the face value of the shares, the share capital is reduced. As a result, the right of the preference shareholder to the dividend or his 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. Such extinguishment of rights by virtue of reduction in share capital clearly amounts to a transfer within the meaning of section 2(47) of the Income Tax Act, 1961.

For instance, if such shareholder had a right to dividend on a capital of Rs 500 per share that stood reduced to receiving dividend on Rs 50 per share or, if liquidation was to take place where originally such shareholder had a right to Rs 500 per share which now stood reduced to receiving Rs 50 per share only. Even though the preference shareholder continued to remain a shareholder his right as a holder of those shares clearly stood reduced with the reduction in the share capital.

Conclusion

This is a welcome decision for the taxpayers claiming capital loss on account of a reduction in share capital of the company. For a long time, contradictory positions were taken on this issue, leading to uncertainty and confusion.

The Special Bench of Mumbai ITAT in Bennett Coleman & Co. Ltd v. ACIT^[iv] held that the replacement or substitution of shares will not be considered ‘transfer’. The capital loss arising from the reduction of share capital without consideration would not be permitted. However, this view was later overturned by the Mumbai ITAT in Tata Sons Limited v. CIT,^[v] which allowed the capital loss on the reduction of share capital without consideration.

Further, in this case the Supreme Court referred to the decision of Gujarat High Court in the case of CIT v. Jaykrishna Harivallabhdas,^[vi]wherein it was held that receipt of some consideration in lieu of the extinguishment of rights is not a condition precedent for the computation of capital gains. This decision may provide some guidance in cases involving a reduction of capital without payment of consideration.

Despite this decision of the Supreme Court, there remains a lack of clear guidance on the allowability of capital loss arising from the reduction of share capital. Courts are required to consider various factors, such as the reduction in share price, any extinguishment of rights, and the payment of consideration, before determining the eligibility of a claim for capital loss in cases involving reduction of share capital.

The information contained in this document is not legal advice or legal opinion. The contents recorded in the said document are for informational purposes only and should not be used for commercial purposes. Acuity Law LLP disclaims all liability to any person for any loss or damage caused by errors or omissions, whether arising from negligence, accident, or any other cause.

[i] (2025) 170 taxmann.com 305 (SC).

[ii] (1998) 228 ITR 163 (SC).  

[iii] (1997) 224 ITR 422 (SC).  

[iv] TS-580-ITAT-2011 (Mum).

[v] TS-42-ITAT-2024(Mum)

[vi] (1998) 231 ITR 108 (Gujarat).