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Runit Rathore and Yashashvi Sharma*
I. INTRODUCTION
Recently, in the case of Principal Commissioner of Income Tax-4 & Anr. v. M/S. Jupiter Capital Pvt. Ltd., the Supreme Court (SC) cleared the air on whether reduction in a company's share capital constitutes a “transfer” under Section 2(47) of the Income Tax Act, 1961 (IT Act). Capital reduction is the process by which a company reduces its equity through the cancellation or repurchase of shares held by its shareholders. This process may result in either a capital gain or a capital loss, depending on the acquisition cost of the shares and the consideration received during the reduction. To determine whether a capital gain or loss has occurred, it is crucial to establish that a “transfer” has taken place, which was the central issue before the court.
The SC’s ruling carries significant implications, as losses incurred from a reduction in share capital can now be leveraged by taxpayers to claim benefits under the IT Act. While gains from such a capital reduction will be taxable as capital gains, taxpayers can offset losses arising from the reduction to avail themselves of tax advantages. The Court's reasoning heavily relied on the precedent set in Kartikeya V. Sarabhai v. Commissioner of Income Tax (Kartikeya Case), However, the author is of the opinion that such reliance is not free from defects. There are certain inconsistencies in the SC’s interpretation, which affect the taxability of the capital gains under Section 45 of the IT Act.
This piece critically analyzes the judgment by first addressing the issue that the proportion of shareholding was unchanged even after capital reduction and its implications on the shareholders rights. It then emphasizes that the court overlooked the distinction between preference and ordinary shareholders and it also argues that capital reduction should not be equated with the buy-back of shares. The post concludes with summarising key insights and a proposed way forward to resolve the conundrum.
II. FACTUAL BACKGROUND OF THE CASE
In the present case, M/s Jupiter Capital Pvt. Ltd. (Respondent) was engaged in the business of investing and financing and held a 99.88% stake in Asianet News Network Pvt. Ltd. (ANNPL). Due to financial losses, ANNPL sought approval from the Bombay High Court for a reduction in share capital to offset losses. The court approved the reduction, lowering the total shares from 15.35 crores to 10,000, which resulted in proportionate reduction of the Respondent's shares from 15.33 crores to 9,988, while maintaining the face value at Rs.10 per share. It also received Rs.3.17 crores as consideration.
The Respondent claimed a long-term capital loss arising from this reduction, but the Assessing Officer disallowed it, asserting that such loss does not fall within the ambit of “transfer” as envisaged under Section 2(47). However, the Income Tax Appellate Tribunal ruled in favor of the company, which was subsequently upheld by the Karnataka High Court (HC). The Revenue authorities later challenged the order of the HC before the Hon’ble Supreme Court.
III. RULING OF SUPREME COURT
It is to be kept in mind that claiming long-term capital loss as a deduction has been a long-standing issue before the tax authorities. In Vania Silk Mills (P) Ltd. v. Commissioner of Income Tax, Ahmedabad, the SC ruled in favor of the assessee, holding that the insurance compensation received for the destruction of machinery was not subject to capital gains tax under Section 45 of the IT Act. In Bennett Coleman & Co. Ltd, Mumbai v. Assessee , the assessee was denied the benefit under Section 45, as the tribunal held that capital reduction did not constitute a transfer under Section 2(47). It was further held that even if there was an extinguishment of rights in shares, it would not amount to a transfer under Section 2(47). Thus, there are diverging opinions of the courts on the interpretation of the term ‘transfer’ in the realm of tax matters.
The SC, in the present case, upheld the decision of the HC, by observing that such capital reduction constitutes a “transfer” under Section 2(47). The Court observed that when capital reduction occurs by lowering the face value of shares, it impacts the shareholder's rights, such as share capital and the distribution of net assets in the event of liquidation.
It went on to observe that although the taxpayer still remains a shareholder in the company following the capital reduction, the process ultimately results in the extinguishment of rights of certain shareholders. However, the judgment lacks further explanation for this latter observation. The SC relied on the Kartikeya Case, which established that sale is just one method of transfer, and relinquishing assets or the extinguishment of rights also qualifies as a “transfer” under Section 2(47). Thus, the court aligned the reasoning of the precedent in the case in hand, and held that such reduction also falls within the umbrella term of ‘transfer’. Hence, the SC dismissed the petition by the Revenue authorities.
IV. ANALYSIS
A. Unchanged Proportion and Its Impact on Shareholder Rights
Despite a significant reduction in the number of shares held by the assessee, the proportion of shares remained unchanged at 99.88%, even after the capital reduction. Since the proportion remains the same, it would not affect the rights of the shareholders, as their value in the company is still intact. Although certain rights, such as the dividend amount were reduced, the shareholders received consideration for this reduction.
This transaction cannot be classified as a “transfer” under Section 2(47), as it does not constitute a sale. Attempting to fit the transaction within the section through any other means would be futile. It also cannot be regarded as an “exchange”, as the definition provided in Section 118 of the Transfer of Property Act (TPA) is not applicable in this context, which defines an exchange as a mutual transfer of ownership between two parties, where one asset is given in return for another. In Commissioner of Income-Tax v. G. Narasimhan, the Madras High Court cautioned against directly applying the TPA definition of “exchange” to tax laws. The Court emphasized that in an exchange, there must be a reciprocal transfer of assets between two parties. Instead, the court in the same case emphasised that the general meaning of “exchange” must be considered, where one thing is exchanged for another. In this case, the company does not receive anything in return, as the shares are eventually cancelled. Furthermore, the transaction cannot be regarded as a relinquishment. “Relinquishment”, in the context of Section 2(47), refers to an act of giving up ownership of a capital asset without receiving any payment or compensation, such as through a gift or voluntary surrender. However, this does not apply in the case of capital reduction as the shareholder’s proportionate rights in the company remain unchanged and reduction does not alter their ownership stake relative to other shareholders. At the time of liquidation as well, the assessee would receive the same percentage of assets as they held prior to the capital reduction. The possible argument of an assessee receiving a lesser amount due to the reduction runs on the assumption that company will not prosper in the future and it is pertinent to mention that such assumption was deemed invalid by the Madras High Court. In this case, the assessee was a shareholder in a company, wherein the share capital was reduced and following the reduction of assets and payment of proceeds to the shareholders, the question arose whether the transaction resulted in a “transfer” under Section 2(47) IT Act. The court opined that no transfer had taken place and the contention that the shareholders might receive lower amounts in a future liquidation was deemed irrelevant, as the right to receive assets arises only upon actual liquidation. Until that event occurs, no conclusion can be drawn regarding any extinguishment of rights. In the same case, it was also clarified that reliance on Section 48 of the IT Act, which outlines the method for calculating capital gains by deducting the cost of acquisition and transfer expenses from the full consideration received, is misplaced in the context of capital reduction. The Court held that it is impossible to ascertain the cost of acquisition or transfer in such cases, further supporting the argument that capital reduction does not qualify as a "transfer" under Section 2(47) of the IT Act.
B. Distinguishing Preference and Equity Shareholders
The SC failed to distinguish between preference and ordinary shareholders in its ruling. It relied on the Kartikeya case, which involved a reduction in share capital affecting preference shareholders. However, the present case pertains to ordinary shareholders, specifically equity shareholders, who have distinct rights from preference shareholders. In Kartikeya Case, it was established that preference shareholders may be deemed to have relinquished their rights in the event of capital reduction, as they are entitled to a fixed dividend and a preferential claim on assets during liquidation. These constituted a substantial part of the Court's reasoning in that case. However, applying such reasoning in the present case is far-fetched since ordinary shareholders have equal and similar rights, and no preferential treatment or fixed entitlements are involved. Moreover, according to the waterfall mechanism given under Section 53 of the Insolvency and Bankruptcy Code, equity shareholders are the last in the priority of payment, in contrast with preference shareholders. By failing to account for this distinction, the SC not only misapplied the Kartikeya Case ratio but also made a precedent that blurs the fundamental differences between equity and preference shareholders. This oversight could lead to an erroneous interpretation of shareholder rights in future cases, particularly in matters of capital restructuring, where the financial and legal consequences for equity shareholders differ significantly from those of preference shareholders. As in the context of capital reduction, preference shareholders are generally less affected, as they receive greater protection due to their priority claims on dividends and assets in liquidation. However, equity shareholders, who do not have such fixed entitlements, are more vulnerable to fluctuations in ownership percentage and potential earnings per share. Capital reduction can lead to a decrease in the overall value of their holdings without any guarantee of proportional compensation.
C. Capital Reduction vs. Buy-back of Shares
The SC also relied on Anarkali Sarabhai v. Commissioner of Income Tax, wherein it was held that the reduction of share capital and the redemption of shares entails the same meaning of the purchase of its own shares by the company. However, the SC failed to distinguish between capital reduction and a buy-back of shares. The National Company Law Tribunal (NCLT) held that once a company receives approval from the NCLT for capital reduction, it can repay the shareholders, and this would not be characterized as a buy-back of shares. Similarly, Re L&T Investment Management Limited clarified the distinction between capital reduction and buy-back. In a buy-back, the company first acquires the shares from the shareholders and subsequently cancels them. In contrast, in capital reduction, the shares are cancelled immediately upon receiving approval from the NCLT.
Therefore, in a buy-back, a transfer can be said to occur, as the company purchases the shares from the shareholders and pays them consideration, resulting in an exchange. However, in capital reduction, while shareholders may receive some consideration, the company does not gain any new asset or right in return. The reduction merely alters the capital structure by reducing the number or value of shares without any reciprocal benefit to the company. Since a “transfer” under Section 2(47) implies an exchange of rights or assets between parties, the absence of any corresponding acquisition by the company in capital reduction prevents it from being classified as a transfer. Thus, the SC erred in equating capital reduction with a buy-back of shares.
V. CONCLUSION AND WAY FORWARD
The judgment of the Hon'ble SC raises the issue of capital reduction regarding the interpretation of “transfer” under Section 2(47) of the IT Act. This is particularly crucial in cases of proportional reduction, where shareholder ratios remain unchanged and ambiguities persist regarding tax liability. Hence a more thorough and broader explanation must be given while dealing with the cases of proportional reduction, ensuring tax neutrality for such scenarios. A clear distinction between different types of shareholders needs to be established when determining the tax implications of capital reduction. Legislative amendments should clearly define the distinct rights and obligations of different shareholder classes to prevent the misapplication of legal precedents. Furthermore, precise boundaries for what constitutes a transfer in such cases must be established. While capital reduction typically involves cancellation without reciprocal transfer and does not amount to purchasing from shareholders, the differentiation must be clearly outlined to avoid misinterpretation and maintain consistency in the application. These steps would provide a judicious application of the provisions, foster transparency, and align tax implications with the economic realities of capital reduction transactions.
*Runit Rathore and Yashashvi Sharma are third year law students at Hidayatullah National Law University, Raipur.
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