The recent Supreme Court’s judgement in the case of Jupiter Capital Pvt. Ltd.[1] has brought the focus on taxability of a capital reduction transaction. With this thought in mind, we thought it apt to revisit two landmark Supreme Court judgements on this topic.

Capital gains taxation was first introduced in India in 1946 under section 12B of the 1922 Act. Section 12B covered ‘sale’, ‘exchange’, ‘relinquishment’ or ‘transfer’ of a capital asset, with the term ‘transfer’ being undefined. Since 1939, distribution on reduction of capital was included within the definition of ‘dividend’ under section 2(6A)(d) of the 1922 Act.

In the 1961 Act, the charge of capital gains tax was created by section 45 and the term ‘transfer’ was defined in section 2(47) to include ‘sale, exchange or relinquishment’ of a capital asset (clause (i) ), as well as ‘extinguishment of any rights therein’ (clause (ii) ).[2] Section 2(22)(d) of the 1961 Act was enacted in the same terms as its predecessor provision section 2(6A)(d) of the 1922 Act. The Supreme Court in the case of Kartikeya V. Sarabhai vs CIT[3] held that reduction of share capital by a company by paying off a part of the capital and reducing the face value of the shares would result in extinguishment of proportionate rights[4] in the shares held by shareholder, so that amount paid by company to shareholder on reduction of share capital would be liable to capital gains tax in the hands of shareholder under section 45. The interplay of capital gains tax provisions and dividend taxation under section 2(22)(d) was not a matter before the Court in this case.

Section 46(2) of the 1961 Act provides that where a shareholder receives any money or other assets from the company on its liquidation, he shall be chargeable to capital gains tax on the money so received or market value of other assets, as reduced by the amount assessed as dividend under section 2(22)(c) of the 1961 Act[5], and the difference shall be deemed to be the full value of consideration for capital gains tax purposes.

There is however no provision dealing with the manner of adjustment of amount assessed as deemed as dividend under section 2(22)(d) while computing capital gains tax on a reduction of share capital to prevent double taxation of the same receipt.

This aspect came to be raised before the Supreme Court in the case of CIT vs. G. Narasimhan.

In this case, the taxpayer, who was a shareholder in a company named Kasthuri Estates Pvt. Ltd., held 70 shares having face value of Rs. 1,000 per share. The company undertook a capital reduction and the face value of the shares was reduced from Rs. 1,000 each to Rs. 210 each. As a result of this reduction of capital, there was a pro-rata distribution of some properties of the company and payment of money to the shareholders including the taxpayer. 

The Income-tax Appellate Tribunal held that no capital gains accrued to the taxpayer as there was no extinguishment of any rights of the taxpayer, and, consequently, there was no ‘transfer’ within the meaning of section 2(47). The Madras High Court, in a reference from the Tribunal[6], upheld the order of the Tribunal. The matter travelled to the Supreme Court by way of an appeal against the judgement of the High Court.

The Supreme Court observed that money and other assets received by the taxpayer from the company on reduction in the face value of his shares is a capital receipt subject to section 45, relying on the principle laid down by it in the case of Kartikeya V. Sarabhai.

Considering the provisions of section 2(22)(d), the Court observed that it is only when any distribution is made which is over and above the accumulated profits of the company that the question of a capital receipt in the hands of a shareholder arises. It also observed that the cost to the shareholder of the acquisition of that right in the share which stands extinguished will have to be deducted from the capital receipt so determined to compute the capital gains taxable under section 45. Only when the capital receipt is in excess of the cost of the acquisition of such interest which stand extinguished, will any capital gains arise. Thus, the Court held that to the extent of the accumulated profits in the hands of the company, the return to the shareholder is a return of such accumulated profits, and would be taxable as dividend under section 2(22)(d). Only the balance, if any, would be subject to tax as capital gains under section 45.

The principle laid down by the Supreme Court in this case is that, even in absence of a provision such as section 46(2) applicable in the context of a capital reduction, the amount assessed as deemed dividend under section 2(22)(d) should be reduced for the purpose of determination of full value of consideration for levy of capital gains.

The Court was not required to examine, and therefore did not provide any guidance on, how the assets received by the taxpayer had to be valued, or the determination of the cost of acquisition of the right in the shares which stand extinguished on reduction of capital.