Corporate restructuring enables businesses to adapt effectively to market dynamics, enhance operational efficiency, and maximize shareholder value. This is especially crucial when a parent company holds significant investments across diverse subsidiaries. An alternative method, capital reduction u/s 66 of the Companies Act, 2013, allows companies to distribute specific assets directly to shareholders, bypassing cash payments. 

In this article, Rohan Sogani (Partner, R Sogani & Associates) explores different legal aspects under the Companies Act, 2013 and critical tax considerations, such as, capital gains implications and anti-abuse provisions - involved in executing a spin-off via capital reduction, specifically in relation to private limited companies. Emphasizing that it is crucial to distinguish this method from other forms of corporate distributions like dividends or share buybacks, author sets forth the distinct advantages which capital reduction u/s 66 offers.

Author apprises that unlike a Court-approved demerger, a capital reduction is not automatically tax-exempt. Further, elaborating the implications on company transferring assets, as well as that under ITA, author remarks that by demonstrating that shareholders do not gain undue advantages, but rather achieve clearer and distinct ownership structures, the legitimacy and commercial purpose of the restructuring can be established.

"Spin-Off via Capital Reduction – Tax And Company Law Aspects”

1.1.Corporate restructuring enables businesses to adapt effectively to market dynamics, enhance operational efficiency, and maximize shareholder value. This is especially crucial when a parent company holds significant investments across diverse subsidiaries.

1.2. Consider a manufacturing parent company (“X Pvt. Ltd.”) holding significant equity in a hospitality subsidiary ("Y Pvt. Ltd."). Investors interested solely in manufacturing may hesitate due to indirect exposure to hospitality. A clear separation allowing shareholders [say existing shareholders, A, B and C] to directly own shares in both X Pvt. Ltd. and Y Pvt. Ltd. enhances transparency and investment flexibility. Snapshot of the object to be achieved through such restructure is as under:-

1.3. Traditional restructuring approaches, such as direct sales and statutory demergers under the Income-tax Act, 1961 ("ITA"), have notable drawbacks. Direct sales require cash outflows and trigger immediate taxation. Statutory demergers require transferring a defined business undertaking, making them unsuitable for passive investments.

1.4. An alternative method, capital reduction under Section 66 of the Companies Act, 2013, allows companies to distribute specific assets directly to shareholders, bypassing cash payments. This approach effectively achieves a spin-off without meeting the stringent criteria associated with statutory demergers.

1.5. This article explores different legal aspects under the Companies Act, 2013 and critical tax considerations—such as capital gains implications and anti-abuse provisions—involved in executing a spin-off via capital reduction, specifically in relation to private limited companies.

2. WHETHER TO SALE OR DEMERGE?

2.1. Companies seeking to restructure indirect shareholdings into direct ownership typically consider standard methods. However, these conventional approaches often encounter significant tax and procedural challenges, particularly when separating passive investments rather than active business operations.

2.2. A direct sale involves the parent company (X Pvt. Ltd.) selling shares it owns (e.g., in Y Pvt. Ltd.) directly to its shareholders [in this case, A,B,C]. This approach is procedurally simple compared to court-sanctioned methods but requires shareholders to pay cash to X Pvt. Ltd., potentially causing liquidity issues. 

2.3. Another alternative is a statutory demerger under Section 2(19AA) of the ITA, potentially allowing tax-neutral transfer if stringent conditions are met. This involves transferring an undertaking to a resulting company with shares issued proportionately to existing shareholders. A compliant demerger avoids immediate taxation for both company and shareholders, subject to strict conditions like transferring all assets and liabilities, proportionate share issuance, and continuity of shareholding. However, Section 2(19AA) specifically requires transferring an integrated business unit operating independently (an "undertaking"). Passive investments, such as mere shareholding, generally do not meet this requirement, failing the active business or going-concern criteria. Consequently, attempting to demerge passive investments often results in non-compliance and similar tax consequences as a direct sale.

2.4. Given these financial and tax challenges, along with restrictive statutory demerger conditions, companies should consider other flexible restructuring alternatives, such as capital reduction.

3.  SPIN-OFF VIA CAPITAL REDUCTION: AN EFFECTIVE ALTERNATIVE

3.1. Faced with the limitations inherent in direct sales and statutory demergers, particularly when seeking to separate passive investments from a holding company structure, the mechanism of Capital Reduction under Section 66 of the Companies Act, 2013, presents itself as an option which could be explored. 

3.2. A spin-off via capital reduction allows a company (X Pvt. Ltd.) to distribute specific assets, such as shares held in a subsidiary (Y Pvt. Ltd.), directly to its shareholders as consideration for the reduction or cancellation of a portion of its own share capital.

3.3. In essence, this restructuring technique involves X Pvt. Ltd. undertaking a formal reduction of its paid-up share capital. Instead of returning cash to shareholders corresponding to the reduced capital value, X Pvt. Ltd. distributes assets in specie – in this context, the shares it holds in Y Pvt. Ltd. The value of the shares in Y Pvt. Ltd shares effectively substitutes the cash payout that might otherwise occur in a capital reduction. This results in the shareholders of X Pvt. Ltd. receiving direct ownership of Y Pvt. Ltd shares, thereby achieving the desired separation of ownership structures.

3.4 It is crucial to distinguish this method from other forms of corporate distributions like dividends or share buybacks. Dividends, governed primarily by Section 123 of the Companies Act, 2013, must typically be paid out, in cash, of the company’s distributable profits (current or accumulated). Further, Buybacks, regulated under Section 68 of the Companies Act, 2013, involve the company repurchasing its own shares from shareholders, typically for cash consideration. Section 68 imposes several restrictions, including limits based on net worth and debt-equity ratios, and sources from which buybacks can be funded (e.g., free reserves, securities premium). Buybacks primarily result in cash outflow from the company to shareholders and extinguishment of shares, not the distribution of specific assets like subsidiary shares.

3.5. Capital reduction under Section 66 offers distinct advantages in this context. It is not contingent upon the existence of distributable profits, allowing distributions even from capital sources. Crucially, it explicitly permits the return of capital in specie, providing the necessary flexibility to distribute non-cash assets like shares of a subsidiary directly to shareholders in satisfaction of the capital reduction amount. This makes it a particularly suitable tool for achieving a spin-off of investments where profit availability or cash resources might be constraints, or where the specific objective is asset distribution rather than returning cash to the shareholders or consolidating the shares. 

4.    COMPANY LAW FRAMEWORK: SECTION 66, COMPANIES ACT, 2013

4.1. Section 66(1) of the Companies Act, 2013, grants a company the authority, subject to NCLT confirmation and adherence to procedural requirements, to reduce its share capital “in any manner.” This broad phrasing provides considerable flexibility in structuring the reduction. The power must, however, be authorized by the company’s Articles of Association. If the Articles do not contain such authorization, they must first be amended via a special resolution before proceeding with the capital reduction process.

4.2. While Section 66(1) outlines several specific methods for capital reduction, such as extinguishing liability on unpaid shares (clause (a)) or cancelling lost capital (clause (b)(i)), the most relevant method for facilitating a spin-off involving the distribution of assets in specie (like subsidiary shares) is typically clause (b)(ii). This clause permits a company to “pay off any paid-up share capital which is in excess of the wants of the company.” In the context of a spin-off, the company effectively declares that the capital represented by the value of the investment being spun off is surplus to its requirements and proposes to “pay off” this excess capital by distributing the investment asset itself to the shareholders, rather than cash.

4.3. The permissibility of distributing assets in specie as part of a capital reduction under Section 66 has been affirmed, although it requires careful justification. In In re Vodafone India Limited (CP No. 407 of 2017, NCLT Mumbai Bench, Order dated 17 May 2018), NCLT approved a scheme involving the reduction of capital where consideration was discharged by transferring certain assets (investments held by the company) to the shareholder whose capital was being reduced. 

4.4. However, if a capital reduction involving in specie distribution appears designed primarily for tax avoidance or lacks a genuine commercial rationale, it may face scrutiny or rejection. For instance, objections might be raised if the distribution seems to unfairly benefit only select shareholders without a clear business purpose. Therefore, articulating a bona fide commercial reason for the spin-off (e.g., unlocking value, focusing business activities, simplifying group structure) is crucial for obtaining NCLT approval.

5. TAX IMPLICATIONS UNDER THE INCOME TAX ACT, 1961 

5.1.A spin-off via capital reduction triggers several income-tax considerations for both the company and its shareholders. Unlike a Court-approved demerger (which can be tax-neutral if it meets the conditions of Section 2(19AA) and related provisions), a capital reduction is not automatically tax-exempt. The tax effects need to be analyzed in terms of capital gains, deemed dividends, and anti-abuse provisions:

5.2. IMPLICATION ON COMPANY TRANSFERRING ASSETS [X Pvt. Ltd.]:

5.2.i When the company transfers a business or asset as part of the capital reduction (for example, distributing shares of a subsidiary or an undertaking to shareholders), this constitutes a transfer of a capital asset by the company, attracting capital gains tax. In a spin-off, the company is transferring ownership of certain assets (or shares of a subsidiary) and giving them to shareholders, which would come under the definition of transfer as defined in Section 2(47) of the ITA and thus would taxable under the head capital gains. 

5.2.ii Now the question arises, how to determine the “sale price” for the assets given out. Often, the company does not receive money in return – it is extinguishing part of its share capital instead. ITA may deem a fair market value (FMV) in such cases. Section 50CA  provides that if unlisted shares are transferred for a consideration lower than FMV, the FMV is deemed to be the full value of consideration for computing capital gains. 

5.2.iii In a capital reduction spin-off, if the company distributes shares of a subsidiary (Y Pvt. Ltd.) to its shareholders for no monetary payment, technically no consideration is “received” by the company (aside from the reduction of its share capital liability). It can be argued that Section 50CA applies only where some consideration is received or accrues; if no consideration at all is involved, 50CA might not be triggered. One may argue that “received or accruing” in Section 50CA presupposes an actual or enforceable right to receive something, which is absent in distribution of assets to the shareholders via capital reduction. Accordingly, there may be a scenario that the shares may be transferred to the shareholders, through the route of capital reduction, and there may not be any applicability of Section 50CA as there is no consideration occurring or received by the company transferring the shares. 

5.3. TAX FOR SHAREHOLDERS – DEEMED DIVIDEND AND CAPITAL GAINS:

From the shareholder’s perspective, a capital reduction is effectively a corporate action where they give up part of their shareholding (or share value) in exchange for some form of payout (cash, assets, or new shares). The implication under ITA can be at the two levels. 

5.3.i Deemed Dividend (Section 2(22)(d)): To the extent that the company is distributing its accumulated profits in the by way of capital reduction, such distribution is treated as a dividend for tax purposes. Section 2(22)(d) of the Income Tax Act, 1961 specifically includes “any distribution by a company to its shareholders on the reduction of its capital, to the extent of the accumulated profits of the company (whether capitalized or not)” as a deemed dividend. In other words, the portion of the spin-off payout that is attributable to the company’s profits will be taxed as if it were a normal dividend paid to the shareholder. 

5.3.ii Capital Gains for Shareholders: If the amount (or value of assets) received by a shareholder exceeds the accumulated profits of the company, the excess represents a return of capital. The cancellation or reduction of shares in the reduction process is treated as an extinguishment of the shareholder’s rights, which is a “transfer” of a capital asset under Section 2(47). From the shareholders perspective Section 50CA impact also has to be considered. 

5.3.iii Receipt of Shares or Assets at lesser than the Fair Market Value : In a spin-off via capital reduction, shareholders typically receive shares of Y Pvt. Ltd. or specific assets rather than cash. This raises the tax consideration under Section 56(2)(x) of the ITA, which taxes recipients of assets (including shares) obtained without consideration or below fair market value, treating the difference as income from other sources. However, in a well-structured spin-off, shareholders receive new shares or assets proportionate to their existing shareholding. This pro-rata distribution does not result in enrichment for any shareholder at the expense of others; rather, it represents a rearrangement of their existing investment. As shareholders surrender a portion of their original shares in exchange for new shares or assets, Section 56(2)(x) typically does not apply, since there is no gratuitous transfer or undue benefit. Even in selective capital reduction scenarios—where only certain shareholders have their shares cancelled—remaining shareholders merely experience an increase in their ownership percentage without acquiring new property. Thus, no transfer of assets triggering Section 56(2)(x) generally occurs. However, if the spin-off structure results in a disproportionate allocation or selective benefit to particular shareholders, the excess benefit received could potentially trigger Section 56(2)(x). 

6. CONCLUSION 
In conclusion, a properly structured spin-off through capital reduction generally does not result in gains either for the company or its shareholders. Post-spin-off, shareholders retain an equivalent overall shareholding value as prior to the restructuring. Proper documentation and clearly articulated rationale can effectively address and counter any allegations of the restructuring being a colourable device. By demonstrating that shareholders do not gain undue advantages, but rather achieve clearer and distinct ownership structures, the legitimacy and commercial purpose of the restructuring can be established.