The Hindu Business Line : 'Deemed dividend' in capital reduction versus buyback

CHENNAI: Colgate Palmolive India Ltd recently informed the bourses about a 'deemed dividend' at Rs 9 per share, apart from a special '70th anniversary dividend of Rs 2 per share'. The deemed dividend is proposed to be through a return of Rs 122.40 crore (excluding dividend distribution tax) to shareholders. "The same will not be liable to tax in the hands of shareholders," clarified the company.

The announcement had more details, such as that the reduction of capital, which is in excess of the company's operational needs, is proposed under Section 100 of the Companies Act, 1956 and would be achieved by reducing the face value of the existing sha res from Rs l0 per share to Re 1 per share. The number of shares issued, paid-up and outstanding and the pattern of shareholding are to remain unchanged, and the 'reduction' proposal is subject to 'approval by the shareholders at the ensuing annual gener al meeting and confirmation by the Bombay High Court'.

To know more about the law on the subject, Business Line spoke to Mr Sandeep Chaufla, director, tax and regulatory services, BSR & Co, a firm of chartered accountants. He has over 14 years of experience in advising clients on issues relating to in ternational taxation, interpretation of treaties, cross-border transactions and corporate taxation.

Excerpts from interview.

What is the law about 'deemed dividend'?

In common parlance, return of capital to the shareholders should not have any tax implications either for the company that is reducing its share capital or for the shareholders who are receiving back a part of their investment. However, Section 2(22)(d) of the Income Tax Act, 1961 deems, as dividend in the hands of the shareholders, distribution to the shareholders by the company, on reduction of capital (to the extent company possess accumulated profits).

Any significant legal precedents of relevance?

Yes, there are. The Supreme Court in the case of Kartikaya V. Sarabhai vs CIT (228 ITR 163), held that reduction in face value of a share amounts to extinguishment of rights in such share, resulting in capital gains, and stated that the assessee in that case was liable to pay capital gains tax as result of reduction in the face value of shares of the company.

The controversy whether reduction of share capital is 'deemed dividend' or results in capital gains was put to rest by a subsequent decision of the Supreme Court in the case of CIT vs G. Narasimhan (decd.) and others (236 ITR 327), wherein it was held th at the amount distributed by the company on reduction of its share capital has two components - distribution attributable to accumulated profits of the company and distribution attributable to capital (except capitalised profits).

Which is why, we have the stipulation of 'to the extent of...'?

True. The apex court held that the distribution to the extent of accumulated profits is a return of accumulated profits to the shareholders, and is therefore, to be treated as deemed dividend. Accordingly, distribution over and above the accumulated prof its (after reducing the cost of shares) would be taxable as capital gains.

On the move by Colgate.

Applying the above logic to Colgate's case, the return of capital to the shareholders upon its reduction would be treated as deemed dividend in the hands of shareholders, to the extent of accumulated profits of the company. Since such distribution of div idend is by a domestic company, the same would be exempt in the hands of shareholders under Section 10(34) of the Income Tax Act. However, the company would be liable to pay dividend distribution tax at 16.995 per cent (considering the Budget proposal fo r 2007) on the amount distributed to shareholders as a result of capital reduction.

What could have been an alternative course?

As an alternative, a company may return proportionate capital to its shareholders under a buyback scheme under the Companies Act read with the relevant rules.

How different would the tax impact be, then?

Buyback of shares is not considered as deemed dividend; but it is considered as a 'transfer' for the purpose of capital gains. Taxation in the hands of the shareholders as well as levy of STT (securities transaction tax) would depend on the status of the company, whether the shares are listed or not, and the manner in which the buy-back scheme is effected.

D.Murali

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