This article has been written by Palak Gupta pursuing the Diploma in General Corporate Practices from LawSikho. This article has been edited by Tanmaya Sharma (Associate, Lawsikho) and Smriti Katiyar (Associate, Lawsikho).
Table of Contents
Introduction
Restructuring of a company takes place by capital reorganization where the surplus money is given to the shareholders. There can be many other reasons for reducing the share capital, such as lack of funds. The reduction of the share capital of a company includes reducing the same amount of shares of the company on similar terms and conditions offered to all the shareholders whose shares are being reduced by the company. On the other hand, a ‘selective’ reduction of the share capital of a company means differentiating between shareholders of the same class by reducing the capital of some shareholders and leaving the remaining shareholders of the company untouched (i.e., their shares are not reduced). The need to reduce share capital may arise in several situations, such as assets of reduced value and accumulated business losses. Resultantly, the company’s share capital is lost, and the company is on its own to find more resources to keep going. Therefore, in both these cases, the company has to adjust its capital according to the situation. Here’s how this can be done without the sanction of the Court:
Reasons for reduction of share capital
The need to reduce the share capital may arise for various reasons such as pare off debt, capital expenses, distributing assets to shareholders, making up for trading expenses etc. Most companies have more reserves and resources than they can use. Additionally, when the company is suffering losses, the financial position is not shown appropriately. The balance sheet may have fictitious assets with debit balance in profit and loss account, and the assets are overvalued. In this situation, to reduce the share capital, this portion will have to be written off; only then will the balance sheet look good.
Modes of reduction of share Capital
There are three modes for reducing the share capital. They are:
- Extinguish or Reduce the Liability;
- Cancel any Paid-up Share Capital;
- Pay off any Paid-up Share Capital.
- Extinguish or Reduce the Liability
The company can reduce the share capital by extinguishing or reducing the liability on its partly paid-up shares. E.g., if the shares are of face value Rs. 100, each of which Rs. 60 has already been paid, it can lower them down to Rs. 60 fully paid-up shares. Therefore, relieving the shareholders from the liability of the uncalled capital of Rs. 40 per share.
- Cancel any Paid-up Share Capital
Another way of reducing the share capital is to cancel the shares which are unrepresented by available assets or are lost. E.g., the shares are of face value Rs. 100, each fully paid, and these shares are represented by Rs. 75 worth of assets. In this situation, the share capital can be reduced by cancelling Rs. 25 per share and writing off the same amount of assets.
- Pay off any Paid-up Share Capital
The company may reduce the share capital by paying off fully paid-up shares that are more than the company’s wants. E.g. the shares are of face value Rs. 100, each fully paid, can be lowered down to the face value of Rs. 75 per share by paying back Rs. 25 per share to the shareholders.
Statutory requirements
Section 66 of the Companies Act, 2013 (“Act“) lays down the requirements and provides disclosures for reducing the share capital. Every company must fulfil these requirements because a company’s share capital is the only security that the shareholders have; hence, reducing the same leads to diminishing the fund out of which they are to be paid. Therefore, it is closely guarded by this section, providing a safe route for reducing it in case it becomes necessary to do so.
This section states that on application, a company limited by guarantee or limited by shares and having a share capital may be allowed to reduce its share capital by passing a special resolution, subject to the confirmation of the National Company Law Tribunal (“Tribunal”). [Sub-Section 1]
As mentioned above, the share capital of a company can be reduced by extinguishing or reducing the liability, cancelling any paid-up share capital and paying off any paid-up share capital. [Sub-Clause a and b of Sub-Section 1]
This section further states that a company cannot reduce its share capital if it has any arrears and has not repaid any deposits accepted by it before or after the commencement of the Act or the interest payable thereon. [Proviso of Sub-Section 1]
On receiving the application of reduction of share capital by a company, the Tribunal must give notice to the Central Government, Registrar of Companies (“ROC”), Securities and Exchange Board of India, and in case of listed companies, to the company’s creditors. It shall consider the representations made to it within three months by the authorities mentioned above from the date of receipt of the notice. [Sub-Section 2]
Suppose it does not receive any representation by them within the said period. In that case, it shall be assumed that they do not have any objection to the share capital reduction of that particular company. [Proviso of Sub-Section 2]
If the Tribunal is satisfied that the claim or debt of the company’s creditors has been discharged or secured or his consent has been obtained, it will confirm the share capital’s reduction on such terms and conditions as it deems fit. [Sub-Section 3]
Provided that, the Tribunal will not sanction any application until the accounting treatment proposed by the company conforms with the accounting standards specified in section 133 or any other provision of this Act. And a certificate to that effect by the company’s auditor has been filed with the Tribunal. [Proviso of Sub-Section 3]
The company is obligated to publish the order of confirmation given by the Tribunal as it may direct. Additionally, the company must deliver a certified copy of the Tribunal’s order to the ROC within 30 days of receiving the copy of the order, who shall register the same and issue a certificate to that effect. The certified copy must mention the amount of share capital, the number of shares into which it is to be divided, the amount of each share and the amount, if any, at the date of registration deemed to be paid upon each share. [Sub-Section 4 and 5]
Implications under the Income Tax Act, 1961
When a company’s share capital is reduced by paying off part of the share capital or reducing the face value of shares, it extinguishes the shareholders’ rights to the extent of share capital’s reduction. Therefore, it is known as transfer under Section 2(47) of the Income Tax Act, 1961 (“IT Act“) and would be chargeable to tax. The income received on capital reduction would be taxable as under:
- The amount distributed by the company on reducing its capital to the extent of its accumulated profits will be known as deemed dividends under Section 2 (22) (d) of the IT Act. Also, the company is obligated to pay dividend distribution tax on the same.
- Distribution over the accumulated profits above the original cost of shares’ acquisition would be chargeable to capital gains tax in the hands of the shareholders.
Reduction of capital without Tribunal’s sanction
As explained above, the reduction of share capital can be carried out by following those requirements. However, if a company wants to reduce its share capital without following those prerequisites (i.e., without the sanction of the Tribunal), it can do so by buy-back of its shares. If the Articles of Association of the company allow, it can forfeit the shares for non-payment of calls by the shareholders. Doing this will enable the company to reduce its share capital, thus fulfilling the purpose without the sanction of the Tribunal.
Conclusion
Sometimes, it becomes necessary for a company to reduce its capital, and section 66 of the Companies Act, 2013 provides a guarded mechanism for the same. The reduction of the share capital of a company has a direct impact on its creditors; therefore, a proper procedure has been laid down for the sole purpose of protecting the creditors from any harm.
Three things must be kept in mind to ensure a successful reduction of capital of the company. They are: the reduction of the share capital must be fair and equitable, majority of the minority shareholders should approve the reduction of capital, and a fair methodology must be adopted for valuation of the shares.
It becomes difficult for the courts to figure out the reason behind reducing the company’s share capital (be it rearranging its balance sheet or inducing to drive out the minority shareholders). In any case, it is the company’s responsibility to prove that reducing its share capital will not harm the minority shareholders in any way.
References
- http://ebook.mca.gov.in/default.aspx
- https://www.incometaxindia.gov.in/pages/acts/income-tax-act.aspx
- https://taxguru.in/company-law/reduction-share-capital.html
- https://huconsultancy.com/reduction-of-capital/
- https://www.legalindia.com/question/under-what-circumstances-reduction-of-share-capital-with-sanction-of-the-court-is-possible/
- https://thecompany.ninja/section-66-reduction-of-share-capital/
- https://indiacorplaw.in/2017/12/can-company-selectively-reduce-capital.html.
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