Tax Consequences When Changing Share Capital

Decreasing a business’s issued, registered, and paid-up share Capital is what is meant by “reduction of share capital” in Section 66 of the Companies Act, 2013. Such decrease may be selective for a certain class of shares and may take many forms, either with or without payment. It does not, however, cover share buybacks.

Companies frequently utilize share capital reduction as a tool for internal restructuring or capital structure modification.

A company may reduce its capital for several reasons, such as decreasing cumulative losses, cancelling the capital of some shareholders, or returning excess cash to shareholders. Understanding company rules, accounting, and tax are necessary for the capital reduction strategy. The specifics about these factors will be covered in this article: –

What is Alteration of Share Capital?

Alteration of share capital is the act of altering the capital structure of a business by modifying the rights linked to existing shares or by adding or lowering the number of shares. It may be carried out for several purposes: capital raising, share consolidation, share class conversion, and share cancellation. Changing the share capital is a difficult procedure that entails adhering to legal and regulatory standards.

The several facets of changing the share capital will be covered in this blog, including the justifications, the different types, the rules and regulations, and the method.

Capital Reduction Tax Implications

The following are the tax ramifications of capital reduction in the control of different parties:

Deemed Dividend: According to Section 2(22)(d) of the Income Tax Act 1961, the business’s capital decrease is regarded as a dividend payout. Such a dividend payout would be subject to shareholder taxation. Nevertheless, the amount that would be considered a dividend would be limited to the amount of accumulated earnings.

Taxed in the hands of the shareholders: – Any distribution that exceeds accumulated earnings will be subject to capital gains tax in the shareholders’ ownership. Yet, the purchase cost in the shareholders’ hands must be reduced to calculate such gains. Additionally, a non-resident shareholder may choose to be taxed under the provisions of the IT Act or claim the benefits of the tax treaty, whichever option is most advantageous.

Capital reduction on accumulated losses: – Any long-term capital loss incurred by the shareholder due to a company’s capital decrease without payment is permitted. However, there are also opposing decisions that indicate the opposite.

Landmark Decisions

The Madras High Court ruled in the dispute of Narasimhan (1999) that a decrease in share capital will end up resulting in a decrease in shareholders’ rights and, as a result, will constitute a transfer for purposes of Section 45 of the Income Tax Act of 1961, allowing shareholders to realize capital gains. In Kartikeya v. Sarabhai (1997), the Supreme Court ruled that when a share’s face value is decreased, the rights are extinguished, and the money is taxed as “capital gains.”

Reasons for Share Capital Change

A company’s share capital may change for a variety of reasons. Several of the frequent causes are:

• To raise money: Businesses could need to raise more money to pay for growth plans or to cover working capital needs. They can issue additional shares and raise money from the market thanks to the alteration of share capital.
• To combine shares: Businesses may have a lot of shares with small denominations, which can make managing their share capital challenging. By increasing the share capital, they can combine their shares into bigger denominations, simplifying management.
• To transfer shares from one class to another: Businesses may have many share classes, each with unique rights. They may transfer shares from one category to another by altering share capital.
• To cancel shares: Businesses’ financial statements may be impacted if they have cancelled or remaining shares on their balance sheet. They may terminate these shares and enhance their financial accounts by changing the share capital.

Kinds of Alteration of Share Capital

There are separate methods to modify the share capital under Section 61 of the 2013 Companies Act:

1. Subdividing the Shares

The worth of the shares that shareholders own can also be divided to alter a company’s share capital. Under Section 61, the Company may subdivide its shares of greater denomination into shares of lower denomination. The corporation may act this way only if the association’s agreement enables it. The requirement that must be satisfied if partly paid-up shares are split is that the distinction between the paid-up and outstanding amounts stays the same. Shareholders own more shares with smaller denominations due to this approach of altering share capital.

2. To increase capital authorization

Approved capital is often referred to as registered or nominal capital. This sum of money is required to launch a business. The corporation can raise more capital by changing the capital provision in the memorandum of association.

3. The exchange of shares for stock

The Company may convert all paid-up shares into stock to alter the capital of its shares. Stock is the aggregate amount of fully paid-up shares. Only if permitted by its articles of association may the Company act this way. Additionally, the Company may exchange its stock for new shares.

4. Consolidation of Shares

By merging shares of smaller denominations into shares of bigger denominations, the corporation can also adjust its share capital. The governing body or court must approve if the consolidation alters shareholders’ ability to vote.

5. Termination of the Unissued Shares 

The corporation may also cancel any unpaid obligation. However, the share capital is unaffected by this. When utilizing this procedure, there is no journal record and no treatment in the accounting books.

Legal Conditions for Share Capital Changes

Changes to share capital are subject to several legal and regulatory criteria. Among the most important legal criteria are:

• Shareholder approval: Any modification to the share capital has to be authorized by the business’s stakeholders by a special resolution adopted at a general meeting.
• Consent from regulating authorities: Some changes may need the consent of regulatory organizations, including the RBI, SEBI, and the Registrar of Companies.
• Document filing: Following shareholder and regulatory authority approval, the firm must file the required paperwork with the Registrar of Companies, including the amended articles of organization and memorandum of association, and acquire a registration certificate.

Share Capital Reduction Techniques

A company may decide to reduce its share capital by: –

• Extinguishment of shares: Where the capital has not been paid up, the firm may cancel or lessen the obligation of its shares. For example, certain equity shares have a face worth of Rs. 500, of which Rs. 400 were previously paid. In this scenario, the corporation can cancel the final liability of Rs. 100 and forego paying the uncalled capital.
• Cancellation of shares: Paid-up shares that have lost price or are no longer accessible as an organization may cancel assets. Extinguishing the shares or lowering liabilities are optional. Take this as a case study. Assume 100 fully paid-up shares, each worth 200 rupees, represent assets. The outcome is that the business can cancel 100 rupees worth of shares and write off equivalent amounts of assets, which is typically the debit amount of the profit and loss account.
• Pay-off: If a business has extra paid-up shares, it may pay them off with or without extinction of the shares or reduced liability. For instance, if the worth of fully paid-up shares is 100 rupees, it can be lowered to 60, with the remaining 40 rupees being refunded to shareholders.

Basic and Required Rules That Must Be Obeyed

First step: If a business’s articles of association do not allow or sanction an increase in share capital, then it must be done to change them. A company must review and analyze whether the business has permission to do so on the face of it.

Second step: The firm must earn other people’s trust. A board meeting must be held for the board to be able to call for a special general meeting, and obtaining shareholder approval for raising the authorized share capital is mandatory.

Third step: The business then calls for a special meeting of the investors by sending them a notice that includes a clear agenda, appropriate explanatory statements, clarification, and justification, as well as the resolutions that need to be passed in order to change the articles of association and memorandum of association, which are to be changed in order to increase the authorized share capital.

Fourth Step: The Company’s permitted capital will then be increased, and the rules of association and memorandum of association will be changed accordingly. After finishing the entire procedural process, the business gives the board the go-ahead to file the required documents and decisions with the ROC with jurisdiction.

The corporation may enhance its share capital by issuing additional shares if it deems it essential and appropriate for growth. A business may combine and split all or a portion of its share capital into several shares. Additionally, a business may divide its lesser-value shares. It may cut its share capital and reject any shares not purchased.

Registration Notice

The registrar must receive notice of any modification from the business’s hands within 30 days; failure to do so might result in severe penalties under the law.

Modification of Share Capital with Various Journal Entry Methods

Increase the approved capital by the number of additional shares if an organization wishes to raise its authorized capital above the amount of share capital to grow its share capital. A completely paid-up share, regardless of denomination, may be converted into stock in its entirety or part, and vice versa.

Provisions for change

If the Articles of Association have a framework for such an amendment, the capital clause may be changed; otherwise, adopting a special resolution would be the first necessary step. The fundamental rule for modification is that the change in share capital must be genuine and in the Company’s best interests.

In most cases, an ordinary resolution is sufficient to change the capital clause, in which case notification of the change must be sent to the ROC when the share capital increases immediately. The capital of a corporation is also increased through a loan from the federal government.

Conditions for Share Capital Alteration

The Articles of Association must allow the business to change its share capital. The firm must be restricted by shares, restricted by guarantee, and restricted by share capital.

Changes to share capital may be made by

Altering the share capital can be accomplished in many ways, including by issuing new company shares into the market, consolidating existing shares, converting existing shares, subdividing existing shares in the market, and removing unoccupied shares from the market.

Share Capital May Boost Immediately

When an authority directs that a debenture or portion of a debenture granted to a government under such conditions be transformed into shares upon the issuance of new capital by the firm.

Conclusion

Changing the share capital is essential for businesses since it enables them to modify their capital structure to suit their demands. To be compliant with legal and regulatory regulations it is a difficult task. Before beginning the procedure, businesses must carefully analyze the justifications for the adjustment, the nature of the alteration, and the regulatory requirements. Businesses can effectively change their share capital and accomplish their business goals by following the right method and receiving the required permissions.

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