Tax on reduction of capital: Here’s how shareholders will get affected

livemint.com:

The news of an unlisted subsidiary of a large listed company recently deciding to cancel all the shares held by shareholders, other than its parent firm, created waves in the investor community dealing in unlisted shares. This is on account of the fact that the price at which the capital reduction is planned is around one-fourth the price at which such shares were transferred to investors by existing shareholders (mainly employees who got these shares through stock options), and around one-third of the prevalent rates being quoted till then in the unlisted market.

There is also a tax angle to this. In case of a capital reduction, shareholders whose shares are being cancelled will be taxed. Such taxation is not only as capital gains. The shareholders are first taxed on the amount paid out by way of capital reduction as dividend, to the extent that the company possesses accumulated profits. In calculating such amount taxable as dividend, it is not the proportionate accumulated profits attributable to each share that is to be taxed as dividend, but the entire amount of accumulated profits.

To illustrate with an example, assume that the company has a share capital of 5 billion shares of ₹10 each (total capital of ₹5,000 crore), of which 5 million shares ( ₹5 crore capital) are held by shareholders other than the parent company. Assuming that the shares are being cancelled at a price of ₹1,000 per share, the total amount being paid out by way of capital reduction would be ₹500 crore. If the company has accumulated profits of more than ₹500 crore (say, for example, ₹20,000 crore), the entire amount of ₹500 crore being paid to the shareholders on cancellation of the shares would be subjected to income tax in the shareholders’