1998 (12) TMI 5 - SC - Income Tax

Deemed dividend u/s2(22)(e) and share capital reduction payouts: accumulated profits reduced; capital gains recalculated on remand

A deemed dividend under s. 2(22)(e) must be treated as a dividend payment out of accumulated profits, because s. 194 mandates tax deduction on such ... Deemed dividend on reduction of share capital - deemed dividend under section 2(22)(d) and section 2(22)(e) - accumulated profits and their adjustment on distribution - extinguishment of shareholder rights as transfer for capital gains - distinction between distribution attributable to accumulated profits and return of capitalDeemed dividend under section 2(22)(e) - accumulated profits and their adjustment on distribution - Whether advances/ payments treated as deemed dividends must be deducted from the company's accumulated profits when computing distributions on reduction of share capital. - HELD THAT: - The Court held that amounts treated as deemed dividends under the deeming provisions must be regarded as paid out of the company's accumulated profits and, therefore, are to be adjusted against accumulated profits when ascertaining the portion of any distribution on reduction of capital attributable to accumulated profits. The reasoning rests on the statutory characterisation of such payments as 'dividend' for income-tax purposes, the obligation to deduct tax at source under the relevant provision treating the payment as dividend, and the Companies Act restriction that dividends can be paid only out of profits. Consequently the legal fiction created by section 2(22)(e) must be carried to its logical conclusion and such deemed dividends reduce accumulated profits (whether capitalised or not) for all purposes when accumulated profits are required to be determined.Answered in the affirmative in favour of the assessee: the sums treated as deemed dividends must be deducted from the company's accumulated profits.Extinguishment of shareholder rights as transfer for capital gains - distinction between distribution attributable to accumulated profits and return of capital - Whether amounts and property received by the assessee on reduction of share capital are chargeable as capital gains. - HELD THAT: - The Court recognised that a reduction in the face value of shares causes a proportionate extinguishment of the shareholder's rights, which can constitute a 'transfer' attracting capital gains under the statutory definition, and followed precedents so holding. However, the Court held that any distribution on reduction of capital comprises two components: (i) the portion attributable to accumulated profits (whether capitalised or not), which is to be treated as dividend and taxed as income, and (ii) the residual portion representing return of capital, which may be a capital receipt liable to capital gains after deducting the cost of acquisition of the diminished interest. The valuation of property transferred in lieu of cash and the computation of any capital gains were not determined by the Court and were left to the Tribunal for fresh consideration.Answered in the negative and in favour of the Revenue as to the Tribunal's conclusion that no capital gains arose; the matter of valuation and computation of capital gains is remitted to the Tribunal for determination.Final Conclusion: The Court held that amounts treated as deemed dividends under the Income-tax Act must reduce the company's accumulated profits when computing distributions on reduction of capital, and that only the component of distributions in excess of such accumulated profits can be treated as capital receipts potentially giving rise to capital gains; valuation and computation of any capital gains were remitted to the Tribunal for determination for the assessment year 1963-64. Issues Involved:1. Interpretation of section 2(22) of the Income-tax Act in relation to deemed dividends.2. Assessment of capital gains tax on amounts received due to reduction of share capital.Detailed Analysis:Issue 1: Interpretation of section 2(22) of the Income-tax Act in relation to deemed dividends:The case involved a shareholder who received amounts from a company due to the reduction of share capital. The question was whether such amounts should be considered as deemed dividends and how they impact the accumulated profits of the company. Section 2(22)(e) of the Income-tax Act deems any payment by a company to a shareholder as a deemed dividend to the extent of the company's accumulated profits. The court clarified that when a company's payment is treated as a deemed dividend, it should be considered as coming out of the accumulated profits of the company, whether capitalised or not. The court emphasized that any legal fiction must be logically concluded, and such payments should reduce the accumulated profits of the company. Therefore, the sum received by the shareholder was deemed as a dividend, reducing the accumulated profits of the company. The court answered Question No. 1 in favor of the assessee.Issue 2: Assessment of capital gains tax on amounts received due to reduction of share capital:The second issue revolved around whether the shareholder was liable for capital gains tax on the amounts received from the company as a result of the reduction in share capital. The court referred to section 45(1) of the Income-tax Act, which imposes tax on profits or gains arising from the transfer of a capital asset. The court interpreted 'transfer' under section 2(47) to include the extinguishment of any rights in a capital asset, leading to a charge under section 45. The court held that the reduction in share capital extinguished the shareholder's rights proportionately, constituting a transfer and subjecting the amount received to capital gains tax. The court also discussed the impact of section 2(22)(d) on such capital gains, emphasizing that distributions correlated with accumulated profits are deemed as dividends. The court concluded that the shareholder's receipt was partly attributable to accumulated profits and partly to capital, with the former being taxable as dividend and the latter as capital gains. The court answered Question No. 2 in favor of the Revenue.In conclusion, the judgment clarified the treatment of amounts received by a shareholder due to the reduction of share capital, addressing both the deemed dividends under section 2(22) and the assessment of capital gains tax under section 45.