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PETITIONER: COMMISSIONER OF INCOME-TAX.  MADRAS

       Vs.

RESPONDENT: G.NARASIMHAN (DIED) BY HEIRS KANTHA, NARASIMHAN ^ORS.

DATE OF JUDGMENT:       14/12/1998

BENCH: SUJATA V.MANOHAR, A.P.MISRA,

ACT:

HEADNOTE:

JUDGMENT:  JUDGMENT Mrs.Suiata V.  Manohar, J. At  all  material  times,  the respondent who is the assessee was a shareholder in  M/s.Kasthur)  Estates  (Pvt.) Ltd., Madras.   During the accounting period relevant to the assessment year ^963-64, the  assessee  held  70  shares  in M/s.Kasthuri  Estates  (Pvt,)  Ltd-  The face .value of each share was Rs.1,000/, During the said accouting period,  the said company  passed a resolution to reduce Us capital.  The procedure  prescribed  under  the  Conpanies  Act  for   the reduction of  share  capital  was undergone.  An appropriate order was obtained from the court.  The recluction was given effect on and from 20.5.1962.  As a result, the  face  value of ths shares in the company was reduced from Rs.1,000/each each to Rs.210/each.  As a result.  of this reduct1on, there was a prorats distribution of some properties of the company and  payment  of  money  to  the snareholders, including the assesses. In  the  income-tax  proceedings  connected with the property/amounts so received by the assesses on reduction of his  share  capital  in  the  said company, the Tribunal was required to consider whether any capital  gains  accured  to the  assessee.  The  tribunal  held  that  no  capital gains accrued to the assessee. At the request of  the  department, the  follwoing two questions were referred by the Income-tax Appellate Tribunal, Madras Bench to  the High Court for  its opinion  under  Section  256(1) of the Income-tax Act. These questions are :            1.   Whether  on  the  facts  wlid  in  the            circumstances  of  the  case, the Appellate            Tribunal was right in directing that a  sum            of  Rs.64, 517/- being ths deemed dividends            assessed  in  the  hands  of  the   various            shareholders in the past assessment surplus            while determining the ’accumulated profits’            in the hands of the Company?            2.Whether   on  the  facts  and  in  the            circumstances of the  case,  the  Appellate            Tribunal  was  right  in  holding  that  no            capital gain was assessable in the hands of

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          the assessee as there was no extinguishment            of  any   right   of   the   assessee   and            consequently  there  was no transfer within            the  meaning  of  Section  2(47)   of   the            Income-tax  Act,  1961,  by the assessee of            any capital asset for the  assessment  year            1963-64?" For  the  purpose  of answering Question No. 1, some further material facts are as follows: The said company in the previous year  had  advanced to   four   of   its   shareholders  sums  of  Rs  48,250/-, Rs.14,667/-, Rs.  1400/-  and  Rs.  200/-.  Thus  the  total advances  to shareholders by the company were to the tune of Rs. 64.517/-. We have to consider  whether  the  accumulated profits of the company would stand reduced by the sum of Rs. 64.517/- We have to consider whether the accumulated profits of the company would stand reduced by the sum of Rs.64.517/- at the time of the company’s reduction of share capital. Under  Section  2(22)  of  the Income-tax Act, 1961, dividend includes :            "2(22):   (a)............            (b).................            (c).................            (d)any distribution to its shareholders by            a  company  on the reduction of its capital,            to the extent to which the company possesses            accumulated profits which  arose  after  the            end  of the previous year ending next before            the 1st day of  April,  1933,  whether  such            accumulated profits have been capitalised or            not;            (e)  any  payment  by a company, not being a            company   in   which    the    public    are            substantially interested of any sum (whether            as  representing  part  of the assets of the            company or otherwise) by way of  advance  or            loan  to  a  shareholder, being a person who            has a substantial interest in  the  company,            or any payment by any such company on behalf            or  for  the individual benefit, of any such            shareholder, to  the  extent  to  which  the            company in either case possesses accumulated            profits; ........... Under Section 2(22)(e) of the Income-tax Act,  1961, any  payment  by  a company in  which  the  public  are  not substantially interested, of any sum by way of any loan to a shareholder,  will, to the extent that the company possesses accumulated profits, be considered as a deemed dividend paid to the shareholder. In  the  present  case,  the  said  four amounts paid to the four shareholders were treated as deemed dividends  in the hands of those shareholders and were taxed accordingly in the relevant assessment  years.  We  have  to consider  whether  these  amounts  will  go  to  reduce  the accumulated profits of  the  company  for  the  purposes  of calculating  the  distribution  of accumulated profits under Section 2(22)(d) of the Income-tax Act, 1961. It was contended  by  the  department  that  Section 2(22)(e)  only  notionally treats such loan to a shareholder by a company as a deemed dividend to  the  extent  that  the company   possesses   accumulated  profits.  Therefore,  the payment so made should not be deducted from the  accumulated profits  of  the  company for the purpose of determining the extent of such accumulated profits. We  fail  to  appreciate this  contention.  A  dividend  under  Section  205  of  the Companies Act can be paid only  out  of  the  profits  of  a

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company  whether  for that year or out of the profits of the company for any previous financial years as set out in  that section,  and  in  the  manner  set  out  in  that  section. Therefore, under Section 2(22) of the Income-tax  Act  1961, when  any  payment  by  a  company  is  treated  as a deemed dividend the section has provided that it should be  treated as  payment  out  of  the accumulated profits of the company whether capitalised or not. In fact, under  Section  194  of the Income-tax Act, an obligation is cast upon the principal officer  of  the  company to deduct from the payment so made under Section 2(22)(e) income tax at  the  rates  in  force. Section   194  clearly  treats  such  payment  as  dividend. Therefore, when a loan by a company to a shareholder in  the manner  set  out  in Section 2(22)(e) is treated as a deemed dividend, it  is  to  be  treated  as  payment  out  of  the accumulated  profits of the company. Any legal fiction will, therefore, have to be carried to its logical conclusion.  If the  payment  under  Section 2(22)(e) is treated as a deemed dividend and is required to be so treated to the extent that the  company  possesses  accumulated  profits,  the  logical conclusion  is  that  this  payment  must  be  considered as adjusted against the company’s accumulated  profits  to  the extent   that   it  is  treated  as  deemed  dividend  whild calculating accumulated profits of the company are  required to be determined such an adjustment will have to be made. The  High  Court  was, therefore, right in coming to the conclusion that when Section 2(22)(e) is read  with  the language  of Section 194 which provides for deduction of tax on such "dividend", as also the statutory restriction  under the  Companies Act on payment of dividend out of any capital assets, it would be reasonable to  come  to  the  conclusion that  the sum of Rs. 64,517/- must be taken to have come out of the accumulated profits. It must, therefore,  be  treated as  dividend  for  all  purposes, and would go to reduce the accumulated profits of the company  whether  capitalised  or not  whenever  such  accumulated  profits are required to be determined. Question No. 1 is, therefore,  answered  in  the affirmative and in favour of the assessee. Question No. 2. We  have  to  consider  whether  the assessee in the present case was assessable to  any  capital  gains  tax  in respect  of  the  amounts/property  received by him from the Company as a result of the reduction of his share capital. U nder Section 45(1)  of  the  Income-tax  Act,  any profits  or  gains  arising  from  the transfer of a capital asset are chargeable to income-tax under the  head  ’capital gains’.  "Transfer"  is  defined  in  Section  2 (47) of the Income-tax Act, 1961 as follows:            "2(47):     ’Transfer’ in relation to a capital            asset includes -            (i)the sale, exchange or  relinquishment  of            the asset or;            (ii)the extinguishment of any rights therein;            or            ................" In the case of Kartikeya sarabhai v. commissioner of Income-tax [228 Itr 163] this Court examined the question of capital gains in the context  of  an  amout  received  by  a shareholder from a company on reduction in the face value of shares on account of a reduction in the share capital of the company.  This  Court  said  that  it  is  not necessary for capital gain to arise that there must be a sale of a capital asset. Relinquishment of the asset or extinguishment of  any right  in  it,  which  may not amount to a sale, can also be considered as a transfer. Any profit or  gain  which  arises

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from  the  transfer of a capital asset is liable to be taxed under Section 45. As a result of a  reduction  in  the  face value  of the share, the share capital is reduced, the right of the shareholder to the dividends and his right  to  share in  the  distribution  of  net  assets  upon liquidation, is extinguished proportionately to the extent of  reduction  in the   capital.   Even   though  the  shareholder  remains  a shareholder, his right as a holder of  those  shares  stands reduced  with the reduction in the share capital. Therefore, this  extinguishment  of  right  is  transfer.  The   amount received  by  the  assessee  for such reduction is liable to capital gains  under  Section  45.  The  Court  followed  an earlier  decision of this court in Anarkali Sarabhai Ltd. V. Commissioner of Income-tax (224 ITR 422). In  view  of  this judgment,  the  property  and money received by the assessee from the company on the reduction in the face value  of  his shares in a capital receipt subject to Section 45. However   in  the  case  of  kartikeya  Sarabhai  v. Commissioner  of  Income-tax  (supra)  this  Court  did  not consider  the  provisions of Section 2(22)(d) in the context of capital  gains  arising  on  a  reduction  of  the  share capital.  Under  Section  2(22)(d)  any  distribution to its shareholders by a company on the reduction of  its  capital, is  deemed  to  be  a distribuiton of dividend to the extent that the company possesses accumulated profits whether  such profits   have  been  capitalised  or  not.  Therefore,  any distribution which is made by a company on  a  reduction  of its share capital which can be correlated with the company’s accumulated  profits  (whether  capitalised or not), will be dividend in the hands of the assessee.  Therefore,  it  will have  to  be  treated  as  income  of the assessee and taxed accordingly. It is only when any distribution is  made  which  is over  and  above  the  accumulated  profits  of  the company (capitalised or otherwise), that the question of  a  capital receipt  in the hands of a shareholder, arises. The original cost to that shareholder of acquisition of that right in the share which stands extinguished as a result of reduction  in the  share capital will have to be deducted from the capital receipt so determined. Only when the capital receipt  is  in excess  of  the  original  cost  of  the acquisition of that interest which stand extinguished, will  any  capital  gians arise. In  the case of Commissioner of Income-Tax v. Urmila Remesh (230 ITR 422),  this  Court,  in  the  context  of  a balancing charge, dealt with Section 2(22) of the Income-tax Act  in  a similar manner. The Court held that under Section 2(22) only the distribution of the accumulated  profits  can be  deemed  to be dividend in the hands of the shareholders. By using the expression "whether  capitalised  or  not"  the legislative  intent  ’clearly  is that the profits which are deemed to be dividend would be those which were  capable  of being  accumulated  and which would also be capable of being capitalised. This would clearly exclude return of a part  of the  capital  by the company from Section 2(22), as the same can not be regarded as profits capable of being capitalised, the return being of the capital itself. Thus  the  amount  distributed  by  a   company   on reduction   of   its   share   capital  has  two  components distribution  attributable  to   accumulated   profits   and distribution  attributable  to  capital  (except capitalised profits). Therefore, in the present case, to the  extent  of the  accumulated  profits  in  the  hands  of  M/s. Kasthuri Estates (Pvt). Ltd., whether such  accumulated  profits  are capitalised  or  not,  the  return to the shareholder on the

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reduction  of  his  share  capital,  is  a  return  of  such accumulated profits. This part would be taxable as dividend. The  balance  may be subject to tax as capital gains if they accrue. The assessee in the present case has been  paid  not merely  cash  but  has  also  been  given a property for the reduction in the value of his shares  from  Rs.  1,000/-  to Rs.210/-.  Out  of  the  total amounts so received including the  value  of  the  property  so  received,   the   portion attributable   to  accumulative  profits  will  have  to  be deleted. Only the balance amount can be treated as a capital receipt. Thereafter looking to the cost  of  acquisition  of that protion of the share which has been diminished, capital gains will have to be determined. The questions before us do not require us to examine how  the property transferred to the assessee by the company has to be valued. The company obviously has transferred  the property in lieu of the return of Rs. 790/- per share to the assessee.  This  property has not been sold to the assessee. The Tribunal, while computing capital gains,  will  have  to decide how this property should be valued for the purpose of deciding  what the assessee has received on reduction in the value of his shares, and  whether  any  capital  gains  have accured  to  the  assessee  or  not.  This  question was not required to  be  considered  by  the  Tribunal  because  the Tribunal came to the conclusion that there being on transfer of  any capital asset, the question of capital gains did not arise. But the question will now have to be  considered  and decided  by the Tribunal when the matter goes back before it for the determination of capital gains, if any, Question No. 2 is, therefore, answered in the negative and in  favour  of the Revenue. The appeal is disposed of accordingly. capital gains if they accrue.