At all material times the respondent was a shareholder in M/s Kasturi Estates Pvt Ltd holding equity shares of Rs 1,000 each. The company passed a resolution for reduction of capital and followed the procedure prescribed under the Companies Act and an appropriate order was obtained from the court. Consequently, the face value of the share fell from Rs 1,000 to Rs 210 each. As a result of this reduction there was pro rata distribution of some properties of the company and payment to the shareholders including assessee.

In the income tax proceedings, the tribunal held that no capital gain accrued to assessee on distribution of property consequent to reduction of capital. TheMadras High Court had to consider the following two questions referred by the appellate tribunal, Madras.

1) Whether on facts and circumstances of the case the appellate tribunal was right in holding that no capital gain was assessable on the hands of the assessee as there was no extinguishment if any right of the assessee and 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 relevant assessment year?

While answering the first question, the Supreme Court considered some material facts namely: the company had in the previous year had given loans to shareholders amounting to Rs 64,517. The question to decide was whether the accumulated profits of the company would stand reduced by sum of Rs 64,517 at the time or reduction of capital Supreme Court examined in detail the relevant provisions of the Income Tax Act and in particular Section 2 (22) (d) e(e)- on plain reading of sub-section (e) it was clear that loans given to shareholders of a company in which public are not interested are deemed to be dividend in the hands of those shareholder. The Supreme Court noted that those shareholders were taxed accordingly in the relevant assessment year.

The Supreme Court stated: "A dividend under Section 205 of Companies Act can be paid only out of profits of the company whether for that year or out of the accumulated profits of previous year as set out in that section. When under Section 2 (22) of the IT Act when any payment is treated as deemed dividend, it should be treated as payment out of the accumulated profits whether capitalised or not. Further Section 194 of Income Tax Act clearly treats such payment as dividend for the purposes of deducting tax at source. Any legal friction will have to be carried to its logical conclusion." The Supreme Court agreed with the high court's decision that deemed dividend of Rs 64,517 must be taken to have come out of the accumulated profits and whenever accumulated profits of the company arerequired to be determined, an adjustment in respect of deemed dividend will have to be made. Hence, the Supreme Court upheld the tribunal's and the high court's decision in adjustment of Rs 64,517 being deemed dividend from accumulated profits.

Regarding the second question, the Supreme Court had to consider whether the assessee is liable for capital gains tax in respect of property received on reduction of capital. The Supreme Court followed the reasoning in Kartikeya Sarabhai vs Commissioner of income tax (1997) 228 ITR 163 in which it was observed that relinquishment of the asset or extinguishment of any right in it which may not amount to sale can also be considered as transfer and is liable for tax under Section 45 on reduction of capital, the right of shareholder to the dividends and high right to share in the distribution of net assets upon liquidation is extinguished proportionately to the extent of reduction in the capital. This extinguishment of right is transfer. Hence the property and moneyreceived by the assessee from the company on reduction of capital is a capital receipt subject to Section 45 of the Income Tax Act.

The Supreme Court observed in Kartikeya Sarabhais case court did not consider the provisions of Section 2(22)(d) in the context of capital gains arising on reduction of share capital. The Supreme Court observed that distribution made by company on reduction of capital which can be correlated with the company's accumulated profits (whether capitalised or not) will be dividend in the hands of assessee and will be treated as income of the assessee and taxed accordingly.

Thus, the amount distributed by a company on reduction of capital has two components. To the extent of accumulated profit such distribution will be considered dividend. The balance will be subject to tax as capital gains if they accrue. In the present case out of the total amount so received, the portion attributable to accumulative profits will have to be deleted. Only the balance amount can be treated ascapital receipt. Therefore looking to the cost of acquisition of that portion of the share which has been diminished capital gains will have to be determined.

Tribunal will have now to consider whole computing capital gains now this property should be valued and whether capital gains if any has accrued on reduction of value of shares. The question two was answered in negative and in favour of revenue.

The author is a Mumbai-based chartered accountant