COMMISSIONER OF INCOME TAXversusG. NARSHIMHAN (DIED) BY HEIRS

A                     COMMISSIONER OF INCOME TAX
                                          v.
                      G. NARSHIMHAN (DIED) BY HEIRS

                               DECEMBER 14, 1998

B              [SUJA TA V. MANOHAR AND A.P. MISRA, JI.]


         Income Tax Act, 1961:

         Sections 2(22)(e) and 194-Dividend-Deemed dividend-Treatment
C ofin computing accumulated profits ofthe company-Private limited company
    reducing its share capital-Pro rata distribution of some properties of the
    company and payment of money to its shareholders-Treated by the
    shareholders as deemed dividend and taxed accordingly in relevant
    accounting year-Held, the amounts have to be treated as dividend for all
D   purpose and would reduce the accumulated profits (whether capitalised or
    not ) and be considered as ac/justed against the accumulated profits to the
    extent it is treated a deemed dividend-Income Tax-Accumulated profits-
    Quantification of-Companies Act, 1961, Section 205.

          Sections 45(1), 2(47) & 2(22) (d) & (e)-Dividends-Capital receipts-
E   Amounts received by shareholders on reduction of company's capital-If
    constitute capital gains-For reduction of company's value the shareholders
    received cash as well as property-Held, portion of the total amount so
    received including the value of the property to the extent attributable to
    accumulated profits of the company (whether capitalised or not would be a
    return thereof and, therefore, taxable as dividend-Only a balance amount
F   would be a capital receipt out of which capital gains will have to be
    determined looking to the cost of acquisition of that portion of the share
    which has been diminished-Income Tax-Capital gains.

          The assesse was a shareholder in a private limited company. For the
    accounting year relevant to AY 1963-64, the company reduced its capital and
G   consequent to such reduction of the face value of each share, there was a pro
    rata distribution of some properties of the company and payment of money
    to the shareholders, including the assessee. In the income tax proceedings
    connected with the property/amounts so received by the assessee on the
    reduction of his share capital, the Tribunal held that no capital gains accrued
H   to the assessee. At the request of the Revenue two questions were referred
                                         532
                          C.I.T. v. G. NARSHIMHAN                          533
by the Tribunal to the High Court. The questions were, (i) whether the            A
Tribunal had rightly held that the amounts advanced by the company to its
shareholders and assessed in their hands as dividends should be deducted
from the surplus while determining the 'accumulated profits' in the hands
of the company; and (ii) whether the Tribunal had rightly held that no capital
gains accrued to the assessee on receiving the amounts and property               B
consequent to reduction in the face value of the shares. The High Court
found the above questions in favour of the assessee. Hence this appeal by the
revenue.

      Partly allowing the appeal, this Court

      HELD: 1. In view of Section 205 of the Companies Act and Sections           C
194 and 2(22)(e) of the Income Tax Act, 1961 when a loan by a comany 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 has to be carried to its logical conclusion.
Therefore, this payment must be treated to be dividend for all purposes and       D
must, therefore, be considered as adjusted against the company's accumulated
profits to the extent it is treated as deemed dividend. (537-8-C)

      2.1. In view of Section 2(22)(d) of the Income Tax Act, any distribution
which is made by a company on a reduction of its share capital which can
be corelated with the company's accumulated profits (whether capitalised or       E
not), will be dividend in the hands of the assessee. Therefore, it will have to
be treated as income of the assesse 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 to that right in the share which stands extinguished as a result   F
of the reduction in the share capital will have to be deducted from the capital
receipts so determined. Only when the capital receipt is in excess of the
original cost of the acquisition of that interest which stands extinguished,
will any capital gains arise. (538-F-H]
                                                                                  G
      2.2. By using the expression "whether capitalised or not" in Section
2(22) in the Income Tax Act, 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, H
    534                        SUPREME COlJRT REPORTS [1998] SUPP. 3 S.C.R.

A 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, to the extend of the accumulated
    profits in the hands of a company, whether such accumulated profits are
B   capitalised or not, the return to the shareholder on the 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 capital gains tax if they
    accrue. (539-C-E]
            Commissioner ofIncome Tax v. Urmi/a Ramesh, (230 ITR 422), referred
    to.
c         2.3. The assessec in the present case has been paid not merely cash
    but also given a property for the reduction in the value of his shares. 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 capital receipt. Thereafter
D   looking to the cost of acquisition of that portion of the share which has been
    diminished, capital gains will have to be determined. (539-F]

            CIVIL APPELLATE JURISDICTION : Civil Appeal No. 6799 of
    1983.

E        From the Judgment and Order dated 30.3.78 of the Madras High Court
    inT.C.No.116of1975.

         Ranbir Chandra and C.V.S. Rao, (Rajiv Nanda) for B.K. Prasad for the
    Appellant.

            A.T.M. Sampath, S. Rajappa and V. Balaji for the Respondents.
F
            The Judgment of the Court was delivered by

          MRS. SUJATA V. MANO HAR, J. At all material times, the respondent
    who is the assessce was a shareholder in M/s Kasthuri Estates (Pvt.) Ltd.,
    Madras. During the accounting period relevant to the assessment year 1963-
G   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 accounting period, the said
    company passed a resolution to reduce its capital. The procedure prescribed
    under the Companies Act for the reduction of share capital was undergone.
    An appropriate order was obtained from the court. The reduction was given
H   effect on and from 26.5.1962. As a result, the face value of the shares in the
                    C.I.T. v. G. NARSHlMHAN [SUJATA V. MANOHAR, J.]                 535
      company was reduced from Rs.1,000 each to Rs. 210 each. As a result. of this         A
      reduction, there was a pro-rata distribution of some properties of the company
      and payment of money to the shareholders, including the assessee.

·-"          In the 'ncome-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           B
      the assessee. The tribunal held that no capital gains accrued to the assessee.
      At the request of the department, the following 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:

               I.     Whether on the facts and in the circumstances of the case, the
                                                                                           c
                      Appellate Tribunal was right in directing that a sum of Rs. 64,517
                      being the deemed dividends assessed in the hands of the various
                      shareholders in the past assessment years, should be deducted
                      from the surplus while determining the 'accumulated profits' in
                      the hands of the Company?                                            D

               2.      Whether on the facts and in the circumstances of the case, the
                       Appellate Tribunal was right in holding that r>o capital gain was
                       assessable in the hands of 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    E
                       Income-tax Act, 1961, by the assessee of any capital asset for
                       the assessment year 1963-64?"

            Question No. /,

            For the purpose of answering Question No. I, some further material             F
      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             G
      stand reduced by the sum ofRs.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) .......... ..                                                      H
    536                            SUPREME COURT REPORTS [1998] SUPP. 3 S.C.R.

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
B            accumulated profits which arose after the end of the previous year
             ending next before the !st 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
C            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;
D
           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
E   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.
F
          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
G 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 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 I 96 I, when any payment by a company
H is treated as a deemed dividend the section has provided that it should be
              C.l.T. v. G. NARSHIMHAN [SUJATA V. MANOHAR, J.]              537

treated as payment out of the accumulated profits of the company whether           A
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 UIJder 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         B
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             C
accumulated profits to the extent that it is treated as deemed dividend while
calculating accumulated profits of the company. Whenever 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        D
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. 64,5 I 7
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    E
profits of the company whether capitalised or not whenever such accumulated
profits are required to be determined. Question No I is, therefore, answered
in the affirmative and in favour of the assessee.

      Question No. 2.
                                                                                   F
      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.

      Under 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        G
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;               H
    538                           SUPREME COURT REPORTS [1998] SUPP. 3 S.C.R.

A           (ii)   the extinguishment of any rights therein; or ................"

    In the case of Kartikeya Sarabhai v. Commissioner of Income-tax, [228 !TR
    163] this Court examined the question of capital gains in the context of an
    amount 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.
B   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 from the transfer of a capital asset
    is liable to be taxed under Section 45. As a result of a reduction in the face
C   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 transfered. The amount received by
D   the assessee for such reduction is liable to capital gains under Section 45. The
    Court followed an earlier decision of this court in Anarlmli Sarabhai Ltd. v.
    Commissioner of Income-tax, (224 !TR 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
E   45.
          However, in the case of Kartikeya Sarabhai v. Commissioner ofIncome-
    /ax (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
F   reduction of its capital, is deemed to be a distribution 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
G   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 qtherwise ), that the question
    of a capital receipt in the hands of a shareholder, arises. The o~iginal cost to
    that shareholder of acquisition of that right in the share which stands
H   extinguished as a result of reduction in the share capital will have to be
            C.I.T. v. G. NARSHIMHAN [SUJATA V. MANOHAR,J.]                   539
deducted from the capital receipt so determined. Only when the capital receipt      A
is in excess of the original cost of the acquisition of that interest which stand
extinguished, will any capital gains arise.

      In the case of Commissioner ofincome-Tax v. Urmila Ramesh (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        B
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              C
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         D
and distribution attributable to capital (except capitalised profits). Therefore,
in the present case, to the extent of the accumulated profits in the hands of
Mis. Kasthuri Estates (Pvt). Ltd., whether such accumulated profits are
capitalised or not, the return to the shareholder on the 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.        E
      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       F
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 portion 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 G
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 H
    540                        SUPREME COURT REPORTS (1998] SUPP. 3 S.C.R.

A   considered by the Tribunal because the Tribunal came to the conclusion that
    there being no 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
B   and in favour of the Revenue. The appeal is disposed of accordingly.

    R.KS.                                                  Appeal partly allowed.