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

The information of an unlisted subsidiary of a giant listed firm not too long ago deciding to cancel all of the shares held by shareholders, apart from its mum or dad agency, created waves within the investor group dealing in unlisted shares. This is on account of the truth that the value at which the capital discount is deliberate is round one-fourth the value at which such shares have been transferred to traders by present shareholders (primarily staff who bought these shares by means of inventory choices), and round one-third of the prevalent charges being quoted until then within the unlisted market.

There can be a tax angle to this. In case of a capital discount, shareholders whose shares are being cancelled will likely be taxed. Such taxation shouldn’t be solely as capital positive aspects. The shareholders are first taxed on the quantity paid out by means of capital discount as dividend, to the extent that the corporate possesses collected earnings. In calculating such quantity taxable as dividend, it’s not the proportionate collected earnings attributable to every share that’s to be taxed as dividend, however all the quantity of collected earnings.

To illustrate with an instance, assume that the corporate has a share capital of 5 billion shares of ₹10 every (complete capital of ₹5,000 crore), of which 5 million shares ( ₹5 crore capital) are held by shareholders apart from the mum or dad firm. Assuming that the shares are being cancelled at a value of ₹1,000 per share, the full quantity being paid out by means of capital discount could be ₹500 crore. If the corporate has collected earnings of greater than ₹500 crore (say, for instance, ₹20,000 crore), all the quantity of ₹500 crore being paid to the shareholders on cancellation of the shares could be subjected to earnings tax within the shareholders’ arms as dividends. In computing their taxable dividends, they’d not be capable to declare the quantity that they could have paid to amass the shares—whether or not by means of allotment by the corporate, or as buy value to the promoting shareholders from whom they could have bought the shares.

This is due to this fact a double whammy for the shareholders. Not solely are they getting far lower than the quantity that they paid to amass the shares, but additionally all the quantity that they’d be getting could be subjected to tax, and, usually, it will be taxed at 35.88%.

Even staff persevering with to carry the shares acquired by means of inventory choices would endure such tax on all the proceeds, although they’d have already got suffered tax on the worth of their inventory choices exercised at their slab charges of tax. The solely comfort for such staff could also be that, in contrast to traders who bought the shares within the unlisted market, they could be getting nearly the identical or a better value for the shares, than that at which they acquired them below the inventory choices plus the perquisite worth on which they paid tax.

The solely redeeming issue is that they’d be capable to declare a capital loss (long run, if the shares are held for greater than two years, or in any other case short-term) to the extent of the quantity paid by them for buying the shares, which they could presumably be capable to set off towards their different capital positive aspects.

This is in distinction to a state of affairs the place, if the corporate had achieved a buyback of the shares, the corporate would have needed to pay a buyback tax at 23.296% of the distinction between the buyback value and the problem value, the efficient charge of tax being lower than 20%.

Possibly, the corporate was pushed by different compulsions to resort to a capital discount somewhat than a buyback. In case of a buyback, shares of solely these shareholders who comply with tender their shares in a buyback could be purchased again. Besides, the corporate wouldn’t have been in a position to problem additional shares until expiry of a yr after the buyback.

The drawback, maybe, lies within the distinction that the tax legal guidelines make between a buyback, a capital discount and a sale of shares (had shares been bought to the mum or dad firm), all 3 of that are handled in another way for tax functions.

It is probably time to harmonise the tax remedy of those three varieties of transactions, because the financial penalties are the identical, in order that shareholders doesn’t endure hostile tax penalties merely as a result of an organization chooses to compensate them for his or her shares in a distinct method.

Gautam Nayak is associate at CNK & Associates LLP.

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Updated: 13 Jul 2023, 11:03 PM IST