For a company limited by shares, the creditors of the company rely on the capital invested by the shareholders or the net worth of the company. Whenever, a creditor gives loan to the company, he analyses the source of funds and application thereof. Any reduction of share capital diminishes the funds out of which the creditors are to be paid. A company limited by shares, therefore is not allowed to reduce the share capital. But, in certain cases, the law allows to reduce the share capital of the company after taking due care of the creditors of the company in case of any reduction of the funds.
The company can propose for reduction of share capital. Section 66 of the Companies Act read with applicable rules prescribes the procedure for the same.
The reduction of capital is generally done to:
To cancel any paid up capital (and share premium amount) that is lost or unrepresented by available assets. (Represented by Accumulated Losses). It helps the company to accurately and fairly reflect the liabilities & assets of the Company in its books of accounts; and better presentation of the financial position of the Company.
Company may reduce share capital by paying off fully paid up shares which is in excess of the wants of the company. This option is adopted when company has surplus funds and company do not want to use the funds for its business.
In case of over valuation of assets (due to accumulated losses of the company), to depict the real net worth of the company, the company opts for internal restructuring. The Company write-off the portion of the capital that is already lost due to accumulated losses. It presents a true and fair view of the state of the affairs of the company.
The company will set off its accumulated losses to the extent of reduction of its paid up share capital. There will be no payment made to the shareholders.
The face value of the shares will be reduced per share. Therefore, the shareholding holding pattern of the company will not be changed. The number of shares held by each shareholder would be same as before the reduction of share capital.
Further it will not affect the ability of the company to pay to its creditors as there is no cash outflow. So, creditors will not have issues for giving approval/no objection for capital reduction.
There can be another scenario. The company has more capital invested in the company than that it can profitably employ. In such a case, the company opts for paying the excess part of the capital (the capital which the company thinks it cannot employ profitably) to its shareholders. As, the company is paying funds to the shareholders, it is important that the source of the funds is such that it does not adversely affect the position of the creditors of the company. The company shall take the approval of the creditors.
An application to NCLT would be filed after taking care of interests of the stakeholders of the company (Approval from Shareholders and Creditors).
In case of the over valuation of assets, the shareholding pattern remains unchanged and no payment is made to the shareholders, FEMA compliances would be minimal.
In case of excess capital in the company, the company shall pay funds to the shareholders and in such case the company shall report the transaction to Reserve Bank of India.
In case, the share holding pattern of the company remains unchanged and no payment is made to the shareholders for reduction of share capital, the Income Tax department considers it a notional loss and the assesse cannot claim the loss as capital loss.
Where the company has made a payment to the shareholders and reduce the excess capital,
The amount distributed to the extent of accumulated profits is considered as “Deemed Dividend under Section 2 (22) and the company will have to pay dividend distribution tax on the same.
Internal restructuring is required to adjust the relation between the capital and the assets of the company. The capital of the company should be valued same as the assets of the company. Both overvaluation and under valuation of the assets of the company does not present the true and fair view of the state of the affairs of the company.