Laws hampering tax neutrality on restructuring

A large listed company recently announced that it would cancel the equity shares with differential voting rights (DVRs) that it had issued and instead allot a lesser number of ordinary equity shares to the DVR shareholders. This exchange is being achieved through a restructuring scheme being filed before the National Company Law Tribunal (NCLT) under the Companies Act, 2013.

One would have expected that there would be no tax on such exchange of one type of shares of a company for another type of shares of the same company, like in the case of conversion of preference shares into equity shares, which is exempt. In fact, there is a provision in the tax laws that permit a conversion of one kind of shares into another kind. Indirectly, this means that such conversion is exempt.

However, the said company has also announced that the entire cancellation value of the DVRs would be taxed as dividend income in the hands of the shareholders, and that it would be accordingly deducting tax at source on such amount. This is on account of the fact that the DVR shares would not be automatically converted into equity shares, but would be cancelled through reduction of capital, and fresh ordinary equity shares allotted to the DVR shareholders out of the capital reduction proceeds.

In case of reduction of capital, to the extent that the company possesses accumulated profits, the payout is regarded as dividend under tax laws. So long as the total accumulated profits are more than the amount being paid towards capital reduction, the amount is taxable as dividend—irrespective of the price at which the shares were issued, whether it was repayment of capital or not, and irrespective of the cost at which the shareholder had acquired the shares.

This seems highly unfair to the DVR shareholders, who would be taxed on the amount of capital reduction proceeds, though they may be able to claim a capital loss on account of extinguishment of the DVRs. However, the capital loss cannot be set off against the dividend but only against other capital gains.

Why is there such an unfair tax treatment to DVR shareholders? It appears that corporate laws did not leave much choice to the company which wanted to discontinue the DVR shares as their purpose was not being achieved. It appears that corporate laws do not permit such equity shares with DVRs to be directly converted into ordinary equity shares, in which case the conversion would have been tax neutral.

This perhaps is a lacuna in our corporate law. If preference shares and even debentures or bonds can be converted into equity shares, why can one class of equity shares not be converted into another class of equity shares?

In this case, the shareholders are not really disposing of their DVR shares—they are merely getting equivalent value in ordinary equity shares. Why should they be taxed, and again, on the entire reduction proceeds as regular income, not only on the appreciation as capital gains?

This is a classic case of a disconnect between corporate laws and tax laws, resulting in a negative outcome for the shareholding public. Perhaps, a relook is required to see whether our corporate laws and tax laws are in sync in treatment of various types of corporate restructuring, so as to facilitate such restructuring, rather than deter it.

Gautam Nayak is partner at CNK & Associates LLP.