Authors: Mahi Agrawal [1] & Krishna Dube [2]
I. Introduction
When does a change in your shareholding transform into a taxable event? The Supreme Court provided much-needed clarity on this aspect of capital gains taxation. The interpretation of the term transfer under Section 2(47) of the Income Tax Act, 1961, (“the Act”) is significant in determining the taxability of capital gains. The scope of transfer has been interpreted broadly by courts to ensure that various forms of transactions, whether direct or indirect, are brought within the tax net. Section 2(47) defines transfer in relation to a capital asset to include:
Sale, exchange, or relinquishment of the asset
Extinguishment of any rights in the asset.
Compulsory acquisition under any law.
Conversion of the asset into stock-in-trade.
Allowing possession of immovable property under Section 53A of the Transfer of Property Act, 1882.
Any transaction that has the effect of transferring or enabling the enjoyment of immovable property.
On January 2, 2025, in the case of Principal Commissioner of Income Tax & Anr. v. M/S Jupiter Capital Pvt. Ltd., the Supreme Court reiterated that a reduction in share capital falls within the definition of transfer. Its scope extends to include not only the sale or exchange of an asset but also the relinquishment or extinguishment of rights associated with a capital asset, such as share capital. The case arose when a company claimed a long-term capital loss due to reduced shareholding in a subsidiary after a share capital reduction. Although the assessing officer rejected the claim, stating that the face value per share remained unchanged, the ITAT Bengaluru and High Court of Karnataka supported the Company’s stance. Upholding these decisions, the Supreme Court held that any reduction in rights associated with shareholding constitutes a taxable transfer. This transfer attracts implications under Section 45 of the Act, which primarily governs capital gains tax. As businesses and companies adopt more innovative restructuring techniques with increased complexity of corporate transactions, this interpretation offers a much-needed clarity for concerned companies and investors. While most of the aspects of transfer are self-explanatory, this blog delves deeper into the concept of the extinguishment of rights in an asset, examining its implications under the Act and providing a clear analysis on when it may attract capital gains tax.
II. Reduction in Share Capital as Transfer
In the above-mentioned case of M/S Jupiter Capital, the parties referred to the Supreme Court’s landmark ruling in Kartikeya V. Sarabhai v. The Commissioner of Income Tax (1997), wherein the Court explained that in cases where the face value of shares is reduced, resulting in the proportional extinguishment of shareholder’s rights to dividends and to share in distribution of net assets upon liquidation, such a reduction is considered as transfer for the purposes of capital gains taxation. The Supreme Court has further clarified that any amount received by the shareholder as a result of such reduction is liable to capital gain tax under Section 45 of the Act. These rulings are particularly relevant in scenarios of share buybacks or capital reductions in startups and private equity deals, where shareholder rights are often diluted or extinguished.
The redemption of preference shares is considered transfer under the Act. Redemption of preference shares is the process by which a company repays or buys back the preference shares issued to its shareholders, either at the original value or with a premium. The Supreme Court, in the case of Anarkali Sarabhai v. Commissioner of Income Tax (1997), explained that a shareholder holding redeemable cumulative preference shares has a subsequent right in the profits of the company, if and when made, at a fixed rate of percentage. This is a valuable right which comes to an end by the company’s redemption of shares. Thus, this transaction amounts to “extinguishment of rights”, attracting Section 2(47) of the Act. Any amount received by the assessee is thereby liable to be taxed under the head Capital gains tax. In this context, the Court also upheld the Bombay High Court’s explanation of the term transfer, provided in the case of Sath Gwaldas Mathuradas Mohata Trust v. Commissioner of Income Tax (1987). Therein, the Court held:
“Here, a regular "sale" itself has taken place. That is the ordinary concept of transfer. The company paid the price for the redemption of the shares out of its fund to the assessee and the transaction was clearly a purchase. As rightly observed by the Tribunal, if the company had purchased a valuable right, the assessee had sold a valuable right, "Relinquishment"”
These interpretations have ensured that transactions like capital reduction and share redemptions are appropriately taxed, reflecting on the economic realities and implications of extinguished shareholder rights.
III. Extinguishment of Rights as Transfer
The extinguishment of rights in a capital asset is well-recognized form of transfer under Section 2(47) of the Act. Such extinguishment could result either from the surrender of rights in property, or from amalgamation of companies. For instance, the ITAT Mumbai examined and held that the extinguishment of rights in a proposed flat, even when the construction was incomplete, qualifies as transfer the Act. The compensation received for surrendering such rights was treated as capital gains. Similarly, the surrender of shares by a defaulting shareholder in a debt restructuring process or the relinquishment of rights under a settlement agreement can also qualify as transfer under the Act, attracting tax liability.
Additionally, in the context of mergers and acquisitions, the extinguishment of rights in shares of an amalgamating company is considered transfer. When shareholders of an amalgamating company receive shares of the amalgamated company in exchange, their rights in the original shares stand extinguished. The Supreme Court has ruled that extinguishment in this context qualifies as a transfer under Section 2(47) of the Act. However, in the case of amalgamation of two companies, when there is neither any exchange not any relinquishment of an asset by the assessee, it was held that no transfer within the meaning of the Act takes place.
In the case of Vania Silk Mills v. CIT (1991), the Supreme Court held that the extinguishment of rights must be linked to a transfer of the asset itself or the transfer of rights in the asset. Mere extinguishment, without a corresponding transfer, would not attract capital gains tax. However, this interpretation was later expanded in the subsequent judgments, including in CIT v. Grace Collis (2001). The Court held that even the partial extinguishment of rights is sufficient to constitute transfer and attract capital gains tax. Subsequent judgements have largely favored the expansive interpretation laid down in Grace Collis, ensuring that even partial extinguishment of rights resulting in a change of ownership is treated as a taxable event. For instance, as held by the Madras High Court, giving up the right to claim specific performance of an agreement to purchase an immovable property constitutes a transfer. Thus, the relinquishment of a specific right, even partial, is treated as transfer for capital gains purpose.
However, the extinguishment must result in the complete termination of rights. It must result in the change of ownership or interest in the asset. For example, if a landowner grants a renewable license to a developer for using a property, it constitutes mere diminution of rights. However, if the owner sells the development rights entirely, it qualifies as extinguishment, attracting capital gains tax. In a similar context, the ITAT Delhi examined a case where a leaseholder granted a conditional license to construct a multistoried building on his land, but his perpetual rights over the property remained intact. Here, the Tribunal noted that though the extinguishment of rights in a capital asset, even if partial, could qualify as a transfer under Section 2(47), this extinguishment must result in the complete termination of rights, and not merely a diminution. A mere permission to use the property or the mere grant of certain permissive right over the property doesn’t amount to transfer of those rights. The owner is such cases still remains the owner, his rights could be substantially diminished but cannot be extinguished. Thus, transfer in such cases doesn’t attract capital gains tax.
These cases effectively demonstrate the careful distinction drawn by courts between partial diminution and full extinguishment of rights that leads to a change in ownership or interest. This clarity is important to ensure that only genuine transactions meeting the threshold of transfer are brought within the ambit of capital gains taxations.
IV. Refining Section 2(47) for Clarity and Compliance
The scope of transfer under Section 2(47) of the Income Tax Act, 196 extends to any termination, cancellation, or cessation of rights, even if no physical transfer of assets occurs. The extinguishment of rights need not involve a traditional sale or exchange and can occur independently, following subtle and indirect shifts in ownership and rights. Any profit or gain arising from any such extinguishment of rights in capital asset is taxable under the head Capital Gains as per Section 45 of the Act, ensuring that the tax net captures a wide range of transaction involving capital assets. This broad interpretation is a reminder that corporate ingenuity in structuring transactions cannot operate outside the ambit of taxation. Whether it is a shareholder losing a portion of their rights through capital restructuring or a landowner relinquishing specific development rights, the essence primarily lies in the substantive change in ownership or control. At the same time, courts have also demonstrated caution by balancing the principle of fairness, ensuring that not every diminution of rights automatically translates into a taxable transfer.
Though these rulings serve as an important guidepost for companies and investors trying to balance strategic planning with tax compliance, for better clarity and applicability, the provision could benefit from the express mention of complex corporate transactions like mergers, buybacks, and debt restructuring, outlining when these qualify as taxable transfers. Moreover, the distinction between full extinguishment and mere diminution of rights, in the form of an illustrative example, would further enhance the clarity of the provision. This would in turn help in simplifying compliance and reduce litigation, making the law more transparent and adaptable to modern business practices.
[1] Mahi Agrawal is a second year student at Hidayatullah National Law University, Raipur
[2] Krishna Dube is a second year student at National Law Institute University, Bhopal