My company reduced its share capital and paid me cash and property for the reduction. Is that dividend, capital gains, or both?
Both, in that order. The Supreme Court held that what a company distributes on a reduction of capital splits into two components. So much as can be correlated with its accumulated profits, capitalised or not, is deemed dividend under section 2(22)(d) and is taxed as income. Only the excess over accumulated profits is a capital receipt, from which the cost of acquiring the extinguished portion of the shareholding is deducted to find any capital gain. The Court also held that a loan already taxed as deemed dividend under section 2(22)(e) reduces the company's accumulated profits.
Decided by the Supreme Court (Supreme Court of India - Mrs Sujata V. Manohar and A.P. Misra, JJ (judgment by Sujata V. Manohar, J)) on 1998-12-14. It bears on section 2(22)(d), section 2(22)(e), section 45, section 2(47), section 194 of the Income Tax Act 1961, in Capital Gains matters.
This is the decision that fits section 2(22)(d) together with the capital gains charge on a capital reduction. Kartikeya Sarabhai and Anarkali Sarabhai had established that a reduction extinguishes rights in the share and so is a transfer within section 2(47), but neither considered the deemed dividend provision. Narasimhan supplies the missing step and fixes the order of taxation: dividend first, up to accumulated profits, capital gains only on what is left. It also decides a point that recurs whenever section 2(22)(e) has been applied to a closely held company - once a loan has been taxed as deemed dividend, the legal fiction must be carried to its logical conclusion, so that sum comes out of accumulated profits and is not available to be treated as dividend a second time.
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The assessee held 70 shares of Rs 1,000 each in Kasthuri Estates (Pvt) Ltd. In the previous year relevant to assessment year 1963-64 the company reduced its capital, following the Companies Act procedure and obtaining an order of the court, with effect from 20 May 1962. The face value of each share came down from Rs 1,000 to Rs 210, and on that reduction the company distributed money and some of its properties to the shareholders pro rata, including to the assessee. In an earlier year the company had advanced Rs 48,250, Rs 14,667, Rs 1,400 and Rs 200 to four of its shareholders, a total of Rs 64,517, and those advances had been taxed in their hands as deemed dividends under section 2(22)(e). The Tribunal held that no capital gains accrued to the assessee because no right had been extinguished and there was no transfer, and that the Rs 64,517 reduced the company's accumulated profits. Both questions were referred at the department's instance.
On the first question the Court held for the assessee: the Rs 64,517 already taxed as deemed dividend under section 2(22)(e) must be treated as having come out of accumulated profits, and goes to reduce those profits, capitalised or not, whenever they fall to be determined. On the second question it held against the assessee. A reduction of capital extinguishes the shareholder's rights proportionately and is therefore a transfer, following Kartikeya Sarabhai and Anarkali Sarabhai. But the distribution has two components. To the extent it can be correlated with the company's accumulated profits, capitalised or not, it is dividend under section 2(22)(d) and taxable as income. Only the excess is a capital receipt, and capital gains arise only where that excess exceeds the cost of acquiring the interest extinguished. The property given to the assessee in lieu of Rs 790 per share had to be valued by the Tribunal, which had never reached the point, and the matter went back for that. The appeal was disposed of accordingly.
On the first question the Court worked from the nature of the fiction. A dividend under section 205 of the Companies Act can be paid only out of profits, and section 2(22) accordingly directs that a payment it deems to be dividend be treated as made out of accumulated profits, capitalised or not. Section 194 reinforces this by requiring the principal officer to deduct tax from such a payment as dividend. A legal fiction must be carried to its logical conclusion: if a loan is deemed dividend to the extent the company possesses accumulated profits, the sum so treated must be adjusted against those profits. On the second question the Court accepted the transfer analysis of Kartikeya Sarabhai - a sale is not necessary, since relinquishment or extinguishment of rights is enough, and reduction of the face value proportionately extinguishes the shareholder's right to dividend and to share in the net assets on liquidation - but pointed out that section 2(22)(d) had not been considered in that case. Read together, the two provisions divide the distribution. The Court drew support from Urmila Ramesh, where it had held that section 2(22) deems only distribution of accumulated profits to be dividend, and that the words whether capitalised or not show the legislature meant profits capable of being accumulated and capitalised, which excludes a return of capital itself. What is returned as capital is therefore left to the capital gains computation, against the apportioned original cost.
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.
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Handle my notice → Ask a CA on WhatsAppBoth, in that order. The Supreme Court held that what a company distributes on a reduction of capital splits into two components. So much as can be correlated with its accumulated profits, capitalised or not, is deemed dividend under section 2(22)(d) and is taxed as income. Only the excess over accumulated profits is a capital receipt, from which the cost of acquiring the extinguished portion of the shareholding is deducted to find any capital gain. The Court also held that a loan already taxed as deemed dividend under section 2(22)(e) reduces the company's accumulated profits. This was decided by the Supreme Court (Supreme Court of India - Mrs Sujata V. Manohar and A.P. Misra, JJ (judgment by Sujata V. Manohar, J)) and bears on section 2(22)(d), section 2(22)(e), section 45, section 2(47), section 194 of the Income Tax Act 1961. This is the decision that fits section 2(22)(d) together with the capital gains charge on a capital reduction. Kartikeya Sarabhai and Anarkali Sarabhai had established that a reduction extinguishes rights in the share and so is a transfer within section 2(47), but neither considered the deemed dividend provision. Narasimhan supplies the missing step and fixes the order of taxation: dividend first, up to accumulated profits, capital gains only on what is left. It also decides a point that recurs whenever section 2(22)(e) has been applied to a closely held company - once a loan has been taxed as deemed dividend, the legal fiction must be carried to its logical conclusion, so that sum comes out of accumulated profits and is not available to be treated as dividend a second time. If it applies to you, the first step is this: On a capital reduction, work out the company's accumulated profits first, including capitalised profits, and treat the distribution as dividend up to that figure before computing any capital gain.
The assessee held 70 shares of Rs 1,000 each in Kasthuri Estates (Pvt) Ltd. In the previous year relevant to assessment year 1963-64 the company reduced its capital, following the Companies Act procedure and obtaining an order of the court, with effect from 20 May 1962. The face value of each share came down from Rs 1,000 to Rs 210, and on that reduction the company distributed money and some of its properties to the shareholders pro rata, including to the assessee. In an earlier year the company had advanced Rs 48,250, Rs 14,667, Rs 1,400 and Rs 200 to four of its shareholders, a total of Rs 64,517, and those advances had been taxed in their hands as deemed dividends under section 2(22)(e). The Tribunal held that no capital gains accrued to the assessee because no right had been extinguished and there was no transfer, and that the Rs 64,517 reduced the company's accumulated profits. Both questions were referred at the department's instance. The matter was decided on 1998-12-14 by the Supreme Court (Supreme Court of India - Mrs Sujata V. Manohar and A.P. Misra, JJ (judgment by Sujata V. Manohar, J)). On those facts the Supreme Court held as follows. On the first question the Court held for the assessee: the Rs 64,517 already taxed as deemed dividend under section 2(22)(e) must be treated as having come out of accumulated profits, and goes to reduce those profits, capitalised or not, whenever they fall to be determined. On the second question it held against the assessee. A reduction of capital extinguishes the shareholder's rights proportionately and is therefore a transfer, following Kartikeya Sarabhai and Anarkali Sarabhai. But the distribution has two components. To the extent it can be correlated with the company's accumulated profits, capitalised or not, it is dividend under section 2(22)(d) and taxable as income. Only the excess is a capital receipt, and capital gains arise only where that excess exceeds the cost of acquiring the interest extinguished. The property given to the assessee in lieu of Rs 790 per share had to be valued by the Tribunal, which had never reached the point, and the matter went back for that. The appeal was disposed of accordingly.
On the first question the Court worked from the nature of the fiction. A dividend under section 205 of the Companies Act can be paid only out of profits, and section 2(22) accordingly directs that a payment it deems to be dividend be treated as made out of accumulated profits, capitalised or not. Section 194 reinforces this by requiring the principal officer to deduct tax from such a payment as dividend. A legal fiction must be carried to its logical conclusion: if a loan is deemed dividend to the extent the company possesses accumulated profits, the sum so treated must be adjusted against those profits. On the second question the Court accepted the transfer analysis of Kartikeya Sarabhai - a sale is not necessary, since relinquishment or extinguishment of rights is enough, and reduction of the face value proportionately extinguishes the shareholder's right to dividend and to share in the net assets on liquidation - but pointed out that section 2(22)(d) had not been considered in that case. Read together, the two provisions divide the distribution. The Court drew support from Urmila Ramesh, where it had held that section 2(22) deems only distribution of accumulated profits to be dividend, and that the words whether capitalised or not show the legislature meant profits capable of being accumulated and capitalised, which excludes a return of capital itself. What is returned as capital is therefore left to the capital gains computation, against the apportioned original cost. In the words reproduced by the source cited on this page: "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."
It was decided by the Supreme Court on 1998-12-14. Binding on every court and authority in India. A Supreme Court decision binds every assessing officer, every Commissioner (Appeals), every bench of the Income Tax Appellate Tribunal and every High Court in India. An officer who declines to follow it is acting contrary to law, and that refusal is itself a ground of appeal. On section 2(22)(d), section 2(22)(e), section 45, section 2(47), section 194, the practical question is whether the facts of your own notice match the facts of this case closely enough for the same rule to apply.
It cuts both ways and is cited by both sides. On the first question the Court held for the assessee: the Rs 64,517 already taxed as deemed dividend under section 2(22)(e) must be treated as having come out of accumulated profits, and goes to reduce those profits, capitalised or not, whenever they fall to be determined. On the second question it held against the assessee. A reduction of capital extinguishes the shareholder's rights proportionately and is therefore a transfer, following Kartikeya Sarabhai and Anarkali Sarabhai. But the distribution has two components. To the extent it can be correlated with the company's accumulated profits, capitalised or not, it is dividend under section 2(22)(d) and taxable as income. Only the excess is a capital receipt, and capital gains arise only where that excess exceeds the cost of acquiring the interest extinguished. The property given to the assessee in lieu of Rs 790 per share had to be valued by the Tribunal, which had never reached the point, and the matter went back for that. The appeal was disposed of accordingly. It arises in Capital Gains matters, on section 2(22)(d), section 2(22)(e), section 45, section 2(47), section 194 of the Income Tax Act 1961, and was decided by Supreme Court of India - Mrs Sujata V. Manohar and A.P. Misra, JJ (judgment by Sujata V. Manohar, J). Before relying on it, read the source linked on this page and check whether it has since been distinguished, overruled or overtaken by an amendment to the Income Tax Act. In practice the steps that follow from it are these. Deduct from accumulated profits every earlier payment already taxed as deemed dividend under section 2(22)(e), and keep the assessment orders of those shareholders to prove it. Where the shareholder is paid in property rather than cash, settle the valuation of that property - the Court left this open and sent it back to the Tribunal. Apportion the original cost of acquisition to the part of the shareholding that is extinguished; capital gains arise only on the excess of the capital component over that cost.
Still good law. A citator search returns 44 later decisions citing this judgment. Its two-limb rule - so much of a distribution on reduction of capital as is attributable to accumulated profits is deemed dividend, and only the excess is dealt with as capital gains - was applied by the Ahmedabad Tribunal in ACIT v Gautam Sarabhai Trust No. 23 (20 March 2001) and, recently, by the Hyderabad Tribunal in Red Earth Agro Farms LLP v ITO and ITO v Sienna Constructions Pvt Ltd (both 22 July 2024), which held that only the part attributable to accumulated profit can be taxed as dividend. Nothing overruling or doubting it was found; the Chennai Tribunal in Cognizant Technology Solutions India Pvt Ltd v ACIT (13 September 2023) records the argument that there is no conflict between it and Anarkali Sarabhai. No source could be cited for that finding. Checking whether an authority still stands matters as much as knowing what it held: a decision may be overruled on one point and survive on another, or the provision it interprets may have been amended since. Read the source and the editor's note on this page before relying on it in a reply to an Assessing Officer or in an appeal.
The harvested page carries no citation list and no case number, so the reported field is empty. The batch line listed sections 46, 46(2) and 2(22)(c); the judgment in fact turns on sections 2(22)(d), 2(22)(e), 45 and 2(47), and I have taken the sections from the judgment. The harvested text has numerous transcription errors in figures and names - the total advances are given as Rs 64,517 and the shareholding as 70 shares of Rs 1,000 - and the valuation of the property distributed was expressly left to the Tribunal. This library shows the verification state of every entry openly. This entry has not yet been read in full by a chartered accountant. The summary reflects the sources listed on this page. Read the source before you rely on it in a reply to an Assessing Officer or in an appeal before the Commissioner (Appeals) or the Income Tax Appellate Tribunal.
On the first question the Court held for the assessee: the Rs 64,517 already taxed as deemed dividend under section 2(22)(e) must be treated as having come out of accumulated profits, and goes to reduce those profits, capitalised or not, whenever they fall to be determined. On the second question it held against the assessee. A reduction of capital extinguishes the shareholder's rights proportionately and is therefore a transfer, following Kartikeya Sarabhai and Anarkali Sarabhai. But the distribution has two components. To the extent it can be correlated with the company's accumulated profits, capitalised or not, it is dividend under section 2(22)(d) and taxable as income. Only the excess is a capital receipt, and capital gains arise only where that excess exceeds the cost of acquiring the interest extinguished. The property given to the assessee in lieu of Rs 790 per share had to be valued by the Tribunal, which had never reached the point, and the matter went back for that. The appeal was disposed of accordingly.
TaxSphere, “CIT v G. Narasimhan”, https://taxnotice.vittsphere.com/caselaw/case/cit-v-g-narasimhan/ (validity last checked 2026-08-29)
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