Deeming Fiction Under Section 50 Does Not Extend To Section 74

BACKGROUND

• Seaview Developers Pvt. Ltd. (‘Assessee’) was engaged in the business of developing and leasing commercial real estate property in India, particularly an SEZ project in Uttar Pradesh. Being an SEZ developer/operator, the Assessee was eligible to claim deduction under section 80-IAB of the Income-tax Act, 1961 (the ‘Act’) for profits derived from development and operation of the SEZ.
• For AY 2017-18, the Assessee filed its return declaring total income of INR 4.33 crore under normal provisions and book profit of INR 59.12 crore under section 115JB of the Act. The assessment was completed under section 143(3), making various additions/disallowances, including levy of buyback tax under section 115QA on capital reduction, disallowance of interest relating to capital reduction, interest on CCDs, etc.
• The key issue before the ITAT was whether a court-approved capital reduction undertaken by the Assessee could be treated as a buyback of shares liable to tax under section 115QA, and whether related interest expenses were allowable.¹

FACTS

• The Assessee’s equity shares were held by BREP India Office Holdings IV Pte. Ltd. (‘BREP IV’), a Singapore-based foreign company registered as a foreign portfolio investor with SEBI. During FY 2016-17, the Assessee passed resolutions for reduction of share capital under sections 100 to 104 of the Companies Act, 1956, and the scheme was approved by the Bombay High Court.
• Pursuant to the approved scheme, the Assessee cancelled 36,768 equity shares and paid approximately INR 474.98 crore to BREP IV. Out of this amount, INR 136.74 crore was treated as deemed dividend under section 2(22)(d) and Dividend Distribution Tax of INR 27.84 crore was paid under section 115-O of the Act. The balance net consideration was offered by BREP IV as capital gains in its Indian return of income.
• The AO, however, treated the capital reduction as a buyback transaction, alleging that it was a colourable device to avoid tax, and levied tax under section 115QA, along with interest under section 115P of the Act. The AO also disallowed interest on borrowed funds used for capital reduction, interest on CCDs issued to BREP IV.
• CIT(A) upheld the levy under section 115QA and certain interest disallowances

ARGUMENTS PLACED

Assessee’s Arguments

• The Assessee argued that the transaction was a genuine capital reduction, duly approved by the Bombay High Court under sections 100 to 104 of the Companies Act, 1956, and could not be recharacterized as a buyback merely because shares were cancelled and payment was made to the shareholder.
• It was submitted that capital reduction and buyback are legally distinct concepts. In capital reduction, shares are cancelled pursuant to a court-approved scheme, whereas in a buyback, the company purchases its own shares and thereafter extinguishes them. Therefore, section 115QA, which applies to buyback of shares, could not be invoked.
• The Assessee further contended that section 2(22)(d) specifically covers distribution to shareholders on reduction of capital to the extent of accumulated profits, and the Assessee had already discharged DDT under section 115-O on the deemed dividend portion. Applying section 115QA again would result in double taxation.
• On interest expenses, the Assessee argued that borrowings used for capital reduction were incurred for business/commercial expediency, including rationalisation of capital structure and reduction of cost of capital, and therefore interest was allowable under section 36(1)(iii) of the Act.
• Regarding interest on CCDs, the Assessee submitted that CCDs are debt instruments until conversion into equity, and all evidence establishing identity, creditworthiness and genuineness of BREP IV was submitted, including FPI registration, incorporation certificate, PAN, tax residency certificate, FIRC, FC-GPR forms, valuation reports, bank statements and confirmations.

Revenue’s Arguments

• The Revenue argued that though the transaction was structured as capital reduction, its real effect was similar to buyback because shares were extinguished/cancelled and money was returned to the shareholder. Therefore, according to Revenue, section 115QA applied after the Finance Act, 2016 amendment.
• Revenue also contended that the Bombay High Court’s approval of the capital reduction scheme did not determine the income-tax consequences of the transaction and therefore did not prevent the tax authorities from independently examining its taxability under the Act.
• On interest expenditure, Revenue argued that funds borrowed for capital reduction were used for a capital purpose and not for the Assessee’s SEZ business, and hence interest was not allowable under section 36(1)(iii).
• In relation to CCDs, the Revenue supported the disallowance of interest by arguing that the original CCD subscription had been questioned under section 68, and CIT(A) also treated CCDs as capital/equity-like instruments rather than pure debt.

ITAT’S RULING

• The ITAT held that capital reduction and buyback are distinct legal transactions under company law as well as under the Income-tax Act. A capital reduction approved under sections 100 to 104 of the Companies Act, 1956 cannot be treated as a buyback unless the transaction actually satisfies the characteristics of a buyback.
• The ITAT observed that in capital reduction, shares are directly cancelled pursuant to court approval, whereas in buyback, the company purchases its own shares and thereafter extinguishes them. Since the shares did not first become property of the Assessee, the transaction could not be regarded as a purchase of its own shares. Accordingly, section 115QA was held inapplicable, and the levy of buyback tax and interest under section 115P was deleted.
• The ITAT further held that the Finance Act, 2016 amendment to section 115QA merely expanded the provision to cover buybacks undertaken under different provisions of company law and was not intended to bring court-approved capital reductions within its ambit.
• The ITAT also rejected the AO's allegation of a colourable device, noting that the deemeddividend portion had already been subjected to DDT and the balance had been offered by BREP IV as capital gains, so the arrangement resulted in no tax loss when viewed as a whole.
• The ITAT further held that the Assessee had already offered the accumulated profits portion as deemed dividend under section 2(22)(d) and paid DDT under section 115-O. Therefore, applying section 115QA to the same transaction would result in unintended double taxation.
• On the interest relating to borrowed funds used for capital reduction, the ITAT held that the borrowing was commercially expedient and connected with rationalisation of capital structure. The ITAT observed that the expression "for the purposes of business" is of wide import and includes measures undertaken to rationalise a company's capital structure and reduce its overall cost of capital. Relying on principles laid down in judicial precedents² , the ITAT held that the interest expenditure was allowable under section 36(1)(iii) and deleted the disallowance.
• Regarding interest on CCDs, the ITAT held that CCDs remain debt instruments until conversion into equity. Since the Assessee had produced sufficient documentary evidence to prove identity, creditworthiness and genuineness of BREP IV, and the AO had not rebutted such evidence, the disallowance of interest on CCDs was deleted.
• Accordingly, the Assessee’s appeal was allowed.

AURTUS COMMENTS

• This decision reaffirms that a court-approved capital reduction cannot be mechanically equated with a buy-back of shares merely because it results in cancellation of shares and payment to shareholders, especially where the Act provides a specific tax mechanism for capital reduction under section 2(22)(d).
• The decision also lays down an important principle on commercial restructuring, holding that interest on borrowings used for capital restructuring be allowable where such borrowing is backed by commercial expediency.

Footnotes

1 Seaview Developers Private Limited Vs The DCIT [TS-1036-ITAT-2026(DEL)]

2 CIT v. Malayalam Plantations Ltd [1964] 53 ITR 140 (SC) S.A. Builders Ltd. v. Commissioner of Income-tax, Chandigarh [2007] 288 ITR 1 (SC) Colgate-Palmolive (India) Ltd. v. ACIT [2020] 118 taxmann.com 399 (Mumbai – Trib.)

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