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What Is a Capital Reduction

10 Jul 2023

In the pursuit of long-term survival and success, companies often resort to strategic decisions that reshape their financial structures. Capital reduction is one such action taken by businesses to streamline their shareholding equity.

By delving into the concept of capital reduction, this article aims to shed light on its significance and functioning. 

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What is Capital Reduction?

The process of decreasing the company’s shareholding equity with the help of share cancellations and share repurchases is defined as capital reduction. This is generally done in cases of mergers and acquisitions, restructuring, internal reconstruction, increasing shareholder value, etc.

Capital reduction is dealt with in India under Section 66 of the Companies Act, 2013.

How Does Capital Reduction Work?

Capital reduction takes place when a company decides to decrease the amount of its share capital. This is done either by paying the amount to shareholders or by canceling a certain number of shares. This process can be repeated at the discretion of the company, offering a strategic avenue for capital adjustment. 

When a company returns capital to shareholders, it reduces the capital without requiring individual shareholder consent. Permission from each shareholder is not necessary.

During the capital reduction process, it is essential for the company to ensure compliance with relevant rules and regulations. Obtaining proper approval is necessary prior to taking any action.

In order to reduce the share capital, a company needs to follow the following steps:

  1. A notice must be sent to the company's creditors. The notice will relate to the resolution of capital reduction.
  2. After publishing the initial notice, the company has to submit an application to decrease the share capital within a certain time period.
  3. Following the registration of the capital reduction in the commercial register, the company disburses the capital amount to shareholders and subsequently decreases the share capital.

Why Does Capital Reduction Take Place?

Capital reduction takes place due to a variety of reasons, including:

  1. Creating distributable reserves.
  2. Facilitating future dividend payments.
  3. Returning surplus capital to shareholders.
  4. During de-mergers.
  5. Enhancing the efficiency of the capital structure.
  6. Reducing or eliminating paid-up or unpaid shares.
  7. Addressing revenue losses.
  8. Restructuring finances by reducing market capitalization.

What are the Benefits of Capital Reduction?

The benefits of capital reduction include:

  • Safeguarding the company from future losses and potential crises.
  • Mitigating accumulated losses over a period of time.
  • Increasing the company's distributable reserves.
  • Facilitating easier restructuring of the firm, particularly during mergers and acquisitions.
  • Enabling the transfer of non-cash assets to shareholders.

Capital Reduction Vs Shares Buyback

  1. Capital reduction attempts to reduce the tradable shares of the company, whereas through shares buyback, the company repurchases its shares from the market.
  2. The solvency statement provision doesn’t allow shareholders to take any action against capital reduction. But on the other hand, auditor reports and public advertisements are compulsory for share buybacks. The shareholders can easily object here.
  3. Capital reduction results in a rise in distributable reserves, whereas in the case of share buyback, funds are returned to shareholders who do not desire any repayment. 

Conclusion

In conclusion, capital reduction serves as a strategic tool for companies to adjust their share capital and achieve various objectives, such as mergers, restructuring, and increasing shareholder value. By reducing the share capital through share cancellations or repurchases, companies can effectively manage their equity and create distributable reserves.

Capital reduction provides flexibility and enables firms to navigate through financial challenges, safeguard against potential losses, and enhance their financial position. While different from share buybacks, capital reduction offers unique advantages in terms of compliance requirements and the impact on distributable reserves.

By understanding the intricacies of capital reduction, companies can make informed decisions to optimise their capital structure and support their long-term growth.

 

Related Artices: How to handle capital gains on equity MFs through systematic exits | How are capital gains on equity and debt funds taxed? | What can the capital markets expect from the Union Budget 2018?

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