Capital Redemption Reserve Account

Capital redemption reserve account is a reserve created by a company to offset the reduction in capital that occurs when the company redeems preference shares or buys back its equity  shares.

When is a capital redemption 

reserve account created?

A capital redemption reserve account is created in two situations:

• When a company redeems preference shares. The Companies Act, 2013, Section 55 (2) (c) states that if a company proposes to redeem its preference shares out of the profits of the company, a sum equal to the nominal amount of the shares to be redeemed must be transferred to a capital redemption reserve account.

Preference shares are a type of share that gives the holder priority over ordinary shareholders in terms of dividends and repayment of capital. When a company redeems preference shares, it is essentially returning the capital to the preference shareholders. The capital redemption reserve account offsets this reduction in capital. 

• When a company buys back its own equity shares. The Companies Act, 2013, Section 69 (1) states that where a company purchases its own shares out of free reserves or securities premium account, a sum equal to the nominal value of the shares so purchased must be transferred to the capital redemption reserve account.

When a company buys back its shares, it reduces the number of outstanding shares. This can have several benefits, such as increasing the earnings per share (EPS) or returning capital to shareholders. However, it also reduces the company’s capital. The capital redemption reserve account offsets this reduction in capital.

Why is a capital redemption reserve account created?

When a company redeems preference shares or buys back its own equity shares, it effectively shrinks its capital base. This might raise concerns for creditors, who have a preferential claim on company assets over shareholders. After all, if the capital base shrinks before creditors are paid, their claim might be proportionately reduced.

However, companies sometimes engage in buybacks or redemptions even when creditor claims aren’t fully settled. To safeguard creditors’ interests and maintain confidence in the company’s financial health, a capital redemption reserve account is created.

It essentially holds funds equal to the amount of capital lost through share buybacks or redemptions. By maintaining this reserve, the company assures creditors that their claims remain protected, even though the capital base has technically shrunk.

In simpler terms, the capital redemption reserve account serves as a placeholder, representing the missing capital until it’s fully repaid to creditors, upholding their preferential position.

How is a capital redemption reserve account created?

The amount of the capital redemption reserve account is equal to the amount of the capital that is being reduced. For example, Imagine a company has 2,000 preference shares with a par value of Rs.100 each. They decide to redeem these shares by issue of 5000 preference shares with a par value of Rs.10 each and balance by  using their free reserves 

1. Calculate the total value of redeemed shares: 2,000 shares * Rs.100/share = Rs.200,000
2. Calculate the value of new shares issued: 5,000 shares * Rs.10/share = Rs.50,000
3. Determine free reserve used: Rs.200,000 (total value) – Rs.50,000 (new shares) = Rs.150,000

Therefore, the capital redemption reserve account needs Rs.150,000. This amount represents the reduction in capital due to redeeming the original preference shares.

How is a capital redemption reserve account funded?

The capital redemption reserve account is typically funded from the company’s profits or its free reserves.

Frequently asked questions about capital redemption reserve accounts

• Can we use a capital redemption reserve account to write off capital losses?

No, It can be used to issue fully paid bonus shares to the company’s members, as per section 55(4) of the Companies Act, 2013.

• Can a company issue irredeemable preference shares?

No, a company cannot issue irredeemable preference shares, Section 55 (1) of the Companies Act,2013. Preference shares must be redeemable within a certain period, typically 20 years.

• Can a company issue preference shares redeemable for more than 20 years?

Yes, a company can issue preference shares that are redeemable for more than 20 years for the specified infrastructure projects. However, there are strict conditions that must be met.

• Can a capital redemption reserve account be used to make partly paid-up shares as fully paid-up?

No, a capital redemption reserve account cannot be used to make partly paid-up shares as fully paid-up.