In corporate finance, not all reserves are created equal. Some can be freely used, while others are meant to stay untouched unless the law allows otherwise. Capital reserve is one such category that often confuses directors, founders, and even shareholders.
Under the Companies Act, 2013, capital reserves play a very specific role. They arise from capital profits, come with restrictions on usage, and are closely linked to sections like Section 69 (Capital Redemption Reserve), Section 55 (redemption of preference shares), and Section 65 (reserve share capital).
Understanding capital reserve isn’t just about compliance—it’s about knowing what money your company cannot treat as distributable profit.
What Is Capital Reserve?
Simply put, capital reserves are created out of capital profit, not from normal business operations.
These are profits that arise from non-recurring, non-operational activities. Because of their nature, the law places restrictions on how they can be used.
A key rule to remember is this:
Capital reserves are a type of reserve that cannot be distributed as dividends until they are transferred to the common pool of free reserves, and such transfer is allowed only in limited situations.
Capital Reserve vs Revenue Reserve (A Common Confusion)
This confusion comes up almost every time reserves are discussed at board meetings.
Capital Reserve
- Created from capital profits
- Generally not distributable as dividends
- Used for specific statutory purposes
Revenue Reserve
- Created from operating profits
- Freely distributable (subject to conditions)
- Includes general reserve, retained earnings
If you remember one thing—capital reserve is restrictive, revenue reserve is flexible—you’re already ahead.
How Capital Reserves Are Created
Capital reserves don’t appear out of thin air. They come from specific transactions, such as:
- Profit on sale of fixed assets
- Premium on issue of shares (securities premium)
- Profit on revaluation (in certain cases)
- Capital profits arising during company restructuring
- Buy-back related transfers
These profits are not considered regular income, and hence, they’re parked separately.
Capital Reserve Under the Companies Act, 2013
The Companies Act, 2013 addresses capital reserves through several interconnected provisions. Let’s break them down clearly.
Section 69 – Capital Redemption Reserve (CRR)
This is one of the most important references.
When a company:
- Buys back its own shares out of free reserves or securities premium,
It must create a Capital Redemption Reserve (CRR) equal to the nominal value of shares bought back.
Why?
To ensure the company’s capital base is not weakened.
This CRR is treated as capital reserve and can be used only for:
- Issuing fully paid bonus shares
Nothing else. Not dividends. Not operational expenses.
Section 55 – Redemption of Preference Shares
Under Section 55, when redeemable preference shares are redeemed out of profits:
- An amount equal to the nominal value redeemed must be transferred to CRR
Again, this reserve functions as a capital reserve, preserving creditor protection.
I’ve personally seen companies forget this transfer—and end up correcting years of financial statements later.
Section 65 – Reserve Share Capital
This section applies when an unlimited company converts into a limited company.
Here:
- A portion of uncalled share capital may be classified as reserve share capital
- This capital can be called only in the event of winding up
This reserve is also capital in nature and adds another layer of protection for stakeholders.
Why Capital Reserves Cannot Be Used Freely
The law is strict for a reason.
Capital reserves:
- Protect creditors
- Preserve share capital integrity
- Prevent artificial distribution of wealth
Allowing unrestricted use would dilute the company’s financial discipline and mislead investors.
That’s why capital reserves are a type of reserve that cannot be distributed as dividends until they are transferred to the common pool of free reserves, and even that transfer is rarely permitted.
Accounting Treatment of Capital Reserve
From an accounting standpoint:
- Shown under Reserves & Surplus
- Clearly labelled as Capital Reserve
- Cannot be merged casually with general reserves
Auditors pay close attention here. Mixing capital and revenue reserves is a red flag.
Practical Example (Real-Life Scenario)
Imagine a company sells land it bought years ago and earns a large profit.
That profit:
- Didn’t come from business operations
- Came from disposal of a capital asset
So it goes to capital reserve, not profit & loss account.
I’ve seen startups try to use this “extra money” to declare dividends—and then have to reverse the decision once compliance reviews begin.
Can Capital Reserve Be Converted Into Free Reserve?
Short answer: Usually no.
Exceptions exist only if:
- Specifically permitted by law
- Approved by courts/tribunals in restructuring cases
Otherwise, capital reserve stays where it is.
Common Misunderstandings About Capital Reserve
Let’s clear a few myths:
- ❌ “Money is money, we can use it” – No
- ❌ “Share premium is same as revenue” – Incorrect
- ✅ Capital reserve has legal restrictions
Understanding this early saves directors from future compliance stress.
Why Founders and Directors Should Care
Capital reserve directly affects:
- Dividend declarations
- Buy-back decisions
- Bonus issue planning
- Financial statement accuracy
Ignoring these rules can lead to:
- Auditor qualifications
- Regulatory penalties
- Shareholder disputes
Conclusion
Capital reserve under the Companies Act, 2013 is not just an accounting label—it’s a legal safeguard. Capital reserves are created out of capital profit and are meant to protect the company’s capital structure. The Act addresses them through provisions like Section 69 (Capital Redemption Reserve), Section 55 (preference share redemption), and Section 65 (reserve share capital). Most importantly, capital reserves cannot be distributed as dividends until they are lawfully transferred to free reserves, which is tightly restricted.
Knowing where your reserves come from—and how they can be used—keeps your company compliant, credible, and future-ready.
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