Two kinds of income in one payment
A capital reduction pays you money, or cancels some of your shares for a payment, and the tax law does not treat all of it the same way. The part of the payment that comes out of the company's accumulated profits is a deemed dividend under Section 2(22)(d), and it is taxed in your hands as dividend income, the same as an ordinary dividend since dividends became taxable in shareholders' hands. How much counts as the deemed dividend depends on the company's accumulated profits at the date of the reduction, so it is a figure to establish, not a fixed proportion.
The balance of the payment, beyond the accumulated-profits part, goes through the capital-gains rules. Your shares, or some of them, have been cancelled or reduced in return for the payment, and that is a transfer, so you compute a capital gain on that part: the consideration attributable to it, less your cost in the shares given up. So a single capital reduction can produce both a dividend and a capital gain, taxed under different heads at different rates, which is why it needs to be split carefully.
The Supreme Court point, and the NRI withholding
For years there was a question of whether a capital reduction was even a transfer for capital-gains purposes, since you do not sell your shares to anyone. The Supreme Court settled it in Kartikeya V. Sarabhai, holding that a reduction of share capital extinguishes or relinquishes your rights in the shares, and that is a transfer, so the capital-gains rules apply. It reaffirmed this as recently as 2025 in PCIT v Jupiter Capital, confirming that even a proportionate reduction, where your shareholding is cut but the face value stays, is an extinguishment and so a transfer. So the capital-gains treatment of the non-dividend part is well settled.
For an NRI, the withholding follows the split. The deemed-dividend part carries TDS under Section 195, which you bring down to your treaty dividend rate with a tax residency certificate and Form 10F. The capital-gains part is computed with your cost, and can be reduced with a lower-deduction certificate. One thing to keep clear: this is not the same as a share buyback, which has its own, different rule, so the two should not be run together. A practising CA splits the payment correctly, applies the treaty rate to the dividend part, computes the gain on the rest, and handles the TDS.