Proportionate allotment of additional shares does not result into income under Section 56(2)(vii)(c) of the Income Tax Act
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Proportionate allotment of additional shares does not result into income under Section 56(2)(vii)(c) of the Income Tax Act

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Recently, the Mumbai Bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Sudhir Menon HUF held that since shares were allotted on pro-rata basis to the shareholders based on their ...

Recently, the Mumbai Bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Sudhir Menon HUF held that since shares were allotted on pro-rata basis to the shareholders based on their existing holdings, additional property was not received by them. It was only an apportionment of the value of their existing holding over a larger number of shares. Accordingly, Section 56(2)(vii)(c) of the Income-tax Act, 1961 (the Act) does not get attracted in the present case.

With respect to right shares if they are allotted to a person not against his existing shareholding or if they are allotted to existing shareholders but disproportionately, there is a scope for value or property being passed on to him and would attract Section 56(2)(vii)(c) of the Act.

Further in case of bonus shares, there is neither any increase nor decrease in the wealth of the shareholder and therefore, the provisions of Section 56(2)(vii)(c) would not apply to bonus shares.

The Tribunal analysed the tax implication under two categories i.e. allotment on a proportionate basis and on a disproportionate basis. The Tribunal held that as regards proportionate allotment there is no taxability under Section 56(2)(vii)(c) of the Act. However, in case of disproportionate issue of additional shares, these provisions may get attracted.

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Proportionate allotment of additional shares does not result into income under Section 56(2)(vii)(c) of the Income Tax Act Proportionate allotment of additional shares does not result into income under Section 56(2)(vii)(c) of the Income Tax Act Document Transcript

  • © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. KPMG FLASH NEWS KPMG IN INDIA Proportionate allotment of additional shares does not result into income under Section 56(2)(vii)(c) of the Act 19 March 2014 B Background Recently, the Mumbai Bench of the Income-tax Appellate Tribunal (the Tribunal) in the case of Sudhir Menon HUF1 (the taxpayer) held that since shares were allotted on pro- rata basis to the shareholders based on their existing holdings, additional property was not received by them. It was only an apportionment of the value of their existing holding over a larger number of shares. Accordingly, Section 56(2)(vii)(c) of the Income-tax Act, 1961 (the Act) does not get attracted in the present case. With respect to right shares if they are allotted to a person not against his existing shareholding or if they are allotted to existing shareholders but disproportionately, there is a scope for value or property being passed on to him and would attract Section 56(2)(vii)(c) of the Act. Further in case of bonus shares, there is neither any increase nor decrease in the wealth of the shareholder and therefore, the provisions of Section 56(2)(vii)(c) would not apply to bonus shares. ________________ 1 Sudhir Menon HUF v. ACIT (SA No. 192/Mum/2013) The Tribunal analysed the tax implication under two categories i.e. allotment on a proportionate basis and on a disproportionate basis. The Tribunal held that as regards proportionate allotment there is no taxability under Section 56(2)(vii)(c) of the Act. However, in case of disproportionate issue of additional shares, these provisions may get attracted. Facts of the case The taxpayer, held 15,000 shares as on the beginning of the relevant previous year, in Dorf Ketal Chemicals Pvt. Ltd. (DKCPL), representing 4.98 percent of the entire share capital being 3,01,316 shares. The entire (or almost the whole) capital in DKCPL was held by the family members of the taxpayer’s karta’s family. The taxpayer was offered 313,624 additional shares (which works to about 21 shares for each share held) at the face value rate of INR100 each, on a proportionate basis. The taxpayer subscribed to and was accordingly allotted 194,000 of those
  • © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. shares. Further, the other shareholders were allotted similar shares and also those shares which were not subscribed by the taxpayer i.e. 119,624 shares (313624 – 194000). The book value of the shares of DKCPL as at the year-end was INR 1,538 per share and the same adopted as a measure of their fair market value (FMV) under the applicable rules2 . In terms of Section 56(2)(vii)(c) of the Act read with the relevant rules, the Assessing Officer (AO) treated the difference of INR 1,438 per share as inadequate consideration toward the acquisition of additional shares and brought the same to tax. The issue before the Tribunal was the validity in law, of the assessment of income being the difference between the value of the shares allotted to the taxpayer and the consideration paid by it in respect thereof. Tribunal’s ruling  Section 56(2)(vii)(c) gets attracted whenever an individual or Hindu undivided family (HUF) receives without consideration a specified property, the FMV of which is in excess of INR50,000, or in case of consideration where the consideration is less than FMV by an amount exceeding the INR50,000.  Section 56(2)(vii) includes the ‘shares and securities’ as the word property occurring in section defined to mean capital assets. However, the shareholders get the right to acquire the additional shares on the passing of the board resolution. This supported the taxpayer’s contention that the provision being never intended to cover a transaction of this nature i.e. where the shares are offered to the existing shareholders – though below market value, on rights basis.  Relying on the various decisions3 it was held that the shareholders get the right to acquire the additional shares on the passing of the board resolution but the receipt of the property is only on their allotment, on which date the shares, a specifies property, comes in existence.  ‘Right share’ is appropriation out of the previously un- appropriated capital of a company of a certain number of shares to a particular person. Till such allotment, the shares do not exist as such, and in a sense come into existence on their allotment. ____________________ 2 Rule 11U and Rule 11UA of the Income-tax Rules, 1962 (Rules) 3 Shree Gopal and Company v. Calcutta Stock Exchange Ltd. [1963] 32 Comp. Cas. 862 (SC), Khoday Distilleries Ltd. v. CIT [2008] 307 ITR 312 (SC)  The valuation date under Rule 11U(j) is the date of the receipt of the property and the shares are received on their allotment. Subsequently, the share certificates are received which evidences its title thereto.  Section 56(2)(vii)(c) seeks to substitute the FMV as the normative basis for transactions involving the receipt of property by a person, being an individual or HUF. Exceptions for transactions are provided and to that extent the provision is well- founded and adequately excepted.  Section 56(2)(vii)(c) was further strengthened and broadened, with Finance Act, 2010 wherein the same was explained as an anti-abuse measure. In the case of Khoday Distilleries Ltd., the Supreme Court held that this provision together with the Wealth Tax Act, 1957 and the Act forms an integrated code. While the Gift Tax Act had sought to bring to tax the shortfall in consideration in the hands of the donor, the present provision/s seek to bring the same to tax as income in the hands of the recipient of the relevant assets.  In certain situations, through the medium of additional shares the controlling interest in a company or interest in property – movable or immovable, is passed on to another at considerations far below the going rate of the relevant or the underlying assets/interest. Only a pro-rata allotment or, where not so, one that is adequately priced, would effectively ensure an exchange of the assets or interest therein at par values.  In order to demonstrate the wholesomeness of the provision, the matter of bonus share is dwelt upon. Issue of bonus shares is capitalization of its profit by the issuing-company and there is neither any increase nor decrease in the wealth of the shareholder (or of the issuing company) and shareholder’s percentage holding therein remains constant4 . The same has the effect of reducing the value per share, increasing its mobility and, thus, liquidity. Accordingly, the provision would not apply to issue of bonus shares. ________________ 4 CIT v. Dalmia Investment Co. Ltd. [1964] 52 ITR 567 (SC), Khoday Distilleries Ltd. v. CIT [2008] 307 ITR 312 (SC)
  • © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.  In the present case issue of additional shares in fact reduced the taxpayers holding to 3.17 per cent from 4.98 per cent. Therefore, the premise on which this provision was not applicable to issue of bonus shares, would to the extent pari-materia, apply in equal measure to the issue of additional shares, i.e. where and to the extent it is proportional to the existing share-holding.  Section 81 of the Companies Act, 1956 is not applicable to a private company hence the company is neither obliged to issue shares to the existing shareholders nor issue on a proportionate basis. Thus, though the issue has elements of a right issue since the offer is made to the existing shareholders on the basis of their shareholding on proportional basis however, the same cannot be termed as a ‘rights issue’ since the company was appropriating the right which could be offered it to another.  To the extent the value of the property in the additional shares is derived from that of the existing shareholding, on the basis of which the same are allotted, no additional property can be said to have been received by the shareholder. For e.g. shares in the ratio 1:1 are offered for subscription at the face value of INR100 as against the current book value of INR1500. The moment a right share is allotted, the book value shall fall to INR800 per share. It is easy to see that the new share partakes a part of the value of the existing share, which is only on the basis of the underlying assets on the company’s books. The excess or 1,400 gets apportioned over two shares as against one earlier, which is already the shareholders’ property. In support of this the Tribunal placed reliance on various decisions5 .  The shares are allotted pro-rata to the shareholders based on their existing holdings and therefore, there is no scope for any property being received by them on the said allotment of shares; there being only an apportionment of the value of their existing holding over a larger number of shares. Accordingly, Section 56(2)(vii)(c) of the Act does not get attracted in the present case though, it is per se applicable to the transaction, i.e., of this genre.  A higher than proportionate or a non-uniform allotment would attract the rigor of the provision on the same premise. A disproportionate allotment could also result on a proportionate offer, where on a selective basis some shareholders abstain from exercising their rights (wholly or in part) and accordingly, transfer the value/property to other shareholders. For example, a case of a shareholding distributed equally over two ________________ 5 Dhun Dadabhoy Kapadia v. CIT [1967] 63 ITR 651 (SC), H. Holck Larsen v. CIT [1972] 85 ITR 285 (Bom) shareholder groups, i.e., at 50 per cent for each. A 1:1 rights issue, abstained by one group would result in the other having a 2/3rd holding. A higher proportion of ‘rights’ shares (as 2:1, 3:1, etc.) would yield a more skewed holding in favour of the resulting dominant group. The Tribunal observe no absurdity or unintended consequences as flowing from the per se application of Section 56(2)(vii)(c) to right shares, which by factoring in the value of the existing holding operates equitably.  Section 55(2)(aa) of the Act clarifies that the values of the original and the additional financial assets are interlinked and accordingly, a gain cannot be computed independent of each other.  In-as-much the value of the additional shares is derived, if only in part, from that of the existing shares, the decline in the value thereof cannot be excluded or ignored in arriving at the property received by the taxpayer by way of additional shares. As a result of the transaction, the taxpayer becomes poorer in-as-much as the value of his holding witnesses a decline after taking into account the payment made for the acquisition of the additional shares.  The receipt of a capital asset is the basis for the charge to tax as income, unless falling under any of the excepted categories and therefore, the receipt (of an asset) has been adopted as the condition of deeming as income under Section 56(2)(vii)[or clauses (v) and (vi)], and also of the provision as being on a firm footing.  In the context of Section 56(2)(vii) as well as its clear language, ‘receipt’ is not a synonym for ‘transfer’ and it flows from its owner. In the context of the provision, it is completely irrelevant that the shares in the issuing company are not its property and that it does not become any poorer as a result of the allotment of shares therein. ‘Receipt’ is a word or term of wide import, and would include acquisition of the defined capital assets in the present context, by modes other than by way of transfer as well.  To the extent ‘right share’ is allotted to a person not against his existing shareholding or, even so, albeit disproportionately, depending on the terms of the allotment, there is a scope for value or property being passed on to him, which cannot be said to be in lieu of or as recompense of his existing property.
  • © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved.  The interpretation made by the Supreme Court in the case of K.P. Varghese, indicates that the provision6 is not a charging section. The provision does not deem as received, something which is in fact not received. Judicial precedents have held that it is as an anti- abuse measure.  To the extent the shares subscribed are right shares, i.e., allotted pro-rata on the basis of the existing share- holding (as on a cut-off date), the provision though per se applicable, does not operate adversely. A disproportionate allotment, though could be allotted under a rights issue, would however invite the rigor of the provision to that extent.  The provision was brought as an anti-abuse measure, only seeks to tax the understatement in consideration as the income in the hands of the recipient (of the corresponding asset). The provision is well founded, even as it is settled that hardship in a case would not by itself lead to supplying casus omissus or reading down the provision.  No property is being passed on to the taxpayer in the instant case, on the allotment of the additional shares. Accordingly, on the ground of inadequate consideration the provision of Section 56(2)(vii)(c) of the Act shall not apply in the present case and, the difference between the FMV of the shares and the amount paid to acquire the shares in relation to such rights shares shall not be assessed as income in the hands of the taxpayer. Our comments This is a welcome decision by the Mumbai Tribunal which needs to be considered for business restructuring/transactions involving issue of additional shares. The Tribunal in the present case held that the shares were allotted pro-rata to the shareholders of a company based on their existing holdings and, additional property was not received by the taxpayer and therefore the difference between the FMV of the shares and the consideration received by the company for allotment of such shares cannot be deemed as income of the shareholder/taxpayer. This decision may also help firm or a closely held companies to mitigate the taxability under Section 56(2)(viia)7 of the Act on receipt of shares of a closely held company. ____________________ 6 erstwhile section 52 of the Act 7 Where a firm or closely held company receives any property being shares of a closely held company without consideration, the aggregate FMV of which exceeds fifty thousand rupees, the whole of the aggregate FMV or for a consideration which is less that aggregate FMV of the property by an amount exceeding fifty thousand rupees, the difference between such consideration and FMV would be chargeable to tax under the head of income from other sources
  • © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. © 2014 KPMG, an Indian Registered Partnership and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. The KPMG name, logo and “cutting through complexity“ are registered trademarks of KPMG International Cooperative (“KPMG International”), a Swiss entity. www.kpmg.com/in Ahmedabad Commerce House V, 9th Floor, 902 & 903,Near Vodafone House,Corporate Road, Prahlad Nagar, Ahmedabad – 380 051 Tel: +91 79 4040 2200 Fax: +91 79 4040 2244 Bangalore Maruthi Info-Tech Centre 11-12/1, Inner Ring Road Koramangala, Bangalore 560 071 Tel: +91 80 3980 6000 Fax: +91 80 3980 6999 Chandigarh SCO 22-23 (Ist Floor) Sector 8C, Madhya Marg Chandigarh 160 009 Tel: +91 172 393 5777/781 Fax: +91 172 393 5780 Chennai No.10, Mahatma Gandhi Road Nungambakkam Chennai 600 034 Tel: +91 44 3914 5000 Fax: +91 44 3914 5999 Delhi Building No.10, 8th Floor DLF Cyber City, Phase II Gurgaon, Haryana 122 002 Tel: +91 124 307 4000 Fax: +91 124 254 9101 Hyderabad 8-2-618/2 Reliance Humsafar, 4th Floor Road No.11, Banjara Hills Hyderabad 500 034 Tel: +91 40 3046 5000 Fax: +91 40 3046 5299 Kochi 4/F, Palal Towers M. G. Road, Ravipuram, Kochi 682 016 Tel: +91 484 302 7000 Fax: +91 484 302 7001 Kolkata Infinity Benchmark, Plot No. G-1 10th Floor, Block – EP & GP, Sector V Salt Lake City, Kolkata 700 091 Tel: +91 33 44034000 Fax: +91 33 44034199 Mumbai Lodha Excelus, Apollo Mills N. M. Joshi Marg Mahalaxmi, Mumbai 400 011 Tel: +91 22 3989 6000 Fax: +91 22 3983 6000 Pune 703, Godrej Castlemaine Bund Garden Pune 411 001 Tel: +91 20 3050 4000 Fax: +91 20 3050 4010