Analysis Of Two Important Judgements (Jan – March 2014)

1. S. 56(2)(vii) does not apply to bonus & rights shares offered on a proportionate basis even if the offer price is less than the FMV of the shares.

Sudhir Menon HUF vs. ACIT – Mumbai ITAT – “A” Bench – ITA no. 4887/Mum/2013 dated 12-3-2014 for Assessment Year 2010-11. (www.itatonline.org).

1.1. The synopsis of the decision is reproduced as under:-

“Section 56(2)(vii)(c) (ii) provides that where an individual or a HUF receives any property for a consideration which is less than the FMV of the property, the difference shall be assessed as income of the recipient. Section 56(2) (vii) does not apply to the issue of bonus shares because there is a mere capitalization of profit by the issuing-company and there is neither any increase nor decrease in the wealth of the shareholder as his percentage holding remains constant. The same argument applies pari material to the issue of additional shares to the extent it is proportional to the existing share-holding because 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. The fall in the value of the existing holding has to be taken into account. As long as there is no disproportionate allotment, i.e., shares are allotted pro-rata to the shareholders, based on their existing holdings, 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. There is, accordingly, no question of Section 56(2) (vii) (c) getting attracted in such a case. A higher than proportionate or a non-uniform allotment though would attract the rigor of the provision to the extent of the disproportionate allotment and by suitably factoring in the decline in the value of the existing holding.”

1.2. Readers may also examine the conclusion drawn by the Tribunal on the basis on my reasoning given below.

1.3. In my mind, the decision endorses the legal principle that the subject matter of taxation is always ‘income’. There must be a ‘gain’ (in a real sense) in the hands of the assessee – so as to hold that ‘income’ has resulted to him and thereby, tax is attracted as a statutory consequence. A ‘gain is conceivable when some enrichment results to the assessee from a transaction. In short, there must be betterment in the wealth position of the assessee by the transaction.

1.4. This proposition is also manifest from the reading of section 56.

Section 56 (1) – ‘Income of every kind which is not to be excluded from the total income under this Act shall be chargeable to income tax under the head ‘income from other sources’ – if it is not charged to income tax under any head specified in section 14, item A to E’.

Section 56 (2) – “In particular and without prejudice to the generality of the provisions of sub-clause (1), the following incomes shall be charged to income tax under the head “income from other sources” namely …..”.

Section 56 thus clearly reiterates the law that what are chargeable to tax under its provision are items of ‘income nature’.

1.5. The concept of ‘income’ must be understood both in its qualitative sense and quantitative sense.

In a qualitative sense, it flaunts the characteristic of a ‘gain’ resulting to the assessee. In other words, the assessee must become monetarily better off by the transaction of receipt of property.

In its quantitative sense, it is a ‘measure’ of the gain earned in terms of money.

It is the ‘income’ in its qualitative sense that attracts the charge of income tax through the charging section 4 of the Income Tax Act. Once the income is so found chargeable, the next step is to get it measured under the computational provisions pertaining to each head of the income. This is the determination of income in its quantitative sense.

1.6. Applying this principle in the context of section 56 (2), we can note that the taxing of the difference between the consideration paid by the assessee and the market value of the property is only a computation provision and not a charging one. It is only provides a means to measure the gain .

In short, the charge of income tax u\s 56 (2) is only on a ‘gain’ and it is only if there is a gain in the real sense that the same gets measured in terms of the quantifier i.e. the difference between the market value of the property and the consideration paid.

On the other hand, if there is no gain, then there is no need to resort to the computational provision at all.

This is the legal principle that underlies the decision of the Mumbai Tribunal.

1.7. What happens in an allotment of shares by a company? As per the Supreme Court decision in the case of Sri Gopal Jalan and Co. vs. Calcutta Stock Exchange Association – AIR 1964 SC 250 / (1963) 33 Com. Cases 862, an ‘allotment’ means the appropriation out of previously unappropraited share capital of a company of a certain number of shares to a person. Till such allotment, the shares do not exist as such. It is on allotment in this sense that the shares come in to existence.

1.8. Whereas it is true that the shares did not exist as ‘property’ prior to allotment, the same become definitely existent in the hands of allottee when the shares are allotted.

This will be evident on reading of section 44 of the Companies Act, 2013 (corresponding to section 82 of the erstwhile Companies Act, 1956). The section endorses that a ‘share’ in a company is movable property transferable in the manner provided by the articles of the company.

We may therefore agree that a share is ‘movable property’ for purposes of section 56 (2} (vii) of the Income Tax Act 1961.

1.9. The exercise of allotment of shares however does not involve a ‘transfer’ of property. This position has been observed by the Supreme Court in its tax decision in the case of Khoday Distilleries Ltd. vs. CIT – civic appeal no. 6654 of 2008 dated 14-11-2008 reported in www.itatonline.org

Here, the department had held that on the company allotting rights and bonus shares to its shareholders in a disproportionate manner, it had made a “gift”.

The Supreme Court rejecting this contention held as under:-

An allotment of shares is a “creation” of shares and not a “transfer” of shares. There is a vital difference between the two. An “allotment” is the creation of shares by appropriation out of the unappropriated share capital to a particular person. A share is a chose in action. A chose in action implies existence of some person entitled to the rights in action in-contradistinction from rights in possession. There is a difference between issue of a share to a subscriber and the purchase of a share from an existing shareholder. The first case is that of creation whereas the second case is that of transfer of chose in action. An allotment is not a transfer and does not attract s. 4(1) (a) of the Gift-tax Act.

From the above, we can reconcile with the legal position that there is no ‘transfer’ involved in allotment of shares. On allotment, there is only creation of shares.

1.10. But, even though there is no ‘transfer’ involved in allotment, one cannot say that there is no ‘receipt’ of property in allotment. We have seen above that shares are movable property and even though the same were not existent as ‘property’ before allotment, they become existent on allotment.

As per the Supreme Court decision cited above, the shares are ‘created’ by the exercise of allotment. So, on allotment, the shares become ‘existent’ in hands of the allottee, and therefore, it may be fair to say that he ‘receives’ movable property at that time.

1.11. It is seen that the definition of income u/s 2 (24) includes in clause (xv) –“any sum of money or value of property referred to in clause (vii) or clause (viia) of sub-section (2) of section 56”.

We have seen above the subject matter of taxation under section 56 are ‘incomes’. Therefore, it can be fairly said that the ‘value of property’ in section 2 (24) (xv) must necessarily be representative of ‘income’.

1.12. An exercise of issue of bonus shares to shareholders is mere capitalization of the existing profits and reserves on hand of the company. The shareholders were entitled to these existing surpluses. In this sense, what the shareholders receive by way of bonus shares are their pre- existing entitlements only and therefore, there is no new gain created to the allottees on allotment of bonus shares.

On allotment of bonus shares, there is neither ‘gain’ nor betterment in his wealth position to the allottee In absence of income in qualitative sense in the allotment transaction, there is no need to invoke the computation provisions in section 56 (2)(vii). The provisions of section 56 (2)(vii) are meant for computing real gains and not for imputing gains which are nonexistent.

1.13. Let us now consider the case of rights issue by various examples.

Let us assume a model in which a private company has only two shareholders, A & B ,holding 100 shares each of Re. 1. The paid up share capital is thus Rs. 200. Let us assume that the company has reserves of Rs. 600 on hand and all its assets are in liquid form.

The balance sheet can be drawn as under :-

Liabilities.	Rs.	Assets.	Rs
Share capital Mr. A’s shares Mr. B’s shares Total capital (200 shares) Reserves	100 100 200 600	Liquid Assets	800
Total	800		800

From the above example, we can assume that the fair market value of each share of Re. 1 at Rs. 4. ( Rs. 800/200 shares).

1.14. Let us now assume that there is a rights issue in which each shareholder is being allotted one share for every share at Re. 1 each {i.e. at par}. The balance sheet after allotment will reflect as under :-

Liabilities.	Rs.	Assets.	Rs
Share capital Mr. A’s shares Mr. B’s shares Total capital (400 shares) Reserves	200 200 400 600	Liquid Assets.	1000
Total	1000		1000

From the above example, we re-calculate that the fair market value of each share of Re. 1 at Rs. 2.50. ( Rs. 1000/400 shares) as against Rs. 4.00 before the rights issue.

Two aspects come in to my mind at this juncture.

Firstly, the FMV of the share has fallen from Rs. 4.00 to Rs. 2.50. In other words, the allottee has lost Rs 1.50 on the FMV after the rights issue.

Secondly, out of the FMV of Rs. 2.50, Re. 1 is the contribution of the allottee on the rights issue and the balance of the FMV of Rs. 1.50 is derived from the FMV of Rs. 4.00 of the share held prior to the rights issue.

In short, the FMV component of Rs. 1.50 is not gain derived by allotment of the new share, but merely a carried forward pre-existing value. It cannot be said therefore that the allottee has made a new gain of Rs. 1.50 on account of receipt of the rights share allotted.

1.15. Based on these propositions, let us proceed to determine whether the provisions of section 56 (2) (vii) are attracted on allotment of bonus and right shares.

(a) We have seen above that the general principle in taxation is that the subject matter of tax is always ‘income’. In order to hold that there is income resultant to the assessee, there must be a ‘gain’ to him in the real sense. A ‘gain’ is conceivable when there is some enrichment resulting from a transaction i.e. betterment in his wealth position.

We have seen above that the provisions of section 56 also retain the law that what is chargeable under its provisions are ‘incomes’.

In the above examples of bonus and rights issues, no gain in real sense had resulted to the allottee . The increase in the value of the bonus or rights share was nothing but a derivative from the fair market value of the share existing prior to the new issue. There was no new gain derived on account of receipt of the bonus or rights share.

(b) We have noted that the concept of ‘income’ must be understood in a dual sense i.e. qualitative and quantitative. In qualitative sense, it must flaunt the characteristic of a ‘gain’. In quantitative sense, it must be understood as a measure of the gain earned in monetary terms.

What attracts the income tax charge under the charging section 4 is the income in its qualitative sense. Once a tested item is found to be income, the charge to tax is attracted. The next step would be the determination of the taxable income in a quantitative form. This is done under computational provisions as applicable to each head of income.

(c) In context of section 56 (2) (vii), the first step would be to ascertain whether a transaction of receipt of a property produces a ‘gain’ {i.e. some enrichment or betterment in wealth position) to the assessee. If the answer to the same is in affirmative, then the gain has to be computed as difference between the fair market value of the property and the consideration paid for receiving the property. If the answer is negative, then there is no need to take access to the computation provisions in section 56 (2)(vii).

In short, the provisions of section 56 (2)(vii), which determines the difference between the fair market value of the property and the consideration paid, constitute computational provisions and is not the charging section. The charging section is section 4 only.

In the instant examples of bonus and rights issues, we have seen above that there is no new gain to the allottee on account of the new issue. There is therefore no charge of tax attracted under the charging section 4 on the transaction. In such situation, there ought to be no question of resorting to the computation provisions in section 56 (2) of computing the gain by comparing the fair market value of the property received with the consideration paid.

The conclusion reached by the Mumbai Tribunal that the provisions of section 56 (2) (vii) are not attracted in cases of bonus issue and also rights issues on proportionate basis therefore appears to me correct – though on a slightly different reasoning.

Readers may apply their own minds to the issue.

2. Section 41 (1) – Omission on part of the assessee to pay off a trading liability – can be construed as an unilateral act on part of assessee as not to pay – cessation of liability may be said to result –addition of unpaid trade liability justified u\s 41 (1).

Decision of Delhi High Court in the case of CIT vs. Chipsoft Technology (P) Ltd – 26 taxmann.com 109 (Delhi)

2.1. The assessment year involved in this case is A.Y. 2006-07. The facts of the case are that the assessee had shown in its accounts unpaid liability on account of its employees’s dues. Out of this, a part pertained to salary for the year 2005-06 and the balance pertained to the previous years, some extending to as far back in period as 2000-01. The Assessing Officer held that there was a cessation of assessee’s liability and added the amount invoking the provisions of section 41(1). The assessee succeeded in the appeals before Commissioner (Appeals) and the Tribunal.

2.2. In the appeal filed by the Income Tax Department, the following question of law was posed before the Delhi High Court:-

"Did the Tribunal fall into error of law, in its impugned judgment in setting aside the disallowance of Rs. 32, 28,724/- towards unpaid liability claimed in respect of salaries of the assessee for the assessment year 2006-07?"

2.3. Before the High Court, it was contended that there was cessation of the liability by operation of law and that therefore, there was no case for making an addition u\s 41 (1).

The High Court has however rejected the assessee’s arguments and upheld the addition made by the Assessing Officer with the following findings:-

“Two aspects are to be noticed in this context. The first is the view that liability does not cease as long as it is reflected in the books, and that mere lapse of the time given to the creditor or the workman, to recover the amounts due, does not efface the liability, though it bars the remedy. This view is an abstract and theoretical one, and does not ground itself in reality.

Interpretation of laws, particularly fiscal and commercial legislation is increasingly based on pragmatic realities, which means that even though the law permits the debtor to take all defences, and successfully avoid liability, for abstract juristic purposes, he would be shown as a debtor. In other words, it would be illogical to say that a debtor or an employer, holding on to unpaid dues, should be given the benefit of his showing the amount as a liability, even though he would be entitled in law to say that a claim for its recovery is time barred, and continue to enjoy the amount.

The second reason why the assessee’s contention is unacceptable is because with effect from 1-4-1997 by virtue of the Finance Act, 1996 (No.2), an Explanation was added to section 41 which spells out that ‘loss or expenditure or some benefit in respect of any such trading liability by way of remission or cessation thereof shall include the remission or cessation of any liability by a unilateral act by the first mentioned person under clause’. The expression ‘include’ is significant; Parliament did not use the expression ‘means’. Necessarily, even omission to pay, over a period of time, and the resultant benefit derived by the employer/assessee would therefore qualify as a cessation of liability, albeit by operation of law.

The submission of the assessee that no period of limitation is provided for under the Industrial Disputes Act, as a result of which it is exposed to liability at any time, is insubstantial and unpersuasive”.

2.4. The decision has come indeed come as a shocker to all. Generally, cessation of liability was understood to be an outcome of an operation of law. Also, when the assessee writes back the trading liability in his books, his conduct would draw a presumption of cessation of liability against him. But, this is the first case where an alleged omission to pay over a period of time has be construed as resulting in cessation of liability.

I am not commenting on the correctness of this decision. One should expect the Income Tax Department to take recourse to this decision to make additions u\s 41 (1) in several cases in the future.

2.5. But, the point I wish to put forward to the Readers is on a different lines. In order to invoke the provisions of section 41 (1), it is not enough that the Income Tax Department shows that that the trade liability has ceased. It is further essential that that the cessation is proved to be in the year under assessment only. Since it is the Income Tax Department who is alleging the cessation, the onus lies on it to specifically show that the event of cessation has taken place in the year under assessment. Merely because in the course of assessment, a long outstanding liability is found unpaid, it does mean that that the cessation has taken place in that year itself. It could be in any prior year as matter of fact. While the issue of cessation of trade liability frequently appears in litigations, the issue of the year of cessation rarely figures.

Even in the Delhi High Court decision, the question of year of cessation was not before the High Court and what was involved in question was only whether there was a cessation or not. Therefore, even based on this decision, if an act of omission to pay a trade liability is inferred on assessee in assessment, there still remains on the Income Tax Department the burden of further showing that the alleged act had taken place in the year under assessment only in order to successfully support its addition u\s 41 (1). It may be noted that a decision of a High Court is a precedent only on the question answered by it and not on an issue which was not before it for consideration.

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