Penny Stocks: Capital Gains, Law & Practice

Advocate Paras S. Savla has explained the modus operandi used by unscrupulous taxpayers to launder their unaccounted black money with the aid of bogus capital gains from Penny Stocks. He has also explained the relevant statutory provisions and discussed all the important judgements on the point. He has, however, cautioned that all cases of capital gains from penny stocks cannot be branded by the authorities as bogus and offered advice on what precautions taxpayers should take to avoid being wrongly assessed to tax

Humans! We keep bringing new ideas and creations to simplify our lives and yet end up creating an intricate and complicated web which is anything but simple. We graduated from bartering to commerce and trading to make our lives easy and then to complicate the whole thing, we invented an abstract entity called “company” to limit our risk.

A legal notion of Corporate personhood backed by various legislations across the globe, legalizing companies created a corporation, separate from its associated human beings (like owners, managers, or employees), has at least some of the legal rights and responsibilities enjoyed by natural persons (physical humans). This notion was blessed by House of lords in famous case of Salomon v. A. Salomon and Co. Ltd. (1897) AC 22. These brought about rise of trading of shares and thus formation of Stock Exchanges. In this paper my discussion is restricted to tax implications on penny stocks.

1. What are penny stocks?

The word “penny stocks” comes with a lot of connotations. However, it’s a common term that simply refers to stocks that trade at low prices per share off of major national exchanges. Penny stocks are defined by the US Securities and Exchange Commission (SEC) as a security that trades for less than $5 per share, is not listed on a national exchange, and fails to meet other specific criteria. In the UK, they’re called penny shares, and they’re categorised in a similar way (although the stock price limit is £1). Other countries call them cent stocks.

Over the years, the term “penny stock” has become synonymous with scams and “get rich quick” schemes. One Google Search will reveal thousands of results promising to make you the next penny stock multimillionaire. Not all penny stocks are a scam. However, penny stock markets are abound with low-quality companies, shadow organisations, and pump-and-dump schemes – and a few legitimate companies mixed in for good measure. Penny stocks have existed in some form or another for as long as stock markets have existed. There’s very little information about the early history of penny stocks. After the 1929 Stock Market Crash, however, the US Federal Government realised it needed to overhaul securities regulation and bring an end to the unbridled speculation surrounding penny stocks. In the Government’s eyes, the speculation was what caused the stock markets to crash in 1929. Increased regulation would help investors avoid low-quality, value-less stocks while promoting stocks from more reputable companies – or at least, that was the idea.

Starting in the mid-1990s, penny stock trading exploded with growth, fuelled by the spread of the internet around the world. Prior to the internet, the only real way to trade penny stocks was by phone or over the counter at a stocks exchange floor. Now, with the internet, penny stock discount brokers emerged, offering online platforms where traders could buy and sell penny stocks at discount rates. Investors were lured to penny stocks by the promises of cheap trading fees and the chance of making enormous profits on tiny investments. Throughout the 1990s, new investors entered the stock market.

Penny stocks in the Indian stock market can have prices ranging from ` 5 to 20. These stocks are very speculative in nature and are considered highly risky because of lack of liquidity, smaller number of shareholders, large bid-ask spreads and limited disclosure of information. Considering the nature of penny stocks, they are susceptible to frauds and scams. Hence one has to be cautious while investing in such stocks.

2. News and web-articles

Government is making continuous efforts to curb black money and to stop various schemes being tools used to convert black money, one may still see various and continuous advertisement are made for penny stocks, which can be seen as under:

a) https://rakesh-jhunjhunwala.in dt.21st February, 2018

RadhakishanDamani endorses PorinjuVeliyath’s “Chor” Theory & Buys Recommended stock.

PorinjuVeliyath’s theory with regard to buying stocks of “Chor” promoters has been cold-shouldered by investors. However, the endorsement of the theory by none other than billionaire RadhakishanDamani means that we can no longer ignore it but have to pay attention and implement it.

Porinju explained that there is a world of a difference between a “good company” and a “good stock”, implying that even a “bad company” can be investment worthy if it has the necessary virtues.

b) https://multibaggerpennystocks.in dt. 10th February, 2018

20 multibagger penny stocks which cost less than ` 10 give gains of up to 750% in 2017

c) Business standard dt. 8th February, 2018

CAG seeks SEBI explanation on losses due to long term capital gains benefit.

“The Comptroller and Auditor General of India (CAG) has written to the Securities and Exchange Board of India (Sebi) seeking an explanation on the loss incurred by the exchequer from misuse of the long-term capital gains (LTCG) exemption. According to sources, the market regulator has identified loss worth Rs 150 billion due to price manipulation on the stock market platform to avail the LTCG benefit. So far, Sebi has passed nine interim orders in the matter. Besides, the CAG has sought details of the manipulators. Currently, LTCG is exempt from taxes. The Union Budget 2018-19 proposed to levy a 10 per cent tax on such gains, starting April 1. The regulators have come across several cases were shares of penny stocks and shell companies were jacked up to convert black money into white by showing LTCG.

“The audit authority wants to know the size of the preferential allotment and whether it would be equal to the size of the LTCG violation, especially when the allottee sold the shares,” said a person in the know. In the last one year, the regulator has examined over 14,000 persons but could not establish the trail of fund movement. It was yet to gather sufficient evidence and references to conclude the cases, sources said. Even the information provided by the tax authorities was not sufficient to establish connections among the promoters of these companies, the beneficiaries and the ‘last traded price’ providers and ‘exit’ providers, said the person cited above. In January 2017, the regulator had informed the income tax (I-T) department that there was not enough evidence to establish charges against the manipulators. Sebi, in one of its board information memorandums in 2017, had pointed out practical problems in dealing with these cases. “Enforcement proceedings against such a large number of entities will involve issuing a show-cause notice, inspection of documents, personal hearing and passing of orders.

This is when preliminary examination of cases revealed that collusion among the entities was weak or absent, since most of the transactions were settled in cash. Thus, a further probe based on weak evidence will clog the system and could also result in a futile exercise,” it had said. Official data suggests the I-T department had referred 361 scrips to Sebi for investigating the LTCG manipulation. Of these, Sebi had identified 144 scrips for investigation and concluded investigation in 94 cases during that time. Accordingly, it had barred 1,500 people from trading in the securities market.

Further investigations revealed that over 14,000 people were involved in price manipulation to avail the tax exemption. These were apart from the 64,000 entities identified by the taxman as having evaded taxes worth ` 380 billion. The regulator is examining if the price of shares was manipulated, since it could proceed under Section 11B of the Sebi Act. This allows it to impound or retain the sale proceeds of the company or entity in question. Sebi is of view that it is bound to check only for market manipulation and not the tax evasion angle in these cases.”

d) https://economictimes.indiatimes.comdt. 13th January, 2018

Why investing in low priced penny stocks is not a good idea

e) https://economictimes.indiatimes.comdt. 21st February, 2018

37,000% return!!! This is what a penny stock can do to your wealth

f) https://thewire.in/120384/penny-stocks-bogus-claims-sebi dt. 31st March 2017

SEBI Cracks Down on Misuse of Penny Stocks

g) https://economictimes.indiatimes.com dt. 6th March, 2017

Beware of these 774 rising penny stocks; stock exchanges up vigil

“Mumbai: Stock exchanges have stepped up vigil on movements of smaller and penny stocks in the wake of the sharp surge in their prices. The Bombay Stock Exchange and the National Stock Exchange of India have included 774 lesser-known companies under a graded surveillance measures framework, which is aimed at checking whether the recent advancement in their stock prices was commensurate with their financial health and fundamentals.”

h) https://www.moneycontrol.com/news/business/markets/i-t-department-sebi-begin-crackdown-on-penny-stock-firms-in-pmo-led-push-2442315.html dt.20th November, 2017

I-T Department, SEBI begin crackdown on penny stock firms in PMO-led push.

The Prime Minister’s Office apprised the CBDT of 80 scrips earlier this month. The taxman and SEBI are working together to clamp down tax evasion and tighten the norms.

3. Search, surveys and the investigation report

There are various previous instances where Department investigated in penny stock matters. Not once but twice, Investigation has been conducted on Mr. MukeshChokshi and one may notice many judicial decisions wherein shares dealings took place through his broking firms. On analyzing those decisions one may see that the information collected by the department was not foolproof and the government lost badly in those cases. This turned out a fight for the department to nail down illegal and fraudulent practices in and around penny stocks.

3.1 Kolkata Investigation report

The Directorate of Investigation, Kolkata had undertaken the investigation on a much larger scale than earlier and as a result, they identified a very large number of beneficiaries who may have together taken a huge amount of bogus entries of LTCG. A detailed investigation report dt. 24-7-2015 named “Project bogus LTCG/STCL through BSE listed penny stocks” was made. The span of investigation can be gauged from the fact that they identified 64,811 beneficiaries involving bogus LTCG of nearly ` 38,000 crore.

As per the report, the illegal business of bogus LTCG involves three different personalities. The promoter of ‘Penny stock’ companies (also known as syndicate member), the share brokers & the entry operator who purchases the shares through paper companies by taking cash. Many a times the three categories of individuals perform overlapping roles and, at times, a single individual may perform all the three functions.

In the earlier investigations, the approach was to target the individuals and through them identify the penny stocks and beneficiaries. This method yielded results on a limited scale emanating only from individual / individuals targeted. However, keeping in mind the rampant nature and exponential growth of alleged illegal business in recent times and to cast the net wide, during Kolkata investigations, Department reversed the methodology of investigation. ‘Penny Stocks’ were first identified and then department started targeting the individuals who dealt in them. As a result, department was able to virtually uncover almost all Kolkata based operators in one investigation itself. It was an on-going process, which acquired the character of a project that continued for quite some time, unlike usual investigation which ends with the statement of the individual involved.

3.2 Modus operandi as per the report

As per the report the business of providing entries of bogus LTCG over the years has become much more organised and with economy of scale in full operation the stakes involved had become huge. Before the actual transaction starts taking place, there were brokers in different towns who contact prospective clients and took paper booking for entries. The commission to be paid to the operators was decided at this stage however, no money was paid. Once the booking is complete, the operators have a reasonably good idea of how much LTCG is to be provided along with the break-up of individual beneficiaries. This data is essential to decide which penny stock or companies to use for the job and which beneficiary to buy how many shares.

3.2.1 Types of Penny stock companies

Broadly speaking there are two types of companies.

a) An old already listed company, the entire shareholding of which is bought by the syndicate to provide LTCG entries. These are generally dormant companies with no business and with accumulated losses.

b) A new company which is floated just for the purpose giving LTCG entries. Such new companies are often floated after the initial booking is complete and the capital base is decided keeping in mind the entries to be provided.

3.2.2 The entities involved in the transactions

As mentioned earlier there are three categories of individuals who are involved in the transactions.

a) Syndicate Members

They are the promoters of the Penny Stock companies who own the initial shareholding mostly in the name of paper companies either in a fresh IPO or purchased from the shareholders of a dormant company. They are usually a group of 4-5 individuals who are also referred to as Syndicate Members and are sometimes also referred to as Operators. Their nominees are directors of the Penny Stock companies which are indirectly controlled by them through such dummy directors. The whole operation is managed by them. They get the net commission income from the transactions. Their name however, seldom appear in the actual transactions.

b) The Brokers

These are registered brokers through whom shares are traded both online and offline. They are fully aware of the nature of transactions and get paid a commission over and above their normal brokerage. Some of the big broking houses are also indulging in such transactions mostly through sub-brokers. Even Calcutta Stock Exchange has registered itself as a broker with BSE and has given a large number of terminals to sub-brokers who are dealing into this type of transactions. In the said investigation, some of the sub-brokers of big broking houses like Anand Rathi, Religare Securities, SMC etc. were also uncovered. As a standard modus operandi, the brokers often compromise on KMC norms of the clients to help the Syndicate Members.

c) The Entry Operators

These are individuals who control a large number of paper/shell companies which are used for routing cash for the transactions as well as buying and selling shares during the process of price rigging. They work for commission to be paid by the Syndicate Members. To cut cost sometimes in smaller operations, the same group perform more than one function.

3.2.3 The Transaction

3.2.3.1 Conventional method

The transaction involves three legs.

a) Purchase of share by the beneficiary

In this the beneficiary is sold a fixed number of shares at a nominal rate. The price and the number of shares to be purchased are decided on the basis of the booking taken and the value up to which price would be rigged. This leg of the transaction mostly is offline. This is done to save on STT using the loophole in Section 10(38) of the IT Act which places restriction of trading by payment of STT on sale of shares and not on purchase.

b) Price rigging

After the shares have been purchased by the beneficiaries, the syndicate members start rigging the price gradually through the brokers. In these transactions the volume is almost negligible. Two fixed brokers, who are in league with the Syndicate, buy shares at a fixed time and at a fixed price. These low volume transactions are managed through paper companies of entry operators.

c) Final sale by the beneficiary

This is done after the beneficiary has already held the shares for one year. The period of holding may be a little more to match the amount of booking with the final rate. The beneficiary is contacted either by the Syndicate member or the Broker (Middle man) through whom the initial booking was done. The beneficiary provides the required amount of cash which is routed through some of the paper companies of the entry operator and is finally parked in one company which will buy the shares from the beneficiary. The paper company issues cheque to the beneficiary.

The above mentioned methodology is referred to as Conventional Method.

Another method which also used quite often is called Merger Method. The methodology adopted in Merger Method is as under:

3.2.3.2 Merger method:

In this method the operators first form a Private Limited Company and the shares at par are allotted to beneficiary individuals. This private limited company is then amalgamated / merged with a listed penny stock company by a High Court order. Depending on the capital of the amalgamating and amalgamated companies, the investors are allotted stock of the listed companies in the same proportion. The capital of the Penny stock listed company and the private limited company are so arranged that the beneficiaries post-merger, get shares of listed company in the ratio 1:1, thus the investor gets equal number stocks of the listed company. The promoters of the listed penny stock companies run the syndicate, the brokers and the entry-operators through whose paper/shell company’s cash are routed are merely commission agents. The penny stock listed company is such that though its capital base is small its market capitalisation is many times its capital base. This is managed again through small volume predetermined transaction amongst members of the syndicate. The prices of shares are thus manipulated at 20 to 25 times the face value. For example the quoted price of such a company would be around ` 250 with minor fluctuations synchronised with rise and fall in the market to avoid regulatory glare. One such company is quoted on CSE. The investors hold these shares in the penny stock listed company which it got as a result of merger for one year (statutory lock-in period for exemption under IT Act) and then sell it to one of the shell private limited companies of the operator. The investor thus makes a LTCG of 25 times its original investment. The purchase consideration is again provided in cash by the investor which is laundered to the buyers account through a maze of shell companies as mentioned in the previous method.

Though LTCG is booked while the share price is going up, the downward journey is used by the operators for booking bogus losses. People who have huge profit take the Short Term Capital loss (STCL) to set-off their profit. The methodology used is the same. The beneficiary who wants loss buys the share at a high rate from the beneficiary who is taking LTCG. The loss taking beneficiary pays cheque to the LTCG taking beneficiary and the cash provided by the LTCG beneficiary is returned to the Loss taking beneficiary. The operator deducts his commission before payment by cash. As prices crash the loss taking beneficiary sells these shares bought at high value for small value resulting in artificial loss.

3.3 Results of Kolkata investigations

In the report department identified the 84 BSE listed penny stocks which have been used for generating bogus LTCG from individual / individuals targeted. Post that number of search and surveys were conducted in the office premises of more than 32 Share broking entities, which accepted that they were actively involved in the bogus LTCS/STCL Scam. Surveys were also conducted in the office premises of many accommodation entry providers and their statements recorded. As per the report all had accepted their role in the scam. The report further stated that beneficiaries of more than ` 38 thousand crore were identified.

A Total of more than 60 thousand PAN numbers of the beneficiaries were identified. The report further covered more than 5000 paper/shell companies, also known as “Jamakharchi” companies, which are involved in providing bogus accommodation of various kinds. Statements for most of the directors of companies had been recorded under oath. The department also prepared cash trail of ` 1570 Crore. The case trail reflected how unaccounted/undisclosed cash of beneficiaries was being routed through this modus to convert black money into LTCG. The investigating team had followed the money trail from the point it is being deposited to the undisclosed proprietorship bank accounts, to the accounts of share brokers. Then they recorded statements of share brokers where they have accepted that cash has been used for providing accommodation entry of bogus LTCG.

3.3.1 Capital gain side or sale side beneficiaries (as per the report)

Dgit Wise	No. of Pan	Amount (Rs)
Mumbai	17344	1223392,20,545
Kolkata	12236	671804,06,328
Delhi	6632	609972,97,795
Ahmedabad	6962	241851,44,408
Lucknow	3996	221427,35,005
Chandigarh	2519	165985,63,664
Bhopal	3118	151807,09,899
Jaipur	3471	150909,93,477
Bengaluru	1619	107038,20,659
Hyderabad	2604	105012,00,292
Chennai	1790	90944,04,614
Patna	1133	42251,14,570
Pune	399	514,21,00,307
International Taxation	136	2757,35,307
Kochi	187	2172,38,411
Total	64811	3838746,85,281

3.3.2 Short term capital loss or purchase side beneficiaries / jamakharchi providers (as per the report) :

Dgit Wise	No. of Pan	Amount
Kolkata	12240	2246797,65,038
Mumbai	11854	797756,89,393
Delhi	2920	311585,30,784
Ahmedabad	4742	117224,30,395
Bhopal	1514	87343,71,717
Chandigarh	1241	59263,52,548
Jaipur	2098	57041,28,394
Lucknow	2062	56115,31,092
Bengaluru	914	24008,04,555
Chennai	899	16965,42,285
Hyderabad	1187	16060,99,482
International Taxation	248	11497,68,948
Patna	437	4635,75,503
Pune	300	7950,47,517
Kochi	216	734,28,064
Total	43154	3814980,65,714

Though this report was sent to relevant officers, to further boost the process, new button ‘Penny Stocks’ has been added on Individual Transaction Screen (ITS) to display information related to penny stocks, on the screen of the Assessing Officers (AOs).(See Letter F.No.287/30/2014 IT (Inv.II)- Vol.- III, dated 16-3-2016 issued by CBDT to the officers). Further such information was continuously updated on their computers under Actionable Information Monitoring System (Letter F. No.287/30/2015-IT (INV.II)-VOL-III, dated 29-3-2016)

4. SEBI

The Government’s two-pronged approach — investigation and regulation — involves action against tax evaders and tightening of norms for scrips prone to price manipulation. The market regulator and the taxman have in the past come down strongly on penny stocks. With income tax department into action, SEBI, on the other hand, is drawing up stringent rules for companies prone to price manipulation and widening the scope of Graded Surveillance Measures. SEBI has passed various interim order and confirmatory orders against the operators and its associates upon preliminary enquiry. These orders were passed against:

a) Promoters and promoter related entities

b) Preferential allotttees

c) Penny stock sellers/traders who rig the prices

d) LTP contributers

e) Exit providers.

However, upon completion of the investigation, SEBI did not find any adverse evidence/ findings amounting to any violation in respect of many entities and hence those orders were partially revoked.

5. SOPs, Assessments and tax effects

Post the investigations and to observe that the tax evaders are not left out on procedural and technical grounds, the department had prepared Standard operating procedures (SOPs) to be adopted by the Assessing officers while framing assessment orders in penny stock cases. Not only the procedures standardised, but the specific formats were given for the following:

a) Draft questions for statement to be recorded u/s. 131

b) Draft Show cause notices

c) Draft assessment orders

d) Draft of reasons recorded u/s. 148

Further a draft order noting is given in following situations

a) If a request is made for cross examination

b) If deponent files affidavit retracting statements, etc.

One may observe that the statements recorded and assessment orders are similarly worded except the factual aspects of penny stocks traded in.

In spite of above, in few cases, the Assessing officers have treated LTCG as cash credits u/s. 68 and in few cases as unexplained money u/s. 69A. Addition on account of underling commissions u/s. 69C also varies from 0.10% to 0.50% in different assessment orders.

Rate of tax : Section 115BBE

Finance Act 2012, inserted section 115BBE w.e.f. 1-4-2013, which provides that in case total income of an assessee includes an income chargeable under sections 68, 69, 69A, 69B, 69C or 69D, the income would be chargeable @ 30% without there being any benefit of slab rate which would have been otherwise available to such assessee. This amendment was brought to ensure that the undisclosed income is chargeable to tax @ 30% and the assessees’ should not be able to take advantage of the basic exemption limit or lower slab of the rate of tax applicable to assessees’.

This section was further substituted by the Taxation Laws (Second Amendment) Act, 2016 w.e.f. 1-4-2017 wherein rate of tax was increased from 30% to 60%. The amended section further provides that the section would apply irrespective of fact, whether the income is disclosed by the assessee in its return of income under sections 68 to 69D or the Assessing Officer makes such an addition. Its seems that the purpose of the amendment is to put a check on the assessee depositing money in his bank account pursuant to the demonetisation from 8th November, 2016. Persons who had declared under IDS would be taxed @ 45% and post demonetisation those should not get away by offering the same as income @ 30%. Hence, the rate has been increased to 60%.

6. Judicial Precedents

The issue of penny stocks is not recent. In the “war to curb black money”, wherein usage of penny stock was at its peak, this issue has gained momentum and hence would be worthwhile to be appraised about few important decisions on this issue.

6.1 Pr. CIT v. Prem Pal Gandhi in ITA-95-2017 (O&M) dt. 18-1-2018 (Punjab & Haryana HC)

The Court in the context of penny stocks held that the appreciation in the value of the shares is high does not justify the transactions being treated as fictitious and the capital gains being assessed as undisclosed income if,

(a) the shares are traded on the Stock Exchange,

(b) the payments and receipts are routed through the bank,

(c) there is no evidence to indicate it is a closely held company, and

(d) the trading on the Stock Exchange was manipulated in any manner

6.2 ITO v. Arvind Kumar Jain HUF ITA No. 4862/MUM/2014 dt. 18-9-2017 (Mum.)(ITAT)

Tribunal while dealing with the issue of bogus capital gains from penny stocks held that if the DEMAT account and contract note show details of the share transactions and the AO has not proved the transactions to be bogus, the capital gains earned on the said transactions cannot be treated as unaccounted income u/s. 68. The fact that the broker was tainted and violated SEBI regulations would not make assessee’s transactions bogus.

6.3 ITO v. M/s. Indravadan Jain (HUF) ITA No. 4861/Mum./2014 dt. 27-5-2016

The Tribunal while dealing with LTCG on penny stocks has held that Long-term capital gains arising from transfer of penny stocks cannot be treated as bogus merely because SEBI has initiated an inquiry with regard to the Company if, payment is by cheque and delivery of shares is taken.

6.4 CIT v. Shyam R. Pawar [2015] 229 Taxman 256 (Bombay)

In this case, assessee declared capital gains on sale of shares of two companies. Assessing Officer, observing that transaction was done through brokers at Calcutta and performance of concerned companies was not such as would justify increase in share prices, held the transaction as bogus and having been done to convert unaccounted money of assessee to accounted income and, therefore, made addition under section 68. On appeal, Tribunal deleted addition observing that DEMAT account and contract note showed credit/details of share transactions. The High Court held that the transactions in shares were rightly held to be genuine and addition made by Assessing Officer was rightly deleted.

6.5 CIT v. SmtJamna Dev Agarwal 328 ITR 656 (Bombay)

It was held that from the documents produced before the Court it was seen that the shares in question were, in fact, purchased by the assessees on the respective dates and the company had confirmed to have handed over the shares purchased by the assessees. Similarly, the sale of the shares of the respective buyer was also established by producing documentary evidence. It is true that some of the transactions were off-market transactions. However, the purchase and sale price of the shares declared by the assessees were in conformity with the market rates prevailing on the respective dates, as was seen from the documents furnished by the assessee. Therefore, the fact that some of the transactions were off-market transactions could not be a ground to treat the transactions as sham transactions.

6.6 CIT v. Vivek Mehta 204 Taxmann 177 (Punjab & Haryana)

In this case the assessee declared long term capital gain on sale/purchase of the shares of ‘M’ Ltd. and claimed the same as exempt under section 54F. The Assessing Officer held that the purchase of shares of ‘M’ Ltd. was bogus and manipulated and, therefore, the subsequent sale was also bogus. The Assessing Officer further held that the assessee introduced his unaccounted income under the garb of long-term capital gain and claimed same as exempt under section 54F. The credit entries in bank account of the assessee reflecting sale consideration of share were found to be unexplained credits and added to the income of the assessee under section 68. It was held by the High Court that on the basis of the documents produced by the assessee in appeal, the Commissioner (Appeals), recorded a finding of fact that there was a genuine transaction of purchase of shares by the assessee on 16-3-2001 and sale thereof on 21-3-2002. The transactions of sale and purchase were as per the valuation prevalent in the stock exchange. Such finding of fact has been recorded on the basis of evidence produced on record. The Tribunal has affirmed such finding. Such finding of fact is sought to be disputed in the present appeal. The finding of fact recorded by the Commissioner (Appeals) doesn’t give rise to any question(s) of law as sought to be raised in the appeal.

6.7 CIT v. Mahesh chandra G. Vakil 220 Taxman 166 (Gujarat)(HC)

It was held by the High Court that where assessee proved genuineness of share transactions by contract notes for sale and purchase, bank statement of broker, demat account showing transfer in and out of shares, as also abstract of transactions furnished by stock exchange, Assessing Officer was not justified in treating capital gain arising from sale of shares as unexplained cash credit.

6.8 Ms. Farrah Marker v. ITO (Mumbai) ITA No. 3801/Mum/2011

The assessee, an individual, filed her return of income for A.Y. 2005-06 on 4-8-2005 declaring income of ` 1,19,653/- after claiming the income from long term capital gain (LTCG) of ` 93,00,012/- on sale of listed equity shares and subjected to STT as exempt under section 10(38). In the course of assessment proceedings, the AO observed that the shares of Shukun Constructions Ltd. are nothing but penny stocks and that the assessee has backdated the purchase of the said shares in transactions to generate artificial gain. The AO made an addition of the sale proceeds on sale of the said shares amounting to Rs 95,12,812/- under section 68 of the Act.

Hon’ble ITAT held that the documents pertaining to the purchase and sale of shares of M/s. Shukun Constructions Ltd. such as contract notes of brokers, copies of physical share certificates, transfer of physical shares to the name of the assessee and consolidation by the company, the DEMAT account statement of the assessee with SHCIL confirming the said shares in the assessee’s name, bank statements and summary thereof and financial statements of the assessee, viz., Balance Sheet of earlier years showing that the fact of holding these shares were furnished before the AO from 16-7-2007 onwards, i.e., well before the assessment was concluded on 31-12-2007.

From the details filed by the assessee on record in pursuance of the query by the AO in the course of assessment proceedings, that the shares of Shukun Constructions Ltd. is listed on BSE and that the sale transaction of the ‘said shares’ by the assessee is at the rate quoted on the date of sale has been confirmed both by BSE and the concerned stock broker M/s. Khambatta Securities Ltd. It is strange that the AO has made the addition under section 68 of the Act treating the entire sale proceeds of the ‘said shares’ received by the assessee through regular banking channels from stock broker registered with SEBI, M/s. Khambatta Securities Ltd., which facts have been confirmed by the said stock broker.

6.9 CIT v. Smt. Sumitra Devi 49 taxmann.com 37 (Rajasthan)

The High Court observed that the AO had failed to show that the material documents placed on record by the assessee like broker’s note, contract note, relevant extract of cash book, copies of share certificate, demat statement etc. were false, fabricated or fictitious. The appellate authorities have rightly observed that the facts as noticed by the AO, like the notice under s, 133(6) to the company having been returned unserved, delayed payment to the brokers, and dematerialisation of shares just before the sale would lead to suspicion and call for detailed examination and verification but then, for these facts alone, the transaction could not be rejected altogether, particularly in absence of any cogent evidence to the contrary.

6.10 Arvind Mehta v. ITO ITA No. 2799/Mum/2015 pronounced on 29-2-2016

The assessee had declared a long term capital gain of Rs 7,01,773/- on the sale of said shares of M/s. Essar Oil Ltd. The Assessing Officer noted that certain information was received from the Investigation Wing as a consequence of a search and seizure action carried out under section 132 of the Act in the case of M/s. Mahasagar Securities Pvt. Ltd. on 25-11-2009. As per such information received, it was noted that there was some companies which were under the control of one Shri MukeshChokshi which, inter-alia, included M/s. Alliance Intermediaries & Network Pvt. Ltd., broking concern from whom assessee had claimed the purchase of shares of M/s. Essar Oil Limited.

As a consequence, the entire sale consideration of ` 8,80,332/- was added to the returned income as ‘income from undisclosed sources’. Hon’ble ITAT held that the DEMAT account which evidences the sale of shares does justify an inference that the assessee was indeed in possession of the shares of M/s. Essar Oil Ltd. prior to its sale. There is no material on record to suggest that the sale consideration received by the assessee in question i.e. Rs 8,80,332/- is on account of any transaction other than the sale of shares of M/s. Essar Oil Ltd. Therefore, under these circumstances the onus was entirely on the Assessing Officer to establish that the purchase and sale of the shares of M/s. Essar Oil Ltd. was bogus.

If the orders of the authorities below are examined in this context, it is clear that there is no clinching material to say that the impugned transaction was bogus. Though a reference has been made to the investigation in the case of Shri MukeshChokshi, but no effort has been made by the Assessing Officer to demonstrate that qua the instant transaction of the assessee, any infirmity has been confessed by Shri MukeshChokshi. Be that as it may, assessee has been consistently canvassing before the lower authorities that the statement of Shri MukeshChokshi be confronted to him. There is nothing on record to suggest that any specific statement Shri MukeshChokshi has been confronted to the assessee. Considering the entirety of circumstances and the material on record, there is no justification for the Assessing Officer to hold that that the sale consideration received on the sale of shares of M/s. Essar Oil Ltd. of Rs 8,80,332/- is unexplained or from undisclosed sources.

6.11 Commissioner of Income-tax-I v. Himani M. Vakil [2013]10 taxmann.com 326 (Guj.)

The Court held that where assessee duly proved genuineness of share transactions by bringing on record contract notes for sale and purchase, bank statement of broker and demat account showing transfer in and out of shares, Assessing Officer was not justified in bringing to tax capital gain arising from sale of shares as unexplained cash credit.

6.12 ITO v. Aarti Mittal 41 taxmann.com 118 (Hyderabad – Trib.)

The Tribunal held that the prescribed procedure was followed from the stage of purchase till the shares are dematted, and thus there is hardly any room to doubt or suspect that the transactions in purchase are not genuine. No such cogent evidence having been brought on record, and the Assessing Officer merely proceeded to arrive at his conclusion basing on mere surmise and suspicion that the purchase transactions are bogus. Even though enquiry with Calcutta Stock Exchange (CSE) revealed that no purchase had taken place, since transactions were in physical form and done through off market, question of the same being routed through floor of a recognized stock exchange did not arise.

The most crucial aspect which could be considered as incriminating in such transactions may relate to a case where compensatory payments are made by the seller to the buyer. No evidence has been brought on record that the assessee have made any such compensatory payment to the buyer of the stocks. In the absence of any such observation, the Commissioner (Appeals) was correct in holding the view that the sale transactions cannot be doubted on suspicion.

Moreover, these are the cases in which the transactions have taken place through the floor of the stock exchange and Securities Transactions Tax have been paid. In view of these evidences which have not been rebutted by the Assessing Officer, it is difficult to hold that the sale transactions are non-genuine and the proceeds thereof are liable to be taxed under the head ‘other sources’. Further on the basis of the report received from the SEBI, upon enquiries got conducted that some of the brokers named have been suspended for some act of omission and commission, the Assessing Officer held that the transactions entered through these brokers are not genuine. But merely based on such a report, such transactions cannot be treated as sham merely for some discrepancies or adverse report by the SEBI.

The Assessing Officer has not brought out any material to establish the final outcome of the enquiry initiated by the SEBI and specific shares purchased by the assessee in course of making investment. Therefore, it is not possible to take any adverse view on the basis of mere suspicion that the SEBI had initiated some action and found the brokers violating the rules of the SEBI. It is all the more so, since the assessee has paid STT. Even the absence of experience of the assessees in transaction of the shares except dealing in these penny stocks, does not clinch the issue against the assessee.

This may at the most lead to a suspicion but the same cannot be treated as conclusive to draw any adverse inference against the assessees to the effect that the transactions are not genuine. Similarly, even the opening of DEMAT accounts at Calcutta, a remote place may give rise to a suspicion, but the same cannot lead to any adverse inference against the assessee. Even with regard to the enquiry got conducted by the Assessing Officer through the Deputy Commissioner, Calcutta, which revealed that most of the brokers and the companies were not traceable, the Commissioner (Appeals) was correct in concluding that mere failure to trace the brokers and companies cannot be held as fatal to the transaction of both purchase and sale, when the details of which have been duly explained by the assessee.

The assessee has duly discharged the onus that lies on it in establishing the genuineness of the transactions, and that being so, it is for the revenue to disprove the claim of the assessee, by bringing on record the evidence to the contrary. The Tribunal thus deleted the additions made.

6.13 DCIT v. Anil Kaniya ITA No. 4077/Mum/2013 (Mumbai)

The assessee produced the copies of contract note, money was received through banking channel from sale of shares, and purchases of earlier years were not doubted. Dematting was done by the assessee, sale was affected, thus, addition made u/s. 68 of the Act cannot be sustained and also the resultant disallowance of commission at the rate of 5% made by the Assessing Officer.

Even otherwise, for making addition u/s. 68 of the Act, there has to be credit of amounts in the books of the assessee and if the assessee offers no explanation about the nature and source of such credits, then, the sum so credited may be charged to tax as income of the assessee. However, in the present case, the assessee has offered its explanation and if the learned Assessing Officer is still not satisfied with such explanation, onus shifts upon him to prove otherwise.

The assessee’s burden is confined to prove creditworthiness of the creditor with reference to the transaction found in the books of the assessee. No adverse material was brought on record by the Assessing Officer to substantiate his presumption, and thus addition cannot be sustained.

6.14 Sudhanshu Suresh Pandhare v. ITO I.T.A. No. 5185/Mum/2012 (Mumbai)

The Tribunal held that the assessing officer has disbelieved the claim of Long term capital gain only on the basis of the statement given by the broker. However, the assessee had furnished the details of purchase of shares, copies of share certificates, the details of sale of shares and the details of receipt of money towards the sale consideration. Sale of shares had taken place through Ahmedabad Stock Exchange.

The Tribunal further observed that the documents and the claim of the assessee were not examined by the AO. Assessee filed return of income showing the purchases in the year relevant to AY 2003-04 and the sales in the return of income relating to AY 2004-05. Further, assessee sought for the copy of statement claimed to have been given by Shri Mukesh Choksi with regard to the transactions carried on by his group of companies, which was not provided to the assessee. Since the assessing officer had not shown that the transactions of the assessee have been claimed to be accommodation entries by Shri Mukesh Choksi, he could not have taken adverse view of the matter on the basis of generalized statement.

The statement of Shri Mukesh Choksi has been relied upon without confronting the same with the assessee. Thus there was no justification in disbelieving the claim of the assessee.

6.15 Surya Prakash Toshniwal HUF v. ITO ITA No.1213/Kol/2016 (Kol. ITAT)

The Tribunal observed that in spite of having all information the lower authorities held the long term capital gains as bogus and from undisclosed sources on the basis of certain facts as under :

A) The assessee was a HUF and the transaction was routed for both purchase and sale of the shares through an individual broker who happened to be the Karta of assessee i.e. HUF.

B) The shares were sold to M/s. Ahilaya Commercial Private Limited (for short ACPL) but the financial statements of the company were not filed to the stock exchange. The assessee also failed to furnish the necessary details of ACPL to establish the genuineness of the transactions except that the transactions were routed through account payee cheques.

C) The SEBI has also directed M/s ACPL not to carry out any transaction of purchase and sale of securities in any manner either directly or indirectly.

D) The assessee has also failed to submit the net worth of M/s RFL and ACPL to justify the amount of capital gain earned during the year.

The Tribunal held that the lower authorities have not brought on record any concrete evidence for disallowing the long term capital gain of the assessee. The AO should have issued notices and summons to M/s. RFL and ACPL under sections 133(6) and 131 of the Act for the production of the necessary financial information before rejecting the claim of the assessee.

All the necessary information which were available with the assessee had been brought on record by the assessee before the lower authorities. In case ACPL had not filed the financial statements with the stock exchange then the assessee for the fault of ACPL cannot be held guilty under the income tax proceedings.

The Tribunal held that assessee had made the transactions for the sale and purchase of the shares through a valid stock broker who was in existence at the relevant time with the stock exchange and this fact has not been doubted by the lower authorities.

AGAINST DECISIONS

6.16 ITO v. Shamim M. Bharwani [2016] 69 taxmann.com 65 (Mumbai – Trib.)

The Tribunal was posed with a question that whether the documents furnished by the assessee, including averments made by him, or even his broker, satisfy the test of preponderance of human probabilities. It observed that if the assessee has reasonably explained the ‘intriguing’ facts and circumstances as pointed by the AO, and on the strength of which the genuineness is assailed by him, and with the fact that it is a case of penny stock company, then no case for treating the transaction as not genuine shall ever arise. The Tribunal held that onus u/s. 68 though is on the assessee, so that his explanation is substantiated or proved.

Firstly, documentary evidences, in the face of unusual events, and without any corroborative or circumstantial evidence/s, cannot be regarded as conclusive. Two, the preponderance of probabilities only denotes the simultaneous existence of several ‘facts’, each probable in itself, albeit low, so as to cast a serious doubt on the truth of the reported ‘facts’, which together make up for a bizarre statement, leading to the inference of collusiveness or a device set up to conceal the truth, i.e., in the absence of credible and independent evidences.

For a scrip to trade at nearly 50 times its’ face value, only a few months after its issue, only implies, if not price manipulation, trail blazing performance and/or great business prospects (with of course proven management record, so as to be able to translate that into reality), while even as much as the company’s business or industry or future programme (all of which would be in public domain), is conspicuous by its absence, i.e., even years after the transaction/s. The company is, by all counts, a paper company, and its share transactions, managed. The Tribunal thus confirmed the assessment of the impugned sum u/s. 68 of the Act.

6.17 Sanjay Bimalchand Jain v. Pr. CIT [2018] 89 taxmann.com 196 (Bombay) (HC)

The High observed that the authorities found that the assessee had made investment in two unknown companies of which the details were not known to her. It was held that the transaction of sale and purchase of shares of two penny stock companies, the merger of the two companies with another company, viz. Khoobsurat Limited did not qualify an investment and rather it was an adventure in the nature of trade. It was held by all the authorities that the motive of the investment made by the assessee was not to derive income but to earn profit. Both the brokers, i.e., the broker through whom the assessee purchased the shares and the broker through whom the shares were sold, were located at Kolkata and the assessee did not have an inkling as to what was going on in the whole transaction except paying a sum of Rs 65,000/- in cash for the purchase of shares of the two penny stock companies.

The authorities found that though the shares were purchased by the assessee at Rs 5.50 per share and Rs 4/- per share from the two companies in the year 2003, the assessee was able to sell the shares just within a years time at Rs 486.55 and Rs 485.65 per share. The broker through whom the shares were sold by the assessee did not respond to the assessing officer’s letter seeking the names, addresses and the bank accounts of the persons that had purchased the shares sold by the assessee.

The authorities have recorded a clear finding of fact that the assessee had indulged in a dubious share transaction meant to account for the undisclosed income in the garb of long term capital gain. While so observing, the authorities held that the assessee had not tendered cogent evidence to explain as to how the shares in an unknown company worth Rs 5/- had jumped to Rs 485/- in no time. The Income Tax Appellate Tribunal held that the fantastic sale price was not at all possible as there was no economic or financial basis as to how a share worth Rs 5/- of a little known company would jump from Rs 5/- to Rs 485/-. The findings recorded by the authorities are pure findings of facts based on a proper appreciation of the material on record. The High Court refused to interfere with the Tribunal decision.

7. Penalties and prosecutions

7.1 Penalties

As per sections 271(1)(c) penalty would be leviable in case of concealment of income or furnishing of inaccurate particulars. These may apply on penny stock assessments. The penalty levied may range from 100% to 300%. However, the Taxation Laws (Second Amendment) Act, 2016 has inserted section 271AAC w.e.f. 1-4-2017 which provides for a penalty of 10% of the tax payable under section 115BBE, in case an addition has been made by the Assessing Officer.

However, no penalty would be leviable if assesseesuomotu makes an addition in the return of income. One may observe that the tax rate as per section 115BBE is 60% and penalty over such income is 10% which makes the effective rate of tax for additions made under sections 60 to 69D at 66% plus surcharge plus education cess.

In case such additions have been made pursuant to a search action u/s. 132, then, the penalty is leviable under section 271AAB. The sections provides for lower rate of penalty on fulfilment of certain conditions. One of the conditions is that the assessee “substantiates the manner in which the undisclosed income was derived;” This aspect is subjective in nature and hence litigation prone. Questions like whether an assessee should substantiate during the search action, or during the assessment proceedings, wait till the officer asks relevant questions, would arise.

7.2 Prosecution

The department has issued many show cause notices for initiation of prosecution proceedings u/s. 276C(1)& 277 r.w.s 278E. Sub-section 1 of Section 276C deals with wilful attempt to evade any tax, penalty or interest; whereas sub-section 2 deals with wilful attempt to evade the payment of any tax, penalty or interest levied under Income Tax Act. Section 277 deals with false statements.

The standard of proof required in criminal proceedings is much more than required in penalty proceedings. The fundamental principle of penal liability is that an act alone does not amount to a crime, it must be accompanied by a guilty mind, as laid down by the maxim, ‘Actus Non FacitReum Nisi Mens Sit Rea’, there must be a guilty mind behind an act for the completion of a crime. Thus if a person is punished under criminal law, it is generally agreed that he must have done such act with a guilty mind.

The word ‘wilful’ used in section 276C of the Act generally means an act done with a bad purpose, with an evil motive as a constituent element of the offence and it should be established beyond reasonable doubt and there should be presence of mens rea / bad motive and a guilty mind. Thus, mens rea, (culpable mental state) is an important ingredient of the offences under the act also.

The word ‘wilful’ imports the concept of ‘mens rea’.

The Taxation Laws (Amendment and Miscellaneous Provisions) Act, 1986 inserted with effect from 10th September, 1986 section 278E of the Act, according to which, in any prosecution for any offence under this Act which requires culpable mental state on the part of the accused, the Court shall presume the existence of such mental state. Section 278E also provides that it shall be for the defence of the accused to prove the fact that he had no such mental state with respect to the act charged as an offence. Here, however, it is important to note that the legal presumption contained in section 278E is limited to the existence of mens rea alone and it does not absolve the prosecution of its responsibility to prove the facts which prima facie establish the charge before cognisance of an offence is taken.

A prima facie case for prosecution should be made out against the accused by the Department. A suspicion however, strong against the accused, but, if there is a reasonable possibility of innocence the accused would be entitled to acquittal.

However before accusing the Assessee, an opportunity of cross-examination of the third party whose statements are relied upon needs to be given to the assessee along-with full copy of the statement. The Hon’ble Supreme Court in Andaman Timber Industries v. CCE (2015) 281 CTR 241 (Bom)(HC) has held that failure to give the assessee the right to cross-examine witnesses whose statements are relied upon results in breach of principles of natural justice. It is a serious flaw which renders the order a nullity. Also see KishinchandChellaram v. CIT [1980] 125 ITR 713 (SC).

8. Issues that need to be addressed

Whoever desires any Court to give judgement as to any legal right or liability dependent on the existence of facts, which he asserts, must prove that those facts exist. When a person is bound to prove the existence of any fact, it is said that the burden of proof lies on that person. However, shifting of onus is the process of transferring the obligation to affirmatively prove a fact in controversy or an issue brought during a lawsuit from one party in a legal controversy to the other party. Such a shifting of onus is a continuous process in the evaluation of evidence.

In most of the cases and even in the draft assessment orders circulated by the department it has treated sale considerations of such penny stocks as cash credits under section 68. The Assessee may be able to discharge their onus by providing evidences link contract details, share certificates, demat accounts, trade details on Stock exchanges, banking transactions, etc.

The issue for consideration is whether the assessee is required to prove identity, creditworthiness, and genuineness in spite of the fact that the transaction of sale of shares was made on platform of a recognized stock exchange and was subject to STT. Assuming that the assessee discharges his/her onus, the burden then shifts on the Department. The question then arises that only on the basis of statements recorded and the theory of preponderance of probability, can additions be made in the hands of the assessee.

Considering the fact that there are diverse judgments, and the quantum as envisaged by the department, it is necessary that Supreme Court intervenes. Few important questions are as under:

a. Whether basic principles of cash credit u/s. 68 i.e., identity, creditworthiness, genuineness apply for share transactions under taken at recognized stock exchange?

b. Where share transaction be treated as bogus, where SEBI has revoked its interim order qua few beneficiaries, despite the fact that SEBI has still found few operators and beneficiaries guilty?

c. Whether the transactions have to be looked at holistically including all beneficiaries, operators, etc. or it is necessary to conduct inquiries individually and prove the cash trails for each and every case.

d. Who is supposed to discharge the onus to establish that there is bogus LTCG and whether such onus needs to be discharged for all assessments separately?

9. Conclusion

The allegations made by the department in its report that penny stock are being used as a tool for conversion of black money. However, in some cases, it may just be theory, which further needs to be corroborated with sufficient evidence and statistics. Any way sufficient amendments have been brought in to put this menance at rest, and hence use of penny stocks to evade taxes may decline drastically.

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