Decision cited :

In the case of K P Varghese v. ITO (1981) 131 ITR 597 (SC), the Apex Court has held that the object and purpose of section 52(2), as explicated from the speech of the Finance Minister, was not to strike at honest and bona fide transactions where the consideration for the transfer was correctly disclosed by the assessee but to bring within the net of taxation those transactions where the consideration in respect of the transfer was shown at a lesser figure than that actually received by the assessee, so that they do not escape the charge of tax on capital gains by understatement of the consideration.

In the case of Sudhir Menon HUF v. ACIT bearing ITA no. 4887/Mum/2013, order dt. 12/03/2014, the Mumbai ITAT held that 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), though per se applicable to the transaction, i.e., of this genre, getting attracted in such a case. A higher than proportionate or a non-uniform allotment though would, and on the same premise, attract the rigor of the provision.  Thus, when a higher than a proportionate allotment is received by a shareholder the provisions of section 56(2)(vii) get attracted.

It further held that the taxability u/s. 17 of the Act will arise only if there is inadequate consideration involved.

Acelegal Analysis :

The Mumbai ITAT has taken into consideration the fact that post allotment of right shares the value of holding of the assessee has decreased. Therefore, there is no real gain merely because allotment of share is at face value. Coupled by fact that the transaction was a bonafide business transaction, there was no scope of applying section 56(2)(vii) of the Act. The ITAT has taken into account the purposive which is a welcome step since legislature only enacted the provision as a counter evasion mechanism of tax.

Facts of the case :

The assessee is an individual and one of the promoters and Director of a company namely, Dorf Ketal Chemicals India Pvt. Ltd, ("the company"). The appeal relates to the AY 2010-11. As on 01/04/2009, the assessee held 1,04,179 shares equivalent to 34.57% of the total issued share capital of the company. The company has a wholly owned subsidiary in USA namely, Dorf Ketal Speciality Catalyst LLC ("the subsidiary"). During AY 2010-11, the subsidiary intended to acquire the chemical business of Du Pont Inc., USA. To finance the acquisition, the subsidiary entered into a loan agreement which required the promoters of the company to increase the total net worth to Rs. 150 crores by 31/03/2010.

In order to comply with this covenant in the loan agreement, the board of directors of the company passed a resolution on 07/09/2009 to issue 63,00,000 shares at the face value of Rs.100 to the existing shareholders in proportion to their holding so as to increase the share capital by Rs.63 Crores. On the same day, an offer letter was circulated to the existing shareholders. Based on the existing shareholding of 34.57%, the assessee was offered 21,78,204 shares at face value of Rs. 100. The assessee accepted part offer to the extent of 20,94,032 shares. Accordingly, the shares were formally allotted by the company on 28/01/2010. As the assessee only partly accepted the shares offered to him, his shareholding came down from 34.57% to 33.30%. The assessee filed his return of income for AY 2010-11 declared total income of Rs. 25,04,16,549/-.

AO’s contention :

Vide assessment order dated 28/03/2013 passed u/s. 143(3), the AO worked out the fair market value of the share by applying Rule 11UA(c) of the Income Tax Rules, 1962 at Rs.1,538.64 per share as against the allotment value of Rs.100/- and the difference of Rs.1,438.64 per share in share value was brought to tax u/s. 56(2)(vii)(c) of the Act in the hands of the assessee. The AO further stated that if it is held that section 56 is not applicable, then the transaction shall be taxed u/s. 17 being shares allotted to the assessee, a salaried employee is perquisite or profit in lieu of salary.

CIT(A)’s verdict :

The CIT(A) referred to the decision of hon’ble ITAT in the case of Sudhir Menon HUF (supra) and concluded that the facts in the case of Sudhir Menon HUF and the assessee are identical. Thus, section 56(2)(vii)(c) and section 17 are not applicable to the facts and circumstances of the assessee’s case.

ITAT’s verdict :

Section 56(2)(vii)(c) :

The transaction of issue of shares was carried out to comply with a covenant in the loan agreement to fund the acquisition of the business by the subsidiary. Therefore, such a bonafide business transaction cannot be taxed u/s. 56(2)(vii) of the Act especially when there is not even a whisper about money laundering by the AO in the assessment order. Further, the consideration for the shares was received through banking channel. Circular No.1/2011 dated 06/04/2011 issued by CBDT explaining the provision of section 56(2)(vii) specifically states that the section was inserted as a counter evasion mechanism to prevent money laundering of unaccounted income. In para no. 13.4. of the said circular, it is stated that "the intention was not to tax transactions carried out in the normal course of business or trade, the profit of which are taxable under the specific head of income". Thus, provision of section 56(2)(vii) does not apply to bonafide business transactions.

Section 17 :

Due to allotment of shares, the shareholding of the assessee came down from 34.57% to 33.30%. Thus, no benefit was received and therefore, section 17 was not applicable.

Further, section 17 do not apply to the shares allotted by the company to the assessee as the shares were not allotted by the company to the assessee in his capacity of being an employee of the company. The shares were offered and allotted by virtue of the assessee being a shareholder. Therefore, section 17 are not applicable. Circular No. 710 dated 24/07/1995 also supports the assessee's stand that where shares are offered by company to a shareholder, who happens to be an employee at the same price as have been offered to other shareholders or the general public, there will be no perquisite in the shareholder's hands.