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

19 March 2014

Background
Recently, the Mumbai Bench of the Income-tax Appellate The Tribunal analysed the tax implication under
Tribunal (the Tribunal) in the case of Sudhir Menon HUF1 two categories i.e. allotment on a proportionate
(the taxpayer) held that since shares were allotted on pro- basis and on a disproportionate basis. The
rata basis to the shareholders based on their existing Tribunal held that as regards proportionate
holdings, additional property was not received by them. It allotment there is no taxability under Section
was only an apportionment of the value of their existing 56(2)(vii)(c) of the Act. However, in case of
holding over a larger number of shares. Accordingly, disproportionate issue of additional shares, these
Section 56(2)(vii)(c) of the Income-tax Act, 1961 (the Act) provisions may get attracted.
does not get attracted in the present case.
Facts of the case
With respect to right shares if they are allotted to a person
not against his existing shareholding or if they are allotted The taxpayer, held 15,000 shares as on the
to existing shareholders but disproportionately, there is a beginning of the relevant previous year, in Dorf
scope for value or property being passed on to him and Ketal Chemicals Pvt. Ltd. (DKCPL), representing
would attract Section 56(2)(vii)(c) of the Act. 4.98 percent of the entire share capital being
3,01,316 shares. The entire (or almost the whole)
Further in case of bonus shares, there is neither any capital in DKCPL was held by the family members
increase nor decrease in the wealth of the shareholder of the taxpayers kartas family.
and therefore, the provisions of Section 56(2)(vii)(c)
would not apply to bonus shares. 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
1
Sudhir Menon HUF v. ACIT (SA No. 192/Mum/2013) 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 The valuation date under Rule 11U(j) is the date
similar shares and also those shares which were not of the receipt of the property and the shares are
subscribed by the taxpayer i.e. 119,624 shares (313624 received on their allotment. Subsequently, the
194000). share certificates are received which evidences
its title thereto.
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 Section 56(2)(vii)(c) seeks to substitute the FMV
measure of their fair market value (FMV) under the as the normative basis for transactions involving
applicable rules2. In terms of Section 56(2)(vii)(c) of the Act the receipt of property by a person, being an
read with the relevant rules, the Assessing Officer (AO) individual or HUF. Exceptions for transactions are
treated the difference of INR 1,438 per share as provided and to that extent the provision is well-
inadequate consideration toward the acquisition of founded and adequately excepted.
additional shares and brought the same to tax.
Section 56(2)(vii)(c) was further strengthened
The issue before the Tribunal was the validity in law, of the and broadened, with Finance Act, 2010 wherein
assessment of income being the difference between the the same was explained as an anti-abuse
value of the shares allotted to the taxpayer and the measure. In the case of Khoday Distilleries Ltd.,
consideration paid by it in respect thereof. the Supreme Court held that this provision
together with the Wealth Tax Act, 1957 and the
Tribunals ruling Act forms an integrated code. While the Gift Tax
Act had sought to bring to tax the shortfall in
Section 56(2)(vii)(c) gets attracted whenever an consideration in the hands of the donor, the
individual or Hindu undivided family (HUF) receives present provision/s seek to bring the same to tax
without consideration a specified property, the FMV of as income in the hands of the recipient of the
which is in excess of INR50,000, or in case of relevant assets.
consideration where the consideration is less than
FMV by an amount exceeding the INR50,000. In certain situations, through the medium of
additional shares the controlling interest in a
Section 56(2)(vii) includes the shares and securities company or interest in property movable or
as the word property occurring in section defined to immovable, is passed on to another at
mean capital assets. However, the shareholders get considerations far below the going rate of the
the right to acquire the additional shares on the relevant or the underlying assets/interest. Only a
passing of the board resolution. This supported the pro-rata allotment or, where not so, one that is
taxpayers contention that the provision being never adequately priced, would effectively ensure an
intended to cover a transaction of this nature i.e. exchange of the assets or interest therein at par
where the shares are offered to the existing values.
shareholders though below market value, on rights
basis. In order to demonstrate the wholesomeness of
the provision, the matter of bonus share is dwelt
Relying on the various decisions3 it was held that the upon. Issue of bonus shares is capitalization of
shareholders get the right to acquire the additional its profit by the issuing-company and there is
shares on the passing of the board resolution but the neither any increase nor decrease in the wealth
receipt of the property is only on their allotment, on of the shareholder (or of the issuing company)
which date the shares, a specifies property, comes in and shareholders percentage holding therein
existence. remains constant4. The same has the effect of
reducing the value per share, increasing its
Right share is appropriation out of the previously un- mobility and, thus, liquidity. Accordingly, the
appropriated capital of a company of a certain number provision would not apply to issue of bonus
of shares to a particular person. Till such allotment, the shares.
shares do not exist as such, and in a sense come into
existence on their allotment.
________________
____________________
2 4
Rule 11U and Rule 11UA of the Income-tax Rules, 1962 (Rules) CIT v. Dalmia Investment Co. Ltd. [1964] 52 ITR 567 (SC), Khoday
3
Shree Gopal and Company v. Calcutta Stock Exchange Ltd. [1963] 32 Comp. Cas. Distilleries Ltd. v. CIT [2008] 307 ITR 312 (SC)
862 (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 shareholder groups, i.e., at 50 per cent for each.
reduced the taxpayers holding to 3.17 per cent from A 1:1 rights issue, abstained by one group would
4.98 per cent. Therefore, the premise on which this result in the other having a 2/3rd holding. A
provision was not applicable to issue of bonus shares, higher proportion of rights shares (as 2:1, 3:1,
would to the extent pari-materia, apply in equal etc.) would yield a more skewed holding in favour
measure to the issue of additional shares, i.e. where of the resulting dominant group. The Tribunal
and to the extent it is proportional to the existing observe no absurdity or unintended
share-holding. consequences as flowing from the per se
application of Section 56(2)(vii)(c) to right shares,
Section 81 of the Companies Act, 1956 is not which by factoring in the value of the existing
applicable to a private company hence the company is holding operates equitably.
neither obliged to issue shares to the existing
shareholders nor issue on a proportionate basis. Thus, Section 55(2)(aa) of the Act clarifies that the
though the issue has elements of a right issue since values of the original and the additional financial
the offer is made to the existing shareholders on the assets are interlinked and accordingly, a gain
basis of their shareholding on proportional basis cannot be computed independent of each other.
however, the same cannot be termed as a rights
issue since the company was appropriating the right In-as-much the value of the additional shares is
which could be offered it to another. derived, if only in part, from that of the existing
shares, the decline in the value thereof cannot be
To the extent the value of the property in the additional excluded or ignored in arriving at the property
shares is derived from that of the existing received by the taxpayer by way of additional
shareholding, on the basis of which the same are shares. As a result of the transaction, the
allotted, no additional property can be said to have taxpayer becomes poorer in-as-much as the
been received by the shareholder. For e.g. shares in value of his holding witnesses a decline after
the ratio 1:1 are offered for subscription at the face taking into account the payment made for the
value of INR100 as against the current book value of acquisition of the additional shares.
INR1500. The moment a right share is allotted, the
book value shall fall to INR800 per share. It is easy to The receipt of a capital asset is the basis for the
see that the new share partakes a part of the value of charge to tax as income, unless falling under any
the existing share, which is only on the basis of the of the excepted categories and therefore, the
underlying assets on the companys books. The receipt (of an asset) has been adopted as the
excess or 1,400 gets apportioned over two shares as condition of deeming as income under Section
against one earlier, which is already the shareholders 56(2)(vii)[or clauses (v) and (vi)], and also of the
property. In support of this the Tribunal placed reliance provision as being on a firm footing.
on various decisions5.
In the context of Section 56(2)(vii) as well as its
The shares are allotted pro-rata to the shareholders clear language, receipt is not a synonym for
based on their existing holdings and therefore, there is transfer and it flows from its owner. In the
no scope for any property being received by them on context of the provision, it is completely irrelevant
the said allotment of shares; there being only an that the shares in the issuing company are not its
apportionment of the value of their existing holding property and that it does not become any poorer
over a larger number of shares. Accordingly, Section as a result of the allotment of shares therein.
56(2)(vii)(c) of the Act does not get attracted in the Receipt is a word or term of wide import, and
present case though, it is per se applicable to the would include acquisition of the defined capital
transaction, i.e., of this genre. assets in the present context, by modes other
than by way of transfer as well.
A higher than proportionate or a non-uniform allotment
would attract the rigor of the provision on the same To the extent right share is allotted to a person
premise. A disproportionate allotment could also result not against his existing shareholding or, even so,
on a proportionate offer, where on a selective basis albeit disproportionately, depending on the terms
some shareholders abstain from exercising their rights of the allotment, there is a scope for value or
(wholly or in part) and accordingly, transfer the property being passed on to him, which cannot
value/property to other shareholders. For example, a be said to be in lieu of or as recompense of his
case of a shareholding distributed equally over two existing property.
________________
5
Dhun Dadabhoy Kapadia v. CIT [1967] 63 ITR 651 (SC), H. Holck Larsen v. CIT
[1972] 85 ITR 285 (Bom)

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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
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