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From the Judiciary

Ahmedabad Tribunal – Allows reduction in investment value on account of capital reduction by the subsidiary as a business loss

Citation: DCIT v. GHCL Ltd (ITA No. 976/Ahd/2014 & other multiple appeals)

Indian Britain BV (IBBV) was a wholly-owned subsidiary (WOS) of M/s. GHCL Ltd (GHCL/assessee). Due to heavy losses, the capital reduction was carried out by IBBV by way of cancellation of shares. In view of the said capital reduction, the assessee company incurred a loss of INR 998.9 million on the investment made in the subsidiary and claimed such loss as a capital loss in its return of income. However, during the course of assessment proceedings, the assessee contended that such loss should be allowable as a business loss as the investment was made out of commercial exigency to expand its business. The AO disregarded such a claim in the absence of a revised return by placing reliance on the decision of the Apex Court6.

The CIT(A) and the Tribunal upheld the allowability of such loss as a business loss by observing as under:

  • The entire investment in WOS was made by the assessee company for acquiring global units of soda ash manufacturing and textile businesschain as a measure of commercial expediency to further its business objective. The appellant, through IBBV, formed step-down subsidiaries in the Netherlands and USA for various acquisitions of textile business;
  • It is clear that the purpose of investment in subsidiaries was to expand globally and after such acquisitions, the sales and export would shoot up substantially;
  • Due to the recession in Europe and the USA, continued financial difficulty and other adverse factors, all the three subsidiaries incurred huge losses and became sick units. The subsidiary has reduced its capital to offset such huge losses.

On a separate ground, the Tribunal has also allowed a loss of ~INR 309.6 million suffered on the crystallization of guarantee provided on the letter of credit for another subsidiary. Tribunal rejecting the AO’s finding that the same was capital in nature observed that the guarantee was given as a temporary measure to tide over the financial difficulties and further expand the business of the assessee company.

Our Comments

The Tribunal has laid a key principle that, as long as the investment is justified on the grounds of commercial exigency, the loss on sale of such investments is to be considered as business loss. The nature of business exigency could vary from case to case, but there must be an underlying motive to serve the business interest in making such investment.

Delhi High Court – Confines from interfering with the valuation in view of the recognized method adopted by the assessee. Holds it to be a question of fact and not a question of law

Citation: PCIT v. M/s. Cinestaan Entertainment Private Limited (ITA No. 8113/Del/2018)

Cinestaan Entertain Private Limited (assessee), during the relevant assessment year, allotted shares at a premium to various persons. The case was selected for limited scrutiny on the premise of large share premium received during the year and low income in comparison to high investment.

During the course of assessment proceedings, the assessee submitted an independent valuer’s report from a CA valuing the shares, basis the Discounted Cash Flow method (DCF). The AO disregarded the valuation report on the ground that the projections of revenue did not match with actual revenues of subsequent years. Observing that the funds received on the issue were invested further by the assessee in 0% debenture of its associate companies, the AO concluded that the basic substance of receiving a high premium is not justified and proceeded to make an addition of INR 909.5 million under section 56(2)(viib).

While CIT(A) upheld the order of AO, on the second appeal, the Tribunal ruled in favor of the assessee setting aside the AO’s order. On further appeal by the department, the High Court also upheld the order of the Tribunal, making the following observations:

  • There is no dispute that the methodology adopted by the assessee is a recognized and accepted method;
  • The Courts have repeatedly held that valuation is not an exact science, and therefore cannot be done with arithmetic precision. It is a technical and complex problem that can be appropriately left to the consideration and wisdom of experts in the field of accountancy, having regard to the imponderables that enter the process of valuation of shares;
  • The Revenue is unable to demonstrate that the methodology adopted by the assessee is not correct and has also failed to provide any alternate fair value of shares;
  • If the third-party investors have seen certain potential and accepted this valuation, then the Revenue cannot question their wisdom;
  • The question of law urged by the Revenue is purely based on facts and does not call for consideration as a question of law.

Our Comments

The ruling emphasizes the need of robust documents and factors/basis for projections to justify the higher premium. While the court ultimately upheld the independent valuer’s report, it was in view of the fact that the Revenue was unable to demonstrate any errors.

It is pertinent to note that as per the amended Rule 11UA, the valuation report for the purposes of section 56(2) (viib) can only be issued by a SEBI registered Category 1 Merchant banker.

Chennai ITAT: Issue of preference shares at face value by a company having negative net-worth held to be a colorable device

Citation: M/s Sindya Securities and Investments Pvt. Ltd. I.T.A.No.1816/Chny/2019

The assessee, a private limited company, raised capital to repay an existing debt by issuing certain preference shares to a related party having common directors and functioning in the same premises. The preference shares were issued at a face value of INR 10,000 per share. The AO treated the amount of excess consideration over the fair market value of such preference shares as income under Section 56(2)(viib) of the Act by observing that it was not a simple commercial transaction between prudent parties for raising share capital. Aggrieved, the assessee filed an appeal before the CIT(A) and subsequently before the ITAT.

In this regard, the ITAT observed as under:

  • To invoke the applicability of Section 56(2)(viib) of the Act, shares should be issued over and above the face value of such shares. However, the assessing officer’s case is not a case of a simple commercial transaction between the parties but a transaction arranged to circumvent taxability. Thus, it is essential to see whether a transaction is a sham transaction arranged by parties to overcome the provisions of the Act;
  • Fixation of face value in this fact pattern raises doubts about the genuineness of the transaction in view of the following:
    • The transaction is between related parties;
    • Memorandum of Association was recently amended to divide the share capital into equity shares and preference shares. The face value of equity shares was retained at INR 10 whereas face value of preference shares was fixed at INR 10,000; Net worth at the time of issue of preference shares was negative;
    • The assessee did not file a valuation report to justify the face value of preference shares;
    • The assessee had no explanation for the basis of fixing different share price for equity shares and preference shares and;
    • The assessee does not have significant activities except investment in Deccan Digital Networks Pvt. Ltd., which in turn invested in Aircel Ltd., a defunct company.

In view of the above observations, the ITAT upheld the addition made by the AO. Relying on the decision of Hon’ble Supreme Court in the case of Mc Dowell & Co Ltd7, the ITAT noted that from the sequence of events and manner in which preference share capital was raised, including terms of repayment, rate of return, and period of shares, it can be easily concluded that transaction of issue of preference share capital is arranged transaction in the nature of a sham transaction to overcome the provisions of section 56(2)(viib) of the Act.

Our Comments

This is a classic case of invocation of judicial General Anti-Avoidance Rule (GAAR) by tax authorities. Section 56(2)(viib) is invocable only when the consideration for the issue of shares exceeds the face value of shares. While a company is free to fix the face value for the shares, the same should be justifiable basis the underlying valuations and other parameters to establish the commercial substance. With the applicability of the GAAR provisions, the tax authorities have assumed wide powers to challenge the genuineness of the transactions.

Mumbai ITAT: Loss on the transfer of shares between group companies by physical delivery and through banking channels held to be a genuine and a non-speculative transaction

Citation: Panther Industrial Products Ltd (ITA no.1080 & 1081/ Mum./2018)

The assessee was engaged in the business of granting loans and advances. It purchased certain shares of Landmark Leisure Ltd. (LLL) at INR 152.40 per share from one of its group companies, i.e., Classic Credit Ltd. (CCL), by way of physical delivery. The consideration for such share purchase was paid to CCL on behalf of the assessee by another group company Panther Fincap & Management Services Ltd (PFMS). Later in the same FY, the assessee sold the said shares held in LLL to PFMS at INR 48.10 per share by way of physical delivery. Resultantly, the assessee reported a significant amount of business loss on account of the purchase and sale of shares of LLL.

The assessing officer and the CIT(A) held the transaction to be sham in nature and further also characterized the same as speculative in nature and disallowed the loss.

On appeal, the ITAT ruled in favor of the assessee laying as under:

  • The transaction cannot be regarded a bogus merely because the assessee has taken advances from its group company to settle purchase consideration;
  • The transaction can be considered speculative only when the transaction is settled otherwise than by actual delivery. In the present case, both purchase and sale transactions were carried out with actual delivery of shares on the specific dates and at the specific rate prevailing on the date of transfer. Further, the settlement of purchase consideration was done through proper banking channels;
  • Furthermore, considering that the assessee’s 75% of the total assets consist of loans and advances, it falls under the category of ‘principal business’ of granting loans and advances. Thus, the explanation to section 73 is not applicable and the loss cannot be considered as a speculative loss.

Our Comments

The above judgment reaffirms the principle that a transaction cannot be treated as bogus or speculative in nature merely because it is undertaken with sister concerns. However, establishing the commercial substance remains the driving factor.

6. Goetz (India) Ltd. v. CIT (157 taxman 1)
7. (1985) 154 ITR 148

Regulatory Updates

Company Law Corner

Companies (Incorporation) Third Amendment Rules, 2021

The Central Government vide Amendment Rules dated 5 March 2021 has amended the Companies (Incorporation) Rules, 2014 (Rules). The Amendment Rules prescribes insertion of the option of Aadhaar authentication for GST Registration for Company Incorporation.

Companies (Management and Administration) Amendment Rules, 2021

Central Government vide Amendment Rules dated 8 March 2021 made the following changes:

  • Release of Form MGT 7A for One Person Company and Small company, as against MGT 7 for ordinary companies;
  • Rule 12 for the extract of Annual return has been amended to remove the obligation to file an annual return in Form MGT 9 along with Board Report;
  • Rule 20 for Voting through Electronic Means, the definition of for the terms remote e-voting, secured system, cybersecurity, etc., has been added to provide clearer grounds for general understanding.

Companies (Amendment) Act, 2020

Ministry vide its Notification date appointed the 24 March 2021 has made the below amendments:

  • Section 127 of Companies Act, 2013, which deals with the Unpaid Dividend Account, the penalty for non-compliance is INR 0.1 million and in case of continuing failure, with a further penalty of INR 500 for each day after the first during which such failure continues, subject to a maximum of INR 1 million;
  • Section 247 of the Companies Act, 2013, which deals with contraventions by the Registered Valuers, the penalty for non-compliance is INR 50,000.