Analysis, Income Tax

A Question Of Strategy

If you have been following this blog, you know what a question of law is. Much of the outcome of an important case hinges on it. The entire judicial system in a sense revolves around what is the best way to interpret questions of law.

Another question

The question to ask though is:

As a lawyer who argues in court, do I have all the information and insights to present my case in front of the judge who will decide on the question of law?

May be not! Before you raise an objection, hear me out. And before I present my argument, let me cite a case, albeit anecdotally.

Sudhir Menon HUF vs Asst CIT

Case Link

Section 56(2)(vii)(c) of the Income Tax Act creates an interesting legal fiction – difference between the fair market value of certain properties and (lower) price actually paid for acquiring such properties are deemed as income from other sources. In this case, Revenue was seeking to tax the difference between the fair market value of certain shares alloted in a rights issue of a private company and the actual  consideration paid for subscribing such shares.  A key argument made before the Mumbai ITAT by the formidable Soli Dastur, Senior Counsel was:

  • Section 56(2)(vii)(c) should not apply to the assessee at all since what the assessee received was a right to apply for shares in a rights issue at a price decided by the board of directors of Dorf Ketal Chemicals Pvt Ltd. Mr Dastur contended that right to apply for shares in a rights issue is not a property specified under the Explanation to Section 56(2)(vii)(c).

The benefit of this argument was that if accepted, the Tribunal did not have to make further observation that in case of a higher than proportionate or a non-uniform allotment in a rights issue, provisions of Section 56(2)(vii)(c) may be attracted.

Reasoning by the Learned Accounting Member who wrote the judgement for the Tribunal.

  • Dealing with two Supreme  Court decisions viz., Shree Gopal ([1963] 32 Comp Ca 862) and Khoday Distillaries Ltd ([2008] 307 ITR 312)], on the point that ‘right’ shares did not come into existence until they were allotted, the Accounting Member came to the conclusion that these precedents only held that the shares issued pursuant to allotment signifies an acceptance of the offer made by a shareholder to subscribe to the shares. To that extent, he held, so long as ‘share’ has been mentioned as a specified property, absence of the term ‘right’ itself in Explanation to Section 56(2)(vii)(c) did not create a bar to apply that Section to the assessee ’s case.

Curiouser & Curiouser

I was a bit foxed with the above reasoning, and particularly so because no precedent was offered by the Tribunal to rule out the preliminary argument made by Mr Dastur. Then I came across paragraph 4.3 of the judgement, where the Hon’ble Tribunal recorded a question posed to Mr Dastur on whether the term “rights issue” has been defined under the Companies Act or Securities Contract (Regulation) Act, 1956. That got me thinking!

Mr Dastur, has vast experience of appearing before judges of various courts and various jurisdictions, including before Hon’ble Member D Manmohan and Hon’ble Member Sanjay Arora. However, it is anybody’s guess whether Mr Dastur could have known that until Sudhir Menon’s case, neither of the Hon’ble Members had delivered a judgement dealing with the concept of “rights issue”.

Mr Arora, Hon’ble Accounting Member, spent more than 13 years on the bench spread over ITAT Cochin, ITAT Chennai and ITAT Mumbai and adjudicated about 2500 cases. However, Sudhir Menon’s case was the first one where scope of a rights issue fell for the consideration of the Hon’ble Accounting Member. On the other hand, Mr Manmohon, Learned VP of the Tribunal, had dealt with rights issue in the context of three judgements (Nancy Mody, Dilip Dhanukar and Wallfort Financials) but none of them required him to substantively analyse the scope of rights issue under applicable law.

How do we know this? We looked it up on Riverus’ strategic research tool for income tax, it just took us two minutes!

Strategy 2.0

In light of the above, Mr Dastur was facing a bench where he could have perhaps dealt in detail with the concept of rights issue under Company law as part of his opening argument. It is well known in company law that the right itself is different from the resulting shares, especially since such a right can be renounced.

Continuing in the same vein and in the spirit of investigation, I also looked for a judgment in an income tax matter that clearly distinguished between the right to receive rights shares and rights shares themselves (which I feel, with all due respect, would have been an instructive precedent). I found the case of Navin Jindal vs ACIT, where in 2008, P&H High Court held that in case of renunciation of right to receive rights shares, the capital asset that is transferred is the right itself and not the right shares. This position has been confirmed by the Supreme Court when the same matter was carried in an appeal by the assessee where the Supreme Court held that the right to subscribe for new shares/debentures is a separate capital asset. The right to subscribe comes into existence when a resolution for the issue of new shares is passed (and not a resolution for allotment).

Closing Arguments

The matter is under appeal by the Revenue before the Bombay High Court and it will be open to the assessee to once again make the preliminary argument viz., Section 56(2)(vii)(c) not  applicable to rights issue. The cases under Section 56(2)(vii) which have come before the Bombay High Court has mostly been decided in favour of the assessees. However, a more tailored approach may be pursued by counsel based on past judicial history and data of the court and judges hearing the matter from time to time.

After all: Data is leverage.

Article written by Dipankar, a lawyer who is also the Founder of Riverus.

Also Read: The Right Markup: A study on Transfer Pricing in Private Equity

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