The decision of the Income Tax Appellate Tribunal Mumbai in the Periar Trading case deals with the taxability of the conversion of preference shares into equity shares and will have considerable significance in transactions for companies.
The Central Board of Direct Taxes issued a Circular ("the Circular") on December 31, 2018 stating that the provisions of section 56(2)(viia) of the Income-tax Act, 1961 (“the Act”) will not apply to issuance of shares. This Circular was withdrawn within four days by Circular No. 02 of 2019 dated January 4, 2019.
Even though the Circular had provoked a debate on whether it was applicable to the new section 56(2)(x), its withdrawal still left the issue of valuation of shares in relation to rights issue open.
Tax Tribunal Decision
Set against the above background, the decision of the Income Tax Appellate Tribunal (“ITAT”) Mumbai, Periar Trading Company Private Ltd v. ITO, ITA No.1944/Mum/2018 (“Periar Trading case”), has particular significance.
The decision deals with the taxability of the conversion of preference shares into equity shares and has great significance for foreign investments, and in cases where the promoters invest in the company without diluting their shareholding.
The decision will also have significance in future transactions, especially for companies, who can plan the cost of capital more effectively.
Periar Trading Company Private Ltd participated in a rights issue of Trent Limited (“the company”) and subscribed to compulsorily convertible preference shares (“CCPS”) of the company which were automatically convertible into equity shares of the company in ratio of 1:1.
The Assessing Officer (“AO”) treated the conversion as a taxable transfer, as it amounted to “exchange,” and the difference between the fair market value of resulting equity shares of the company and cost of acquisition of the CCPS, as long-term capital gains.
The first appellate authority, the Commissioner of Income-Tax (Appeals) (the “CIT(A)”), relying on rulings of the Bombay High Court in CIT v. Santosh L. Chowgule  234 ITR 787 and the Andhra Pradesh High Court in ACIT vs. Trustees of H.E.H. The Nizam’s Second Supplementary Family Trust, (1976) (102 ITR 248), rejected the taxpayer’s appeal and upheld the tax levied by the AO.
The Tribunal primarily relied on a Central Board of Direct Taxes Circular (“the CBDT Circular”) dated May 12, 1984 F No. 12/1/64-IT(A) which in reference to section 55(2)(v) of the Act stated:
“… Section 14 of the Finance Act, 1964, introduces a new clause (v) in sub-section (2) of section 55 of the Income-tax Act, 1961, laying down the method for determining the cost of acquisition of a new share which becomes the property of the assessee on conversion of one type of share into another type of share. A question has been raised whether the transaction of conversion of one type of share into another attracts the capital gains tax under Section 45(1) ... The position in this regard is as follows:
(1) Where one type of share is converted into another type of share (including conversion of debentures into equity shares), there is, in fact, no “transfer” of a capital asset within the meaning of section 2(47) of the Income-tax Act, 1961. Hence, any profits derived from such conversion are not liable to capital gains tax under section 45(1) of the Income-tax Act. However, when such newly converted share is actually transferred at a later date, the cost of acquisition of such share for the purposes of computing the capital gains shall be calculated with reference to the cost of acquisition of the original share of stock from which it is derived.”
The ITAT recognized that if the full effect of section 55(2)(v) is taken into account, it would amount to double taxation. Further, the ITAT also noted that the decisions of the Bombay High Court relied upon by the CIT(A) were without any consideration of the section or the CBDT Circular. It also distinguished the Supreme Court decision, on the point that the decision was given prior to 1964, that is, the year before the provisions of section 55(2)(v) were brought in.
The decision specifically gives an interesting area for companies in India to plan their cost of capital and also to bring in cheaper capital without affecting their debt to equity ratio and their EBITDA (earnings before interest, taxes, depreciation and amortization).
It is important to note that for private companies, it is quite a litigious proposition to increase promoter holding without triggering tax implications. Complications have arisen, particularly in relation to section 56(2)(vii) of the Act [now section 56(2)(x)].
A decision of the Mumbai ITAT in the case of Sudhir Menon v. ACIT, ITA No. ITA No.4887/Mum/2013 had compounded the issue when it observed:
“As long as, therefore, 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, if there is an unequal allotment even in a rights issue where all the shareholders are offered shares, as per the observations of the ITAT there would be tax implications in the hands of the shareholder under section 56(2)(vii) [now under section 56(2)(x)].
- if the fair value of the equity shares is 100 rupees ($1); and
- rights issue is done at face value of 10 rupees and there is an unequal allotment as some of the shareholders abstain,
then the tax would be at 90 rupees in the hands of the shareholder under section 56 as it would be treated as shares received at less than fair market value. The problem has been further compounded by the fact that the Income-tax Rules, 1962 have provided for valuation rules of equity shares which take into account the fair value of all the assets held by the company issuing the shares.
A Simpler Method
Instead, a simpler method could be adopted in view of the decision of the Mumbai ITAT in the Periar Trading case.
One could issue shares as compulsorily convertible preference shares. The Income-tax Rules, 1962 provide for different valuation methodologies for preference shares and equity shares. The valuation of preference shares as per the valuation rules has to be done as per discounted cash flow method and not the fair value of the underlying asset methodology. Subsequently, if the equity of the promoter is to be increased in the hands of the promoter, then the shares could be converted in 1:1 ratio.
It is interesting to note that the current Mumbai ITAT has not discussed the implications of the provisions of section 56(2)(viia) of the Act (now under section 56(2)(x)).
In the above planning point, the AO can take the point that if the conversion ratio is 1:1 then the difference between the market value of the equity shares issued and the subscription price paid for the CCPS is taxable under section 56(2)(x),;effective from April 1, 2018, the conversion of preference shares into equity shares is not taxable as capital gains under section 47(xb). However, no such exemption has been provided in section 56(2)(x) which taxes any property received below the fair market value.
However, now it is possible to rely on the decision and again make the same argument that the same income cannot be taxed twice.
To support the argument, one could rely on section 2(42A) of the Act which was also amended with the introduction of section 47(xb), where for the purposes of determining whether the equity shares received on conversion would be a long-term asset or short-term asset, the period of the holding of the converted equity shares would be taken into account from the date of holding of the preference shares.
Thus, the amendment is brought in to make the conversion tax neutral. Any taxation levied at the time of conversion in any manner would amount to cannibalizing the neutrality promised by the amendment.
Please note that the author is aware of the decision of the Mumbai ITAT in the case of ACIT v. Shubodh Menon, ITA No.676/Mum/2015 order dated December 7, 2018, which held that when the transaction is genuine the provisions of section 56(2)(vii) will not be attracted and has accordingly held that in cases of rights issue the provisions of section 56(2)(vii) would not apply.
Further, ITAT Vizag in the case of Sri Kumar Pappu Singhv. DCIT, ITA No. 270/Viz/2018 dated December 7, 2018 has held that if all the shareholders are related and if there is disproportionate allotment, the provisions of section 56(2)(vii) will not be attracted.
The above decisions, though largely in favor of the taxpayer, do however have flipsides. The Mumbai Tribunal has put the burden of proving the rights issue to be a genuine transaction on the taxpayer, without really laying down any tests for this. Further, the ITAT Vizag also compounds the problem for cases when there are corporate shareholders.
Asim Choudhury is a Principal Associate at Khaitan & Co, India.
He may be contacted at: firstname.lastname@example.org; email@example.com