Commissioner Of Income-Tax, Madras v. Athi V. Ramachandra Chettiar.

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The Judgment of the Court was delivered by Hon’b Jagadisan, J.:


The Appellate Tribunal has referred the following issue[1] to this court under section 66(1) of the Indian Income-tax Act[2], at the request of the Commissioner of Income-tax, Madras: “Whether, in the circumstances and on the facts of the case, capital gains of Rs. 7,269 on the selling of securities computed by the Income-tax Officer is not valid and in compliance with the law?”

Facts and Issues

The assessee is a Hindu family that is not broken. He is not a stock broker. Interest on stocks, land, company, and dividends from shares owned in limited partnerships are all sources of income for him. The assessee was a shareholder of the Karur Vysia Bank Limited. The bank granted incentive shares to the assesses in 1957 in proportion to the shares he already had in the bank. The assesses sold 94 incentive shares for Rs. 7,268.94  during the year of account ended 13th April 1959, which was applicable to the appraisal year 1959-60. Since the Income-tax Officer believed the original expense of these incentive securities was zero, the whole selling proceeds of Rs. 7,269 were charged to tax as capital gains under section 12B of the Act. The assesses argued that the bonus share cost should be determined by applying the “net cost” to each share, taking into account the overall number of shares he owns, including initial and bonus shares. The Income-tax Officer, however, did not support this argument. The assesses opted to appeal to the Appellate Assistant Commissioner, who upheld the Income-tax Officer’s ruling. The Appellate Assistant Commissioner believed that the assessee had not spent any money on these shares and that the initial expense should be regarded as zero. The assessee filed a second appeal with the Income-tax Appellate Tribunal. The Tribunal disagreed with the department’s position and ruled that the incentive shares’ initial expense could not be considered zero.

Arguments and Judgment 

They concluded that the selling proceeds of Rs. 7,299 from the 94 shares sold by the assessee do not entirely reflect capital gains, as the income-tax authorities had said. The Income-tax Officer, on the other hand, has the option of recalculating the benefit if so told and deemed worthwhile. If it’s redone, the closing stock must be priced at the holding’s initial rate, averaged for the original and incentive scrips after issue, or at the market price, whichever is lower.

The Tribunal’s logic is very complex to understand. If the department’s position that the bonus shares had no merit was not to be acknowledged, the value of the bonus shares at the point of issue would be either the market value or the face value. Under either case, the Income-tax Officer has been advised to change the determination that has already been rendered based on the Tribunal’s conclusion. The argument before us now is whether the Tribunal was correct in ordering the government to value the incentive shares using the average value or the market price, whichever is lower.

Mr. S. Ranganathan, the department’s learned lawyer, argued that the bonus shares were given to the assessee as a donation, as an extension or accretion to the initial shares owned by him, and that the assessee did not pay any consideration for these bonus shares. He agreed with the department’s position that the incentive shares’ initial expense should be treated as if they were worthless.

Bonus shares are also a standard feature of corporate governance. When a business is successful and generates a substantial surplus, it turns the surplus into cash and distributes it to its members in proportion to their rights. This is accomplished by selling fully paying securities to reflect the additional money. Bonus shares are sold from the benefit and loss account’s credit balance as well as reserves, and the owners who receive the shares are not required to pay anything. The aim is to use quasi-capital gains or capitalise earnings that might be eligible for separation.

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The modern term for “bonus shares” is “capitalisation shares.” The corporation can capitalise gains or reserves if the articles of incorporation allow it, and sell fully paid shares with a nominal value equal to the sum capitalised to its shareholders. However, in some situations, the papers provide owners with the possibility of receiving cash instead of shares. This will have no bearing on the situation, except to the degree that the option is exercised. When the papers allow for the satisfaction of a dividend or bonus in fully paying bonds, would the buyer become a borrower when the dividend or bonus is declared? Even if the release is mandatory, the dismissal of his lawsuit against the firm for the balance of his proportion is a good and beneficial consideration or set-off in order to have the shares entirely paid.

An incentive issue of stock contributes little to the company’s net worth, according to Spicer and Pegler in their book Book-keeping and Accounts, and the effect is simply to split the money working in the sector into a greater number of shares.

The authors also point out that, in cases where the shares are traded on a stock exchange, the issuance of incentive shares is typically seen as a bullish event, as it raises the market value of the shares and allows shareholders who wish to do so to benefit immediately.

As a result, it is clear that the aim of issuing bonus shares is to align the nominal equity capital with the true asset-to-liability ratio. A business would like to get more operating capital, but it may not need to go to the market to raise funds by issuing additional bonds. It has the requisite funds, which are exchanged into shares, implying that the undistributed earnings have been permanently “ploughed back” into the company and converted into equity stock.

It is self-evident that incentive shares are not received without cost to the owners. They receive these shares only in lieu of dividends that would otherwise be received by the company’s directors. What they would have received in cash after dividends were announced and allocated was given to them in the form of bonus shares.

It seems to us that it would be a misnomer to call the recipients of bonus shares as being donees of shares from the company. The machinery by which the bonus shares are issued is not a simple process of converting the surplus available from profit and loss account or other reserve account into capital by debiting the revenue account and by crediting the capital account. It is not a mere book entry of debit and credit that results in the issue of bonus shares. It is true that ultimately only book adjustments are made, but before this is or can be done, there must be a resolution by the shareholders by which this conversion of income or revenue of the company is transformed into capital.

It’s possible that the permanent purchase of capital by borrowing from the turnover account will provide the corporation with a significant advantage and financial gain. It’s possible that no regulation exists that requires a company’s directors to pay dividends at a certain amount or percentage. However, in substance and in practise, these owners pay for the bonus shares by promising to forgo dividends that would otherwise have accrued to them.

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It was long thought that an incentive given in the form of fully paying business shares was not considered revenue for tax purposes.

In Fisher’s scenario, Viscount Cave cited Viscount Haldane’s observation with approval.

The only issue here is the amount of capital gain realised by the assessee when he sold the bonus securities.

The question is what was the value of the bonus shares in the hands of the shareholder when they were given and allocated to him at the start of the company? The extra realisation made by the assessee above and over the cost of purchase is referred to as capital gains. When incentive shares are issued, it is possible to argue that the price paid by the buyer is the sum of undistributed earnings that he would have received if the profits had been allocated as dividends. However, we do not believe it is a reliable method of determining the real worth of incentive securities. The recipient receives the scrips, which have a face value, as soon as the shares are released. The real share is only of the amount denominated therein, regardless of whether the company sold the stock at a premium or a discount. Thus, there is a lot to be done about the viewpoint that the cost of acquiring incentive shares is actually the face value. The other choice is to determine the share’s market value. The original shares which have a market value at the time the bonus shares are issued. It’s difficult to say how much the bonus share problem would function as a “bull” in the industry. Of course, it’s fair to say that stock in a company in a position to issue incentive shares would typically trade at a premium rather than a discount.

As a result, it is impossible to tell with certainty that the bonus shares’ worth is equal to the value of the original shares on the day of issue. The introduction and circulation of bonus shares creates volatility in the valuation of the shares, and it is impossible to examine the real market value of the bonus shares at the time they are released, in our view. It should also be recalled that the market value of the shares should be that at the time of the matter, if that is the true cost of purchase of the shares by the owners. At the time of the initial public offering, the company only had the original stock in circulation. The new problems in the form of incentive shares would, of course, skew the value of the company’s shares in general.

Analysis and conclusion

The Tribunal, in our view, made a mistake in leading a new capital gain computation by valuing the closing stock as the initial expense of the holding averaged for the original and bonus scraps since released, or at the current price, whichever is lower. The true criteria is to determine the face value of the incentive stock and the surplus, if any, realised by the assesses from the selling of these shares in the accounting year. As a result, we respond to the question in the following manner: Under section 12B of the Act, the amount of Rs. 7,269 cannot be levied in its entirety as capital gains. Just the excess of Rs. 7,269 over the face value of the 94 bonus shares owned and disposed of by the assessee will be subject to tax under that clause. As a result, the connection is addressed. There will be no costing directive.

[1] 1964 52 ITR 96 Mad.

[2] The Income Tax Act, 1995, s. 66.