18 March 2014 EY Tax Alert Mumbai ITAT rules on taxability of allotment of additional shares to existing shareholders under the Gift Tax provision Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax alert summarizes a recent ruling of the Mumbai Income Tax Appellate Authority (ITAT) in the case of Sudhir Menon [HUF] [1] (Taxpayer) on whether allotment of additional shares, on the basis of existing shareholding and at a value less than the fair value, results in taxation under the Gift Tax provision of the Indian Tax Law (ITL). The ITAT analyzed the tax implications under the following categories, i.e., (a) where the allotment is on a proportionate basis, and (b) where the allotment is on a disproportionate basis. The ITAT ruled that both, proportionate as well as disproportionate allotments, fall within the ambit of the Gift Tax provision under the ITL. As regards proportionate allotment, the ITAT ruled that there should be no adverse tax implications as it is similar to the issue of bonus shares, whereby, a share is split and the total value, post issue of additional shares, in the hands of the shareholder, remains the same. Accordingly, there should be no additional Gift tax liability under the ITL. However, in cases of disproportionate issue of additional shares, the Gift Tax provision stands attracted. [1] [ITA No. 4887/Mum/2013]
Background and facts Taxpayer s contentions The ITL taxes an individual/hindu Undivided Family (HUF) on receipt of a specified property (such as shares, securities, immoveable property etc.), without consideration, or for an inadequate consideration [Gift Tax provision]. Inadequate consideration is the difference between fair market value (FMV) [2] and the consideration paid in excess of INR50,000. The ITL taxes the difference in the hands of the recipient of such property. The Taxpayer, along with its family members, held the entire share capital in an Indian company (DKCP). The Taxpayer, independently, held 15,000 shares. DKCP offered additional shares (about 21 shares for each share held) in proportion to the existing shareholding of each shareholder. The Taxpayer was entitled to subscribe for about 3 lacs shares but actually subscribed for about 1.94 lacs shares as a result of which the proportionate shareholding reduced from 4.98% to 3.17%, post additional issue of shares. DKCP offered additional shares at INR100, being the face value. However, the book value of each share, as on that date, stood at INR1538 i.e., the normative value as prescribed under the ITL. As the issue price was INR100 per share, and the book value was INR1538, the Tax Authority sought to tax the difference, i.e., INR1438 per share in the hands of the Taxpayer, treating the same as an inadequate consideration. The First Appellate Authority upheld the Tax Authority s adjustment. The Gift Tax provision was introduced to check bogus capital building or money laundering. One would, accordingly, need to consider this aspect while analyzing the applicability of the Gift Tax provision to a particular case. Issue of additional shares at a discount does not fit into the intent of the provision. Share constitutes a property which comes into existence only on its allotment. However, the right to acquire shares at concessional rate, which the Tax Authority intends to capture within the ambit of the Gift Tax provision, comes into effect on the passing of the necessary resolution by the board of directors of the company. Accordingly, additional shares may not result in a property which can be received. Therefore, the Gift Tax provision would not capture issue of additional shares to existing shareholders. The term receipt as envisaged in the Gift Tax provision should be equated with the term transfer as defined in the ITL. The term transfer envisages (a) existence of property, and (b) ownership in such property. In the present case, additional shares were neither in existence until allotted and nor did DKCP assert ownership rights on such shares. Accordingly, such issue of additional shares falls outside the ambit of Gift Tax provision. ITAT s ruling Scope of Gift Tax provision under the ITL Aggrieved, the Taxpayer appealed before the Second Appellate Authority, i.e., the ITAT. [2] Determined based on normative rules prescribed under the ITL. The Gift Tax provision was first introduced in 2004 with a lower threshold of INR25,000 as against the present threshold of INR50,000. The provision has gradually been enhanced to include gifts in kind and immovable property. The provision, which is akin to an anti-abuse measure, substitutes FMV (as prescribe under the ITL) as the normative basis, and deems this value as the proper measure of the arm s length
price (principle which guides transactions between unrelated parties). Whether additional shares fall within the ambit of the term property under the ITL Under the ITL, the term property includes shares and securities within its ambit. Accordingly, additional shares, i.e., issue of shares to existing shareholders below the market value, would qualify as property. Whether additional shares are received on the date of allotment/date of actual receipt of share certificate A shareholder gets the right to acquire additional shares only on passing of a resolution by the board of directors. Receipt of property, i.e., shares, is only at the time of allotment, on which date, shares are said to come into existence. Allotment process is the act of appropriating, out the previously unappropriated capital, a certain number of shares. Until such allotment, shares do not exist. Accordingly, appropriate date for considering applicability of the Gift Tax provision under the ITL is the date of allotment of shares, as this event signifies receipt. The date of actual receipt of share certificates, which is a constructive receipt, merely evidences title to such shares, and accordingly, cannot be construed as receipt. Receipt, and not transfer, is the determinative test for taxation under the Gift Tax provision The Gift Tax provision do not stipulate transfer, but receipt as the prescribed mode of acquisition. Correlating the term receipt as synonymous to transfer is inconsistent with the unambiguous and clear intent, conveyed by the literal reading of the Gift Tax provision. If the scope of the term receipt is restricted to cases of transfer, the same would be inconsistent with the unambiguous language of the Gift Tax provision. Receipt is of wide import and includes acquisition by modes other than by way of transfer. Receipt as envisaged under the Gift Tax provision, accordingly, includes allotment of additional shares. Whether allotment of bonus shares falls within the ambit of Gift Tax provision Before evaluating whether proportionate issue of additional shares falls within the ambit of the Gift Tax provision, it would be useful to ascertain the rationale for exclusion of bonus shares from the ambit of the Gift Tax provision. Issue of bonus shares is a capitalization of profit by the issuing company, with neither increase nor decrease in the wealth of the shareholder or of the issuing company. What in effect transpires is that a share is split (in the same proportion for all the shareholders), without any actual receipt of any property by the shareholder. There is, accordingly, no gift of or accretion to property as the shareholder gets the value of its existing shares, which stands reduced to the same extent. There is, thus, no receipt of any property by the shareholder, and what stands received is the split shares out of its own holding. This is akin to exchanging a one thousand rupee note for two five hundred or ten hundred rupee notes. There is, accordingly, no question of any gift of or accretion to property; the shareholder merely gets only the value of its existing shares, which stands reduced to the same extent. This has the effect of reducing the value per share, increasing its mobility and liquidity, in the sense that the shares become more accessible for transactions, and, thus, tradable, i.e., considered from the holders point of view.
Whether allotment of additional shares falls within the ambit of Gift Tax provision The above analogy equally applies to the case of proportionate issue of additional shares, as the value of such shares is derived from existing shareholding, which is the basis of allotment. To illustrate, shares in the ratio (say) 1:1 are offered for subscription at the face value of INR100 as against the current book value of say, INR1500. The moment an additional share is allotted, the book value would fall to INR800 per share. Thus, the additional share partakes a part of the value of the existing share. The excess (over face value) or INR1400 is equally apportioned over two shares as against one earlier, which is already the shareholders property. Accordingly, no additional property is received by the shareholder. As long as shares are allotted pro-rata to the shareholders, based on their existing holdings, there is no scope for any property being received on allotment; there being only an apportionment of the value of existing holding. Accordingly, even if the Gift Tax provision is to apply, there would be no adverse tax implication under the ITL when additional shares are issued proportionately. A higher than proportionate or a nonuniform/disproportionate allotment of additional/bonus shares stands on a different footing as compared to proportionate allotment. To the extent of disproportionate allotment, the Gift Tax provision stands attracted. A proportionate offer can, in certain circumstances, result in a disproportionate allotment. One of the ways could be selective basis, i.e., where some shareholders abstain from exercising their rights (wholly or in part) and, accordingly, transfer additional shares to other shareholder. To illustrate, two shareholders equally hold (50% each) in a company. An additional issue in the ratio 1:1, abstained by one shareholder, results in the other having a 2/3 rd holding. A higher proportion of additional shares yield a more skewed holding in favor of the resulting dominant shareholder. This possibly results in divesting the controlling interest in a company to another shareholder at a consideration less than FMV. In the facts of the case, as the Taxpayer received additional shares not in excess of the proportion to its existing shareholding, the Gift Tax provision will not apply. Comments This ruling provides an insight into the Gift Tax provision of the ITL. The ITAT has ruled on a very contentious issue as to whether fresh allotment of shares falls within the meaning of the term property that can be received. Further, the ITAT has bifurcated tax implication on allotment of additional shares under two baskets, i.e., proportionate allotment and disproportionate allotment. Where allotment of additional shares is proportionate to existing shareholding, the ruling clarifies that there should be no adverse implication under the Gift Tax provision. However, in cases of disproportionate allotment of additional shares, the ruling seems to indicate that the Gift Tax provision may apply on such quantum, which is over and above the proportionate entitlement of the shareholder. Impact of this ruling will need to be considered while undertaking any business reorganization or restructuring which may involve issue of additional shares.
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