Tuesday 17 September 2013

Whether when assessee purchased shares for a lock-in period of three years and for acquiring management rights in a company, there cannot be a presumption that shares were acquired with object of trading and not investment - YES: Bombay HC

THE issue before the Bench is - Whether when the assessee purchased shares for a lock in period of three years and for acquiring management rights in the company, there cannot be a presumption that the shares were acquired with the object of trading and not investment. And the verdict goes in favour of the assessee.
Facts of the case

Assessee
is a private limited company engaged in the business of investments. Assessee declared long term capital gain arising from sale of shares of ‘M’ an unlisted company to two other shareholders of ‘M’. Assessee claimed benefit of deduction of entire capital gain as it was invested in specified bonds u/s 54EC.

AO held that the amounts earned on sale of shares by the appellant would be taxable under the head profit and gains of business and not under the head capital gains. Assessee was not an investor in shares as it had subscribed to the shares in May 2003 out of borrowed funds, which no investor would do. Assessee subscribed to 20% of the issued equity shares capital of ‘M’ at the price of Rs. 21.30 per share even when the book value of the shares was almost Nil which would also not be done by an investor. Alternatively consideration received on sale of shares by the assessee was in the nature of compensation for termination of the assessee's position as Manager of ‘M’. Therefore, the amount was taxable under the head Business Income as provided in Section 28(ii) of the Act.

CIT (A) allowed the appeal of the assessee observing that as per the shareholdings agreement and subscription agreement, the sale could only be by any one of the shareholders to any of the other two shareholders during the three year lock in period and even thereafter all the three shareholders would continue to have a right of preemption if any of the other shareholders sought to disinvest/sell its shareholding or part thereof. The subscription to the shares of ‘M’ made by the assessee was with intent to run the business of ‘M’ as a Manager and make it dividend paying company. So far as borrowed funds, amount was borrowed from an outside party for a short span of 12 days and the same was without any interest only as a mode of bridge financing. Regarding alternative view of AO, amount received on sale of shares is not an amount received on surrendering its right to manage. Therefore, application of section 28(ii) is not legally tenable.

ITAT allowed the appeal of the revenue observing that no investor would purchase share at such high price when there is no return in the offing. Shares were purchased / subscribed to from borrowed funds and no investor would purchase shares of loss making company out of borrowed funds when there is no likelihood of earning any dividend income. There was nothing in the shareholders agreement or subscription agreement to indicate that acquisition of 20% share holding in ‘M’ was condition precedent for the assessee acquiring right to manage ‘M’.

Assessee contended that tribunal failed to appreciate that right to manage ‘M’ was acquired by subscribing to 20% of shares of ‘M’. The investor was not a passive investor, but an investor with right to manage who could precieve a potential in ‘M’ leading to its investment. Therefore, only in view of the fact that the assessee had purchased the shares at a higher price then its book value would not by itself result in the investment made in shares becoming an activity of trading in shares. Tribunal overlooked the fact that assessee had subscribed to 20% of the shares at Rs. 21.30 while the other partners acquired 40% at the price of Rs. 35.83 per share while S & N had acquired 40% interest at Rs. 87.95 per share. The funding from outside was only for a period of 12 days and the same was without interest. Agreement provided that the assessee would have a right to nominate the managing director which was dependent upon the subscription agreement. Thus, acquisition of 205 share holding was a necessary condition to give the assessee management rights of ‘M’.

After hearing both the parties, the High Court held that,

++ assessee subscribed to 20% of the issued equity share capital of ‘M’. It acquired the right to manage ‘M’ and in the absence of any other evidence to indicate that there was an intent on the part of the assessee to deal in the shares the only conclusion would be that the entire transaction of purchase and sale by the assessee was on capital account. The subscription of 20% shares in ‘M’ subscribed to by the assessee was not freely transferable but regulated and restricted by the shareholders agreement. There was a three years lock-in period in respect of the subscribed share capital and the appellant could not sell the same during that period. In case the appellant had to sell during three years lock-in period the sale was restricted only to the other two parties to the shareholders agreement. Moreover, even after the three year lock in period was over, the other two parties to the agreement continue to have right of preemption in respect of the assessee's shareholding. In view of the aforesaid restriction and prohibition the person who subscribes to such shares would not do so for the purpose of trading in it as the transferability of the shares is very restricted making it a most unsuitable instrument for purposes of trading;

++ assessee held shares for almost 31 months before selling them is another factor to indicate that these shares were not subscribed to by the assessee for the purpose of trading in them. Assessee had borrowed funds from outside for a period of 12 days without interest. The amounts were sourced from its sister company. Thus, the borrowing of funds is not evidence of the assessee, wanting to trade in the subscribed shares of ‘M’;

++ purchase of shares at a price higher than book value cannot be itself lead to the conclusion that the purchase was not in the nature of investment. It is a well known global phenomena that investors purchase shares of loss making companies because in their perception the company has inherent potential to do well either on account of its business model or on account of the management of the company. The potential perception is unique to each investor and there cannot be any universal yard stick to determine whether such perception was justified or not. The analogy drawn on the basis of the explanation under Section 147 of the Act may not be a proper analogy. Other share holders have subscribed at higher price is an undisputed position. This would establish that perception of the potential of ‘M’ on the part of the assessee was not solitary and unique. A trader in shares normally holds shares for a shorter period of time and looks for quick returns. In such circumstances, he is less likely to purchase share at price higher than the market value and in case of unquoted shares at a price higher than its book value;

++ whether or not a particular purchase/subscription to shares was for the purpose of doing business or for purpose of investment cannot be determined on the basis of whether the amount required for the purchase of the same was borrowed or self generated funds. It is well known that capital assets, at times are acquired out of borrowed funds and the distinction between capital assets and stock in trade is not on the basis of source of funds i.e. borrowed funds or self generated funds but on the basis of assets itself and for the period for which it is held before the same is traded/sold. Thus, the appeal of the assessee is allowed.

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