Mumbai ITAT Rejects LIFO and Upholds FIFO Approach for Capital Gains Computation

 In a recent ruling of Megasolis renewable , the Mumbai ITAT upheld the application of the First-In-First-Out ("FIFO") method for computing capital gains on the sale of shares held in physical form, rejecting the taxpayer's attempt to compute gains based on LIFO method. Significantly, the Tribunal invoked the doctrine of substance over form and characterised the taxpayer's approach as a colourable device aimed at reducing its tax liability.

On 29 January 2016, the assessee sold 46.67 lakh shares of its subsidiary to an unrelated third-party investor. The shares had been acquired in different tranches at varying prices, including a substantial lot acquired on 27 June 2015, i.e., shortly before the sale at a significantly higher cost. While the assessee recorded a profit of approximately INR 5.93 crore in its books by applying the average cost method prescribed under Accounting Standard-13, it computed taxable short-term capital gains of only INR 43.54 lakh in its tax return by specifically following Last-In-First-Out method. The Assessing Officer rejected this approach and recomputed the gains at INR 11.20 crore by applying the FIFO method, resulting in an addition of INR 10.76 crore. The CIT(A) upheld the adjustment.

Before the Tribunal, the assessee argued that Section 45(2A) of the Income-tax Act, 1961, which prescribes FIFO for securities held in dematerialised form, had no application to shares held in physical form. It contended that physical shares were capable of specific identification through share certificates and distinctive numbers and, therefore, capital gains ought to be computed with reference to the actual shares transferred. The Revenue, on the other hand, argued that all equity shares represented identical rights and interests and that the assessee's selective identification of high-cost shares was a tax-motivated exercise lacking commercial substance.

The Tribunal observed that the assessee had adopted different approaches for the same transaction, viz. average cost for accounting purposes, LIFO for tax purposes, and rejection of FIFO altogether which resulted in a substantial reduction of taxable gains. It held that following the LIFO method was merely a device to minimise tax and that the transaction, viewed in substance, involved the transfer of fungible and interchangeable equity shares carrying identical rights and obligations. The Tribunal emphasised that tax consequences must be determined based on the true commercial substance of a transaction rather than its legal form. It further held that, although Section 45(2A) expressly applies to dematerialised securities, the principle underlying FIFO could validly be extended to physical shareholdings especially in this case since the Act does not specifically provide for the computation mechanism for physical shares. Accordingly, the Tribunal upheld the addition made by the Assessing Officer.

The key takeaway from this ruling is that, even in the case of shares held in physical form, taxpayers may not be able to rely on LIFO method of tax computation solely because the shares are distinguishable by certificate numbers. The Tribunal indicated that FIFO shall be the more appropriate method unless the transfer of specifically identifiable shares can be supported by a genuine commercial rationale. The decision also underscores the continued relevance of the substance-over-form doctrine in Indian tax jurisprudence, demonstrating that, even in pre-GAAR years, courts and tribunals are looking beyond legal form and disregarding tax-driven arrangements that lack commercial substance.