Private Placement – of Shares or Unaccounted Money ???

Recent Judgement of Hon’ble Supreme Court in case of NRA Iron and Steel Pvt Ltd.

Introduction

Recently, Hon’ble Supreme Court in the case of M/s NRA Iron and Steel Pvt Ltd. (hereinafter referred as “assessee”) redefined the scope of Section 68 and its operating modality by extending the liability of the company issuing shares. Section 68 already casts responsibility on the person in whose name credit entry has been recorded in the books of accounts, failing which the amount shall be liable to be taxed as unexplained cash credit in the hands of receiver. However, this judgement has also increased the scope of responsibilities of the person receiving money. This has overruled earlier judgements of various tribunals and courts. Let us summarize important points of this judgement.

Section 68 of Income Tax Act

Where any sum is found credited in the books of an assessee maintained for any previous year, and the assessee offers no explanation about the nature and source thereof or the explanation offered by him is not, in the opinion of the Assessing Officer, satisfactory, the sum so credited may be charged to income tax as the income of the assessee of that previous year:

Provided that where the assessee is a company (not being a company in which the public are substantially interested), and the sum so credited consists of share application money, share capital, share premium or any such amount by whatever name called, any explanation offered by such assessee-company shall be deemed to be not satisfactory, unless—

(a) the person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited; and

(b) such explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory:

Provided further that nothing contained in the first proviso shall apply if the person, in whose name the sum referred to therein is recorded, is a venture capital fund or a venture capital company as referred to in clause (23FB) of section 10.

Facts of the case

• The assessee received sum of Rs.17,60,00,000/- from issue of shares on private placement basis to various companies located in different cities. These shares were of face value Rs.10 each and issued at a premium of Rs.190 per share. The AO alleged the genuineness of the transaction and asked for explanations.
• The assessee contended that money has been received through banking channels and identity of investing companies have been duly disclosed. Hence, there is no violation of Section 68
• When AO sought explanations from investor companies, following results were found

i. Some of the companies did not respond.

ii. Some of them were non-existent at the given address

iii. A few of them had reported gross income as NIL or some thousand rupees for the year in which they invested lakhs and crores in the assessee company.

iv. Further, none of the investor companies appeared before AO but only sent a written response.

• Hence, The AO held that the Assessee had failed to discharge the onus by cogent evidence either of the credit worthiness of the so-called investor companies, or genuineness of the transaction.
• As a consequence, the amount of Rs. 17,60,00,000/- was added back to the total income of the Assessee for the assessment year in question.
• Assessee relied on judgement of Delhi HC in case of Lovely Exports Pvt Ltd, at the lower appellate levels, the extract of which is as underIn the case of a company the following are the propositions of law under section 68. The assessee has to prima facie prove

(1) the identity of the creditor/subscriber;

(2) the genuineness of the transaction, namely, whether it has been transmitted through banking or other indisputable cannels;

(3) the creditworthiness or the financial strength of the creditor or subscriber

(4) if relevant details of the address of PAN identity of the creditor/subscriber along with copies of the shareholders register, share application forms, share transfer register, etc, it would constitute acceptable proof or acceptable explanation by the assessee;

(5) The Department would not be justified in drawing an adverse inference only because the creditor / subscriber fails or neglects to respond to its notice;

The Assessing Officer is duty bound to investigate the creditworthiness of the creditor/subscriber the genuineness of the transaction and the veracity of the repudiation.

The lower appellate authorities ruled in favour of assessee and even High Court dismissed the tax department’s appeal. They considered name, address, income tax returns and proof of amount received through banking channels as sufficient to prove the genuineness of the transaction viz. private placement of shares. However, Hon’ble Supreme Court admitted the appeal of Department and made following observations

Observations of Supreme Court

• There was no explanation offered as to why shares were acquired at such a high premium of Rs.190.
• None of the so-called investor companies established the source of funds from which the high share premium was invested.
• The lower appellate authorities have erred in overlooking the field inquiry conducted by AO and also erred in coming to the conclusion that onus on assessee has been discharged merely by submitting primary evidence such as name, address, banking channels etc.
• With respect to the issue of genuineness of transaction, it is for the assessee to prove by cogent and credible evidence, that the investments made in share capital are genuine borrowings, since the facts are exclusively within the assessee’s knowledge.
• The assessee has not discharged the onus of proving the creditworthiness of investor companies and also the explanations of investor companies are ipso facto not reliable.
• The entire transaction seemed bogus and lacked credibility.

The verdict was as under-

• The practice of conversion of un-accounted money through the cloak of Share Capital/Premium must be subjected to careful scrutiny. This would be particularly so in the case of private placement of shares, where a higher onus is required to be placed on the Assessee since the information is within the personal knowledge of the Assessee. The Assessee is under a legal obligation to prove the receipt of share capital/premium to the satisfaction of the AO, failure of which, would justify addition of the said amount to the income of the Assessee.
• If the enquiries and investigations reveal that the identity of the creditors or subscribers to be dubious or doubtful, or lack creditworthiness, then the genuineness of the transaction would not be established. In such a case, the assessee would not have discharged the primary onus contemplated by Section 68 of the Act.

Implications of the above judgement

1. On closely held companies issuing shares

After this judgement, the authorities would get right to question the integrity of every issue or reissue of share capital, especially those by company in which public are not substantially interested because these companies generally issue shares on private placement basis.

The issuing company will now have to prove 1. Genuineness of transaction and 2. Creditworthiness of creditor / subscriber rather than merely providing primary evidences like identity of investors and amount received through banking channels which may be illusionary in some cases.

2. On Start-ups

• Will this judgement affect start-ups receiving angel investments through issue of shares? The start-ups are already under the radar of tax authorities under section 56(2)(viib) where the primary concern is issue of shares at excessive premium. Recently, some relaxations were provided by Government to promote start-ups and ensure that genuine start-ups do not get affected by the angel tax provisions.
• However, Section 68 is broader than Section 56(2)(viib) meaning thereby that if start-ups or any company could not be taxed for excess share premium, but even then they could not avoid their liability under Section 68 whereby they have to prove the genuineness and creditworthiness of angel investors to the satisfaction of tax authorities

3. On Unsecured Loans

• What can be the implications of this judgement on unsecured loans, especially after introduction of highly discussed ordinance on unregulated deposits?
• There are certain exemptions provided in that ordinance to allow amount received genuinely in the ordinary course of business so that working capital flow and normal trade credits are not hampered.
• However, this judgement entitles the tax authorities to question the creditworthiness of lenders. In such situation, fictitious unsecured loans appearing on the liability side of Balance Sheet may put the business entity into troubles of tax unless contrary is proved by them because the primary onus of proof is on assessee.

Conclusion

The above judgement may have far reaching impact on both pending as well as upcoming litigations. The basic intention is to identify and eradicate shell companies which are the common source of bringing unaccounted money into the books. This judgement will work as power booster for the tax authorities and if that power is used wisely, the menace of shell companies and unaccounted money flow in the market may be reduced substantially. But at the same time, it is also important that tax authorities preserve the interests of assessee in cases where shares have been genuinely issued.

In the nutshell, closely held companies issuing shares on private placement or other modes should maintain a proper and genuine evidences about the source of funds with them so that they can present it to tax authorities whenever required unless they may get into troubles.