Enzen Global Solutions Pvt. Ltd Vs ITO (ITAT Bangalore)
Conclusion: While holding that the premium on redemption of preference shares was exigible to tax under the head ‘Income from Capital Gains’, the ITAT held that the revenue authorities were not justified in making the additions to the assessee’s income on the ground of notional premium receivable on preference shares.
Held: Assessee invested an amount in the preference shares of a Private Limited Company. In its income tax return, assessee declared an amount being the premium accrued on the redemption of preference shares under the head “Income from other sources”. Assessee filed a revised return of income, reducing the amount of premium offered to tax. Assessee contended that only the premium actually received by it on redemption, was liable to be taxed at the time of redemption of preference shares under the head “Capital Gains”. AO opined that the preference shares issued to assessee contained features of both an equity and a debt instrument, since the amount of dividend payable to the preference shareholders/assessee was fixed from the beginning. AO ruled that since assessee was entitled to a fixed rate of premium/ dividend on the cumulative preference shares issued to it, the said shares were akin to a debt instrument. Hence, AO held that the taxability of the premium accrued to the assessee did not depend upon its receipt by the assessee. Accordingly, AO passed an order, taxing the premium on preference shares accrued to assessee, under the head ‘Income from Other Sources’. It was held that assessee was only a preference shareholder and a debtor of the company issuing redeemable preference shares and was entitled to claim the redemption premium as a matter of right. The payment of redemption premium could be only out of profits of the company or out of reserves. Even if one were to be regarded the premium as akin to dividend, the assessee could not claim dividend as a matter of right and it is for the directors of the Company to declare dividend which need to be approved by the shareholders in an Annual General Meeting (AGM). It was only when assessee had a right to receive periodic payments can it be said that income had accrued to an assessee under the mercantile system of accounting.In the case of preference shares, such an inference could not be drawn and the repayment of the face value of the preference shares as well as the premium on redemption was uncertain. In such circumstances, the action of the Revenue authorities in making the impugned additions could not be sustained. Therefore, the income brought to tax by the Revenue authorities could not be sustained and the said addition was directed to be deleted.
FULL TEXT OF THE ORDER OF ITAT BANGALORE
ITA No.2332/Bang/2019 is an appeal by the assessee while ITA No.2550/Bang/2019 is an appeal by the Revenue. Both these appeals are directed against the Order dated 17.09.2019 of CIT(A) – 2, Bengaluru, to Assessment Year 2016-17.
2. First, we shall take up for consideration ITA No.2332/Bang/2019, being appeal by the assessee. The only issue that arises for consideration in this appeal by the assessee is as to whether the Revenue authorities were justified in adding a sum of Rs.17,09,02,887/- being notional premium receivable on preference shares as income of the assessee. The grievance of the assessee in this regard is projected in ground Nos.3 to 5 raised by the assessee before the Tribunal, which reads as follows:
2. The learned Commissioner of Income Tax (Appeals), has erred in confirming the addition of Rs.17,09,02,887/- made by the learned assessing officer on the facts and circumstances of the case.
3. The Assessee denies itself to be liable for the addition of Rs.17,09,02,887/- being notional premium receivable at the time of redemption of Preference Shares, held by the Assessee on the facts and circumstances of the case, in as much any appreciation received in the investment is taxable only at the time of redemption and not at any time before as also is subject to tax u/s 45 of the Act, subject to provisions thereof a is not a revenue receipt, chargeable to tax under the head ‘Income From Other Sources’ on the facts and circumstances of the case.
4. Without prejudice, the learned Commissioner of Income Tax (Appeals), failed to appreciate that the Interest Income from Other Sources on the ground that dividend/interest accrued on account of investment is taxable only at the time of redemption by treating the same as Capital Gains on the facts and circumstances of the case.
3. The facts with regard to the aforesaid grounds of appeal are that during the year the assessee invested an amount of Rs.130,00,00,000 in 13,00,00,000 preference shares of M/S. Ensource Consulting Private Limited with a face value of Rs.1000/- per share. In terms of the allotment, the Preference shares are to be redeemed at the end of 20 years, from the date of allotment, at a premium equivalent to 16.5% p.a on of the face value of the shares. The entire amount, i.e., Principal and Premium, shall be paid at the time of redemption. In the original return of income, the assessee declared an amount of Rs.17,09,02,857/- as “Premium accrued on Redeemable Preference shares” under the head “Income from Other Sources”. But subsequently the assessee filed a revised return of income on 14/03/2018 reducing this amount of Rs.17,09,02,857/- from the net profit. The assessee claimed in the revised return of income that the Premium, which is to be received only on redemption is liable to be offered for tax at the time of redemption of shares under the Capital Gains, only to the extent actually received. Thus, the said sum ofRs.17,09,02,857/- the same which was originally offered as income for the year, stood withdrawn.
4. The Assessing Officer (AO) did not accept the contention of the assessee for the reason that Preference shares subscribed to by the assessee contains features of equity and debt as the dividend payments to preference shareholder (assessee) is fixed from the beginning. Like a bond or debenture, the receipt of financial benefit/interest/premium is assured from the beginning. The assessee maintains books of accounts on mercantile basis. Therefore, the taxability of the same does not depend upon receipt of the premium or otherwise. What is important here is that the rate of dividend or rate of interest is 8% on cumulative basis or 14% interest on IRR basis, which is fixed in the offer document subscribed to the assessee. Cumulative Preference shares ensures that missed out dividend payments are carried forward. The fixed rate ensures the dividend due to the investor during the year. Its’ payment may be uncertain, but its accrual is certain in case of a cumulative preference shares. Therefore, income need to be taxed on due basis. For the above reasons, the AO treated the cumulative preference shares as akin to debt instrument on which the assessee is entitled to a fixed rate of premium/ dividend The AO therefore, treated the dividend on Preference share as equal to interest.
5. The AO also made an alternative case by observing that if the cumulative preference share is considered as an equity instrument, the dividend will accrue to the investor irrespective of the fact that the company has declared dividend or not. This income has to be paid in future out of the accumulated profits. Presuming that at the time the dividend distribution, dividend distribution tax is duly deducted by M/S. Ensource Consulting Private Limited, dividend may be claimed as exempt by the investor (i.e., the assessee). According to the AO, loan was taken by the assessee from M/ S KKR Capital for the purpose of subscribing to preference shares. So, if dividend is considered as having accrued to the assessee on accrual basis, then following matching principle, interest expenses incurred for that specific investment can also not be allowed because the interest expense would be expenditure incurred to earn exempt income. Therefore, expenses claimed towards subscribing preference shares, is not allowable as well u/s 14A.
6. Therefore, according to the AO, the sum of Rs. 17,09,02,857/- has to be either taxed as interest income accrued to the assessee or it has to be regarded as expenditure incurred in earning exempt income and therefore should be disallowed u/ s. 14A r.w.r.8D. In either case i.e., taking preference share as debt instrument or equity instrument, the accrued premium needs to be taxed and the interest incurred for the purpose of earning the dividend need to be disallowed.
7. In this regard, the AO also made reference to Circular No.2/ 2002 issued by the Central Board of Direct Taxes (CBDT), in which it has been laid down that “Every person holding a Deep Discounting Bond will make a market valuation of the bond as on the 31St March of each Financial Year (hereafter referred to as the valuation date) and mark such bond to such market value in accordance with the guidelines issued by the Reserve Bank of India for valuation of investments. For this purpose, market values of different instruments declared by the Reserve Bank of India or by the Primary Dealers Association of India jointly with the Fixed Income Money Market and Derivatives Association of India may be referred to. The difference between the market valuations as on two successive valuation dates will represent the accretion to the value of the bond during the relevant financial year and will be taxable as interest income (where the bonds are held as investments) or business income (where the bonds are held as trading assets). According to the AO, though the Circular No.2/ 2002 specifies Deep Discount Bonds and Strips, it has a bearing on the assessee’s case which is holding of Preference shares, which is hybrid of both debt and equity instrument.
8. For the above reasons, the sum of Rs. 17,09,02,857/ – credited to the books of accounts as premium on preference shares was brought to tax under the head ‘Income from Other Sources’, by the AO.
9. Aggrieved by the aforesaid addition made by the AO, the assessee preferred before the first appellate authority, Commissioner of Income Tax (Appeals) [CIT(A)]. Before CIT(A), assessee submitted that the view taken by the AO is not correct for the following reasons:
1. The assessee had in its return of income originally filed, had mistakenly, offered the premium to tax on an annualized basis. On realizing its mistake, it promptly filed a revised return, well in time, by withdrawing the same as income. The assessee did not make any other change in its revised return.
2. The act of Redemption of Preference Shares amounts to a transfer of a Capital Asset u/s 2(47) of the Income Tax Act As natural corollary Premium, if any, received at the time of redemption, is not a revenue receipt, but a Capital receipt, which is exigible to tax under the head ‘Income from Capital Gain s’ in accordance with the provisions related to the same. The assessee relies upon the decision of the Hon’ble Supreme Court in the following cases wherein the Hon’ble Supreme Court has held that Redemption of Preference Shares amounts to transfer of a Capital Asset u/s 2 (47) of the Act, viz., ( a) Anarkali Sarabhai vs CIT 224 ITR 522; (b) Karthikeya Sarabhai vs CIT 228 ITR 163;
3. The assessee also relied upon a decision of the Income Tax Appellate Tribunal, Mumbai Bench, in the case of Parle Biscuits Pvt Ltd vs ACIT (TS-477-ITAT-2011-Mum), wherein the ITAT, following the decisions of the Supreme Court in the above cited cases of Anarkali &. Karthikeya Sarabhai, held that at the time of redemption of preference shares, the assessee is allowed indexation benefit on the original investment, to arrive at the cost and difference between the indexed cost and the redeemed price shall he taxed as Capital gains or Capital loss, as the case may be. In that particular case the assessee claimed capital loss, contending the indexed cost of acquisition exceeded the redemption price, which was allowed by the ITAT.
4. The assessee submitted that in the year under consideration, no premium is due and receivable. The same is to be received at the time of redemption and there is no guarantee that the promised premium will be received at the end of 20 years. Under these circumstances it is wholly unjust to tax an amount which may or may not be received at the end of 20 years. The liability to pay the same arises to the company allotting the shares only at the time of redemption 86 not at any time earlier.
5. The assessee submitted that the AO is not correct in equating Redeemable Preference Shares with Deep Discounting Bonds and Debentures as they are not one and the same. They belong to different Genres. Deep Discounting Bonds and Debentures are liabilities to the recipient, whereas Redeemable Preference Shares are part of Capital. The assessee relied upon the decision of the Bombay High Court in the case of CIT vs Enam Securities 345 ITR 64, wherein the High Court held that Preference Shares are different from Bonds and Debentures and being Capital in nature is eligible to benefit of indexation.
6. The assessee, submitted that the alternate case made out by the AO, by applying the provisions of Sec.14A of the act, cannot be sustained because, the premium on redemption is exigible to tax under the head ‘Income from Capital Gains’ and is not exempt from tax. Further the investment in preference shares is to be regarded as an investment in an unlisted and unquoted security & is therefore definitely exigible to tax. Section 14A comes into play only in the case of investment, income from which, is completely exempt from tax. Hence the question of any disallowance u/s 14A in respect of interest paid on loans, which are utilised to make the investment, is to be allowed as a business expenditure. If the same is claimed and allowed as a business expenditure, the same cannot be treated as part of cost of investment and be allowed for indexation while determining cost at the time of redemption of the shares.
10. The CIT(A) however concurred with the view of the AO. He formulated the issue that he has to decide viz., Whether the AO was right in adding the share premium to the income of the assessee on accrual basis under the head ‘Income from other sources’ treating it as revenue in nature. He observed that it is important to examine the nature of non convertible redeemable preference shares, whether it is a debt instrument or an equity instrument. Preference shares carries characteristics of fixed interest paying securities such as bonds/debentures and offers possible appreciation of the capital as in the case of regular equity shares. Preference shares are generally issued with a fixed rate of premium/interest/dividend, by whatever name called, and premium is paid out of the accumulated profits of the company. Even if the premium is not paid in any particular financial year due to any reason, it will accrue and get accumulated and paid in future if the preference shares are cumulative in nature as in the instant case. Apart from the assured premium/interest/dividend, preference shares holders are also entitled to any capital gains on any appreciation on the face value/issue price of the preference shares realized at the time of redemption. These characteristics give preference shares the nature of a hybrid instrument, i.e., a combination of both debt and equity instruments. If the preference shares are treated as debt investment, the premium accrued should be treated like interest income and should be taxed under the head ‘Income from other sources’. If it is treated as an equity instrument, the premium accrued will be in the nature of dividend which is an exempt income for taxation in which case the interest expenditure on the investment should be disallowed u/s 14A of the Income tax Act. The CIT(A) did not address the argument raised by the assessee that premium on redemption of preference shares is taxable and is not an exempt income and therefore the question of applying provisions of Sec.14A of the Act, does not arise.
11. The CIT(A) thereafter went on to examine Indian Accounting Standards (Ind AS)-32 issued by Institution of Chartered Accountants of India (ICAI) which talks about financial instruments. The relevant portion that mentions about preference shares is extracted hereunder;
“AG25 Preference shares may be issued with various rights. In determining whether a preference share is a financial liability or an equity instrument, an issuer assesses the particular rights attaching to the share to determine whether it exhibits the fundamental characteristic of a financial liability. For example, a preference share that provides for redemption on a specific date or at the option of the holder contains a financial liability because the issuer has an obligation to transfer financial assets to the holder of the share. The potential inability of an issuer to satisfy an obligation to redeem a preference share when contractually required to do so, whether because of a lack of funds, a statutory restriction or insufficient profits or reserves, does not negate the obligation. An option of the issuer to redeem the shares for cash does not satisfy the definition of a financial liability because the issuer does not have a present obligation to transfer financial assets to the shareholders. In this case, redemption of the shares is solely at the discretion of the issuer. An obligation may arise, however, when the issuer of the shares exercises its option, usually by formally notifying the shareholders of an intention to redeem the shares.
AG26 When preference shares are non-redeemable, the appropriate classification is determined by the other rights that attach to them. Classification is based on an assessment of the substance of the contractual arrangements and the definitions of a financial liability and an equity instrument. When distributions to holders of the preference shares, whether cumulative or noncumulative, are at the discretion of the issuer, the shares are equity instruments.”
According to CIT(A), the factor of obligation to redeem give redeemable preference shares a distinct character of a financial liability which otherwise generally is in the nature of an equity instrument. The obligation to redeem coupled with non-convertibility of the preference shares in the instant case heavily tilts the nature of the instrument towards debt rather than the equity
This fact becomes even more emphasized when seen in the backdrop that these preference shares were issued without any voting rights and with a fixed rate of premium which shall accrue on a year on year basis as laid out in the annexure to the share subscription agreement under the head ‘Terms of preference shares’. Hence this is not just a case of preference shares in general, but the fact that then preference shares are redeemable and non-convertible and were issued with a fixed yearly premium has given them a distinct colour of a debt instrument. The assessee duly following the accounting standard had shown the accrued premium as income in its books of accounts and declared as income from other sources in the original return of income filed. But the assessee made a volte-face when the case was selected for scrutiny and filed a revised return stating that it did not receive any premium during the year and the accrued premium will be liable to tax only when it will be redeemed in the future i.e., after 20 years that too as capital gains.
12. The CIT(A) further held that argument of the assessee that the premium should not be taxed yearly on accrual basis and will be liable to tax only when it will be actually redeemed and should be taxed as capital gains, is incorrect because accrual of the fixed premium will not result in any appreciation in the capital asset. If there will be any appreciation in the capital asset in the form of higher redemption price per share compared to its issue price which in the instant case is Rs.1,000/- per share, in addition to the tax on the accrued premium on yearly basis, the assessee will be liable to pay capital gains tax on it or can claim if there is any capital loss after computing indexed cost of acquisition. The CIT(A) also distinguished the two decisions of Hon’ble Supreme Court in the cases of Anarkali Sarabhai Vs CIT 224 ITR 422 and Karthikeya Sarabhai Vs CIT 228 ITR 163 and the decision of ITAT Mumbai in the case of M/s Parley Biscuits Pvt Ltd Vs ACIT in support of its argument by observing that all these case laws address the issue of whether redemption of preference shares would amount to transfer within the meaning of Section 2(47) of the Income-tax Act. In these cases, the investment of the assessee in preference shares were redeemed which resulted in some capital gains to the assessee because the shares were redeemed at a higher price compared to the issued price and the assessee was contesting that it was not liable to pay capital gains tax as there was no capital gain since the redemption of preference shares did not amount to transfer u/s 2(47) of the Income tax Act. The Supreme Court ruled that the redemption of preference shares amounted to transfer within the meaning of Section 2(47) of the Income tax Act and the assessee was liable to pay the tax on capital gains it received. But the issue in dispute in the present appeal is totally different and distinguishable from the issue that was addressed in the above case laws cited by assessee. The CIT(A) was of the view that in the present case, there was no redemption of investment. The assessee has subscribed to the redeemable preference shares on 04/06/2015 and the redemption will happen in future on completion of 20 years from the date of allotment. Here, the premium on preference shares has been brought to tax on accrual basis by the AO and the Assessee is contesting this in appeal saying that the premium can be brought to tax only on redemption in future and not on year on year basis as is being done by the AO. Thus, the above case laws cited by the Assessee have no bearing on the issue at hand in the present appeal.
13. For the above reasons, the CIT(A) held that the AO has done the right thing by treating the non-convertible redeemable preference shares as a debt instrument and taxing the premium on accrual basis under the head ‘Income from other sources’.
14. Aggrieved by the order of the CIT(A), the assessee is in appeal before the Learned Counsel for the assessee drew our attention to the provisions of section 55 of the Companies Act, 2013, and pointed out that as per the aforesaid provisions, irredeemable preference shares cannot be issued. The maximum period of redemption cannot exceed 20 years from the date of issue. He pointed out that redemption of preference shares can be made only out of profits of the Company which will otherwise be available for dividends or out of proceeds of the fresh issue of shares. He also drew our attention to the provisions of section 123 of the Companies Act, 2013, which lays down that dividends can be declared by a company only out of profits of the Company or out of its free reserves. In the light of the aforesaid provisions, the first submission made by the learned Counsel for the assessee was that by no stretch of imagination, the preference shares can be treated as a debt of the company. The preference shareholders have a preference in terms of return of capital over the equity shareholders and but for this difference, the preference shareholders cannot be regarded as a debtor of the company and the preference shares cannot be regarded as a debt. The decisions which were cited before the CIT(A) were also cited before us. Further, learned Counsel placed reliance on the decision of the Hon’ble Bombay High Court in the case of Aditya Prakash Entertainment Pvt. Ltd., Vs. Magikwand Media Pvt. Ltd., CP No.404/2016, judgment dated 05.03.2018. In the aforesaid decision, the preference shareholders filed a petition for winding up of the company under section 433(e) of the Companies Act, 1956, to wind up the company on the ground that the company is unable to pay its debts. It was a case of the petitioners that they were holders of redeemable preference shares and despite exercising of option to redeem the preference shares, the company did not make payment and despite the fact the company had profits. The Hon’ble Bombay High Court, on consideration of several decisions, held that when a company issues redeemable preference shares, it is not obtaining loan as it could by issuing debentures. There is a fundamental difference between the capital made available to a company by issue of a share and money obtained by a company under a loan or a debenture. Respective incidences and consequences of issuing a share and borrowing money on loan or on a debenture are different and distinctive. Relying on the said decision, the learned Counsel reiterated his plea that the action of the Revenue authorities in treating redeemable preference shares as akin to debt and consequently holding that dividend / interest income has accrued to the assessee cannot be sustained.
15. Learned DR, on the other hand, submitted that as per the share subscription agreement, it is specifically provided that “preference shares shall be redeemed at such price, so as to net a premium of 16.5% p.a. Such premium shall accrue on a year-to-year basis and shall be payable on the redemption date”. He also pointed that that in the event of liquidation of the company, preference shareholders rank lower than creditors but higher than equity shareholders. These features according to the learned DR show that the assessee was entitled to the dividend / interest income and on the basis on the accrual and therefore under the mercantile system of accounting, the assessee ought to have offered the income attributable to the previous year as its income and the AO is therefore justified in making the impugned addition.
16. We have carefully considered the rival submissions. It is seen that the Ensource Consulting Pvt. Ltd., made an invitation to the assessee to subscribe for non-convertible redeemable cumulative preference shares of 13,00,000 Nos. of Rs.1,000/- each. The offer was dated 26.05.2015 and as per the offer letter, the rate of dividend / the rate of interest is mentioned as 8% P.A. on cumulative basis 14% on overall IRR basis. The assessee subscribed to the offer and terms of the subscription of preference shares are evidenced by an agreement dated 04.06.2015. As per the terms of the agreement, the issue date means the date on which the company allots and issues preference shares to the assessee. The redemption date was 20 years from the date of issue. The terms of the preference shares are contained in Annexure A to the agreement and the same reads as follows:
Annexure A
TERMS OF PREFERENCE SHARES
