Tax Implications on Issuance of Compulsorily Convertible Preference Shares /Convertible Preference Shares
The issuance of Compulsorily Convertible Prefernce Shares (“CCPS“) and Convertible Preference Shares (“CPS“) and conversion thereof can give rise to two kinds of taxing events for the company issuing such shares. First is when the preference shares are simply redeemed either a higher market value or lower market value. Second is when such preference shares are converted into equity shares at a premium. Each of the situations has its own tax implications.
Case-I: Redemption of Preference Shares
The Andhra Pradesh High Court in Addl. CIT v Trustees of H.E.H. Nizam’s Second Supplementary Family Trust[1] had earlier held that conversion of preference shares into ordinary shares is mere transfer by way of “exchange” within the meaning of Section 45 of the Income Tax Act, 1961 which provides that-
“45. (1) Any profits or gains arising from the transfer of a capital asset effected in the previous year shall, save as otherwise provided in Sections 53 and 54, be chargeable to Income Tax under the head ‘capital gains’ and shall be deemed to be the income of the previous year in which the transfer took place.”
It is to be noted here that to exchange one security for a different security of some kind or for other property or rights is also an exchange.
In a similar situation, the A.P. High Court in CIT v Santosh L. Chowgule[2] held that if the original equity shares are exchanged in a scheme or reorganisation for a new type of equity shares and irredeemable preference shares, the loss occasioned on such conversion with reference to the market value of the substituted asset can be allowed as capital loss.
In Anarkali Sarabhai vs. Commissioner of Income-tax[3], the issue was similar i.e. “whether, on the facts and in the circumstances of the case, the Tribunal was justified in holding that the assessee was liable to pay tax in respect of capital gains on receipt of the amount equal to the face value of the preference shares of Universal Corporation Pvt. Ltd., on the company redeeming its preference shares?” The assessee in this case had purchased the preference shares at less than face value. When the shares were redeemed by the company, she received more than what she had paid for the shares. The Appellant contended that redemption of preference shares cannot be treated as sale, exchange or relinquishment of the asset. It also averred that this is not a case where the extinguishment of any right in the preference shares had taken place. The preference share itself stood extinguished by redemption. Therefore, clause (ii) of section 2(47) could not be invoked in the facts of this case to bring the surplus amount received by the assessee to tax as capital gains under section 45 of the Income-tax Act.
The Court, however, observed that Clause (47) of section 2 gives an inclusive definition to “transfer” which is not exhaustive. Clause (i) of sub-section (47) of section 2 speaks of “sale, exchange or relinquishment of the asset”. This implies parting with any capital asset for gain which will be taxable under section 45. In this case, since the assessee received more than what she had paid for the shares, this came under the redemption clearly came within the mischief of section 2(47)(i). Thus the redemption of preference shares by the company will squarely come within the phrase “sale, exchange or relinquishment of the asset”.
In the light of the above judgments, it is very clear that any excess amount received by the shareholder on redemption of the preference shares will have to be treated as capital gain in view of the provisions of section 2(47) read with section 45 of the Income-tax Act and hence will be taxable accordingly.
Case-II: CCPS/CPS Issued at Premium
Section 56(2) of the Income Tax lists incomes chargeable to income tax under the head ‘Income from Other Sources.’ The Finance Act, 2012 later inserted clause (viib), effective from April 1, 2013, i.e. assessment year 2013-14 to include ‘share premium’ received by a company in excess of its fair market value, as its income chargeable under the head ‘ Income from other sources.’ The clause 56 (viib) thus provides-
“where a company, not being a company in which the public are substantially interested, receives, in any previous year, from any person being a resident, any consideration for issue of shares, in such a case if the consideration received for issue of shares exceeds the fair value of such shares, the aggregate consideration received for such shares as exceeds the fair market value of the shares” shall be chargeable to income tax under the head “Income from other sources”.
Finance Act, 2012 also amended the definition of income in section 2(24) by inserting clause (xvi) to factor in the above consideration exceeding fair market value as ‘income’. With a view to safeguard the genuine investment by bona fide companies it was also provided that this clause will not be applicable to-
- A venture capital undertaking receiving the consideration for issue of shares from a venture capital company or a venture capital fund; and
- A company receiving the consideration from a class or class of persons (‘Notified persons’) as may be notified by Central Government.
The first exception was provided because these entities are anyway regulated under the SEBI (Alternative Investment Fund) Regulations 2012 and there is some measure of scrutiny already in place over investments made by venture capital undertaking. Similarly, with a view to address concerns raised by the angel investors, exclusion has been granted from levy of such tax to certain notified class of persons by way of an enabling provision.
It is to be noted that this amendment has been introduced in order to curb the trend of companies issuing shares at a substantial premium and converting the unaccounted money without providing any valuation justifying the premium. Thus, the amendment takes care of the unjustified premium and the excess is taxed as income in the hands of the company.
However, the provisions of section 56(2)(viib) are applicable only to the shares issued by a closely held company to a resident shareholder and not to the non-residents. The reason for not applying this section to a widely held company is that SEBI monitors and approves the price at which shares are issued by a widely held company. Likewise, the money received from non-resident is already regulated by FEMA as well as RBI. Moreover, a non-resident would not prefer to convert their white money abroad in dollars into unaccounted money in India.
The Finance Act, 2012 also made amendment to section 68 of the Income tax Act. The crux of Section 68 amendment is that the closely held company receiving share application money/share capital/share premium/any such amount has to prove the source of funds in the hands of shareholder/person giving the share application money/share capital/share premium/any such amount.
To sum up, the clear intention behind such amendments is to control the unwarranted or bogus or unjustified subscription to share premium. However, such an amendment also carries the potential to hit genuine transactions of bona fide share premium.
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[1] (1976) 102 ITR 248 (AP)
[2] (1998) 234 ITR 787 (Bom)
[3] [1997] 224 ITR 422 (SC)