ITO v. Shrilekha Business Consultancy (P) Ltd. [ITA No. 1371/Hyd/2018 and ITA No. 1041/Hyd/2019, dt. 4-11-2020] : 2020 TaxPub(DT) 4692 (Hyd.-Trib.)

Taxability of capital contribution in the hands of a firm under section 56(2)(viia) especially when the capital was used for a legitimate layering arrangement to arrive at a desired financial objective

Facts:

Assessee was a partnership firm with the below mentioned partners and was part of Shriram group --

SFS - Srilekha Financial Services

The Capital Contribution of SOT - Shriram Ownership Trust in the above partnership comprised below shares of two group entities :--

Piramal Enterprises Ltd. (PEL) decided to acquire 20% stake in the Shriram group of companies. It was decided that the 20% acquisition would be done in the entity called Shriram Capital Ltd. (SCL). Unfortunately the existing Private Equity investors in SCL had imposed a condition that the shares of SCL can be issued only to any other Shriram group entities but not to any third party.

Accordingly a layering method was adopted by the assessee firm where by PEL invested Rs. 2014.20 crores in the assessee firm in the first tranche for 74% share. This was split into capital contribution for Rs. 5.92 crores and the balance was maintained as capital reserve for Rs. 2008.28 crores.

Accordingly SOT reduced their stake in the partnership in favour of PEL the remaining partners remained as they were. The firm which was a Shriram group entity now became a PEL majority held firm.

In the second tranche PEL invested Rs. 103.25 crores for further 0.95% stake in the partnership which was also split as 0.30 crores as capital and the balance Rs. 102.95 was also credited to capital reserve.

The capital reserve thus now stood at Rs. 2,111.23 crores and the share capital of the reconstituted firm became as under :--

SFS - Srilekha Financial Services

Now the majority partnership of the firm came in the hands of PEL. So a Shriam group entity became a Piramal group entity adopting an inversion process.

A new company called Novus Cloud Solutions Pvt. Ltd. (Novus) was then floated by the said firm SFS where in new shares were alloted by Novus favouring the assessee SFS firm.

Subsequently a scheme of amalgamation was adopted with court approval where by Novus would merge with Shriram Capital Limited thus the partnership firm came in possession of shares of Shriram Capital instead of Novus.

The twin objective of PEL becoming a 20% shareholder in SCL was thus achieved and the restriction of SCL to not to issue shares to an outside entity other than a Shriram group entity was also achieved by the allotment of shares of SCL and another group company in favour of the assessee firm SFS.

Revenue raised the following contentions --

1. The amount received by the assessee firm SFS was income from other sources taxable under section 56(1) and under section 56(2)(viia).

2. The method adopted by the firm was a tax evasion mechanism as by collecting this much capital the firm has transferred shares of SCL indirectly and thus it was a case of colourable transaction connived only to circumvent capital gains tax.

3. The capital contribution of shares of Shiram Ownership Trust (SOT) in the firm which comprised the shares if taken at their market value meant the firm received less consideration than what is the actual consideration envisaged thus inviting sec. 56(2)(viia) and additions sustained.

On appeal the Commissioner (Appeals) after reading the entire routing and layering mechanism adopted concluded that there was nothing untoward and the transaction was transparent and clear and it was the restriction imposed by the Private equity investors which made the firm adopt a circuitous route to make sure PEL invested 20% stake in SCL eventually by legitimate layering.

Aggrieved the revenue went in higher appeal to ITAT

Held in favour of the assessee/against the revenue that they could not find anything wrong in the transaction. It was not a colourable transaction and the views of the Commissioner (Appeals) was upheld. The following points are worth noting --

1. The revenue has alleged that it is taxable as income from other sources inviting section 56(2)(viia) the receipt of capital contribution by a partner cannot fall in this head.

2. No doubt share in a partnership firm is a capital asset. There was no transfer which was subject to capital gains either.

3. The assessing officer's allegation that the firm received less consideration by offering its capital contribution to PEL was also incorrect as receipt the capital contribution is not a consideration under section 56(2)(viia).

4. Section 56(2)(viib) envisages certain receipts as taxable and not all of it. It is like the deeming provision under section 45(3) which is existing to combat specific transactions in the absence of such a deeming provision in the scope of section 56(2)(viia) no such notional/imputed reading is possible alleging inadequate consideration.

5. When a partner offers his rights to another partner then it is for a right to what the firm can earn in future, a consideration which is indeterminate. Using an indeterminate consideration invocation of section 56(2)(viia) on deeming basis is not possible.

6. The case of Sunil Siddharthbhai (1985) 156 ITR 509 (SC) : 1985 TaxPub(DT) 1358 (SC) come to the fore where in if the computation section fails due to indeterminable consideration then the charge also fails.

7. Even if one were to assume that the partners rearranged their shares in the firm and thereby triggered a transfer the firm cannot be brought into the tax ambit that is to be done in the hands of the partners.

8. If at all such a case were to arise of the partners being taxed on alleged basis then the cost of the acquisition of the trade off of the shares need to be given due weight thus no capital gain can be called for into tax possibly.

The remarks of the Commissioner (Appeals) make worthwhile reading --

-- The appellant is a partnership firm and SOT is partner in the firm.

-- The SOT as a partner introduced shares of two companies namely,

-- M/s. Shriram Capital Ltd. and M/s. Shriram Financial Venture (Chennai) Pvt. Ltd., during this assessment year 2014-15 as a capital contribution in the appellant firm.

-- The appellant firm not received consideration for shares but only received capital contribution in the form of shares of two companies from the partner SOT.

-- The partner's capital is not a consideration to be considered as per section 56(2)(viia).

-- Since there is no consideration, then there is no benefit or loss to the appellant firm.

-- Since there is no benefit to the appellant, there is no question of gift.

-- Hence, provisions of section 56(2)(viia) does not come into picture.

-- Since there is no consideration received by the appellant firm, therefore there is no issue of lesser consideration

-- Therefore, as per above discussions in detail, I am of the opinion that provisions of section 56(2)(viia) does not apply in this case.

-- When once the provisions of section 56(2)(viia) does not apply, then there is no question of valuing the shares at Fair Market Value.

Assessee's counter for section 56(2)(viia) which clinched the case for them is as under --

"8.1 We wish to submit that the right in the partnership to which a partner becomes on contribution of capital always constitutes valuable consideration for the purpose of section 56(2)(viia) of the Act and will not fail to be considered as a case without consideration or as a case where the consideration is less than the Fair Market Value.

8.2 In sum, therefore, in the case of a partnership firm, the 'consideration' for the subsistence of the partnership to get his share of profits from to time and after the dissolution of the partnership or with his retirement from the partnership to get his accounts settled.

8.3 Thus, in the instant case, the partnership interest to which SOT (i.e., 99.97%) is entitled pursuant to contribution of shares in the Firm does not fall short of consideration envisaged. SOT's 99.97% interest extends over the very same shares which SOT contributed as capital.

8.4 In summary, the contribution of shares by SOT to the Firm by way of capital contribution does not attract the provisions of section 56(2)(viia) on account of the following :--

The partnership interest which gives the partner a right to share in the profits and losses of the firm and right in the assets of the firm is a valuable and adequate consideration.

Such consideration does not admit of full evaluation.

The partnership interest of 99.97% obtained by SOT pursuant to the capital contribution should by itself constitute 'adequate consideration' for the purpose of section 56(2)(viia) of the Act.

9. For the above reasons, we submit that section 56(2)(viia) is not applicable in our case and request you to drop the section 147 proceedings initiated by you."