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The Tax Publishers Uday K. Pradhan v. ITO [ITA No. 4669/Mum/2014, dt. 6-4-2016] : 2016 TaxPub(DT) 1900 (Mum-Trib) Redemption of preference shares post conversion of firm into company to shareholder/partner--Whether dividend under section 2(22)(d) *Facts:* Assessee was partner in a firm which was converted into a Private Limited company called M/s. Enviro Control Associate Pvt. Ltd. on 31-3-2001 and assessee had a capital balance of INR 38,74,178 against which he received 200,000 equity shares and 207,417 preference shares @ Rs. 10 each (it is not known from the decision how the two adds up to the partners capital balance). The said preference shares were redeemed by the company at par i.e at INR 20,74,170 on 18-6-2004. This was read as dividend under section 2(22)(d) as distribution out of reduction of capital by the assessing officer, also upheld by the Commissioner (Appeals). By an ITAT order the case was remanded to Commissioner (Appeals) for fresh adjudication. In the second round as well the same reading was adopted which had to be appealed by the assessee to the ITAT. The grounds of the assessee were: The said redemption of shares arose out of shares allotted for valid consideration i.e. the share of capital in the erstwhile firm and was not gratuitous as read by the assessing officer. The redemption of preference shares at par does not bring in any distribution of profits. Redemption of preference shares is not reduction of capital as per section 80(3) of the Companies act, 1956 read with section 100 thus held in Parle Biscuits Pvt. Ltd. in ITA Nos. 5318 & 5319/Mum/2006 and ITA 447/Mum/2009 & Ors., dtd. 19-8-2011 by Mumbai ITAT wherein after considering the very same issue of the effect of sale of preference shares on reduction of share capital, the Coordinate Bench had held that by virtue of section 80(3) of the Companies Act the redemption of preference shares cannot be considered as reduction of the company's authorised share capital. To trigger section 2(22) (d) there has to be distribution of profits by way of reduction of capital. Even if 2(22) (d) was read still the dividend would be exempt under section 10(34) in the hands of the shareholder. Held in favour of the assessee that section 2(22)(d) was triggered. Following paragraphs are good read from the ITAT: "37. We have considered the issue. As far as redeeming preference shares are concerned, the Hon'ble Supreme Court in the case of Anarkali Sarabhai v. CIT 224 ITR 422 has examined the provisions of section 77 of the Companies Act, section 80 of that Act and also definition of transfer under section 2(47) of IT ACT and has held that the difference between the sum received by the assessee on redemption of shares and the sum earlier paid by for purchasing them was taxable as capital gain. The decision of the Hon'ble Supreme Court is as under: - "When a preference share is redeemed by a company, what the shareholder does in effect is to sell the hare to the company. The company redeems its preference shares only by paying the preference shareholders the value of the shares and taking back the preference shares. In effect, the company buys back the preference shares from the shareholders. If redemption of preference shares did not amount to sale, it would not have been necessary, in section 77 of the Companies Act, 1956, to specifically provide that the restriction imposed upon a company in respect of buying its own shares will not apply to redemption of shares issued under section 80 of that Act. The redemption of preference shares by a company, therefore, is a sale and squarely comes within the phrase "sale, exchange or relinquishment" of an asset in section 2(47)(i) of the Income-tax Act, 1961."The definition of "transfer" in section 2(47) of the Income-tax Act, 1961, is not an exhaustive definition. Sub-clause (i) of clause (47) of section 2 speaks of "sale, exchange or relinquishment of the asset" and implies parting with any capital asset for gain which will be taxable under section 45 of the Act. When preference shares are redeemed by the company, the shareholder has to abandon or surrender the shares, in order to get the amount of money in lieu thereof. There is, therefore, also a relinquishment which brings the transaction within the meaning of section 2(47)(i) of the Income-tax Act. The appellant had purchased preference shares in a company at less than their face value and held them as capital assets. The company redeemed them at their face value: 38. Similar issue was also considered by Hon'ble Supreme Court in the case of Kartikeya Sarabhai vs. CIT 228 ITR 163 where there is reduction in face value of shares, the definition of transfer were discussed and held as under :-- "Section 2(47) of the Income-tax Act, 1961, defines "transfer" in relation to a capital asset. It is an inclusive definition which, inter alia, provides that relinquishment of an asset or extinguishment of any right therein amounts to a transfer of a capital asset. It is not necessary for a capital gain to arise, that there must be a sale of a capital asset. Sale is only one of the modes of transfer envisaged by section 2(47) of the Act. Relinquishment of the asset or extinguishment of any right in it, which may not amount to a sale, can also be considered as a transfer and any profit or gain which arises from the transfer of a capital assist is liable to be taxed under section 45. A company, under section 100(1)(c) of the Companies Act, 1956, has a right to reduce the share capital and one of the modes which can be adopted is to reduce the face value of the preference shares. Section 87(2)(c) of the Companies Act, inter alia, provides that "where the holder of any preference share has a right to vote on any resolution in accordance with the provisions of this sub-section, his voting right on a poll, as the holder of such shares, shall, subject to the provisions of section 89 and sub-section (2) of section 92, be in the same proportion as the capital paid up in respect of the preference share bears to the total paid-up equity capital of the company". Hence, when as a result of the reducing of the face value of the share, the share capital is reduced, the right of the preference shareholder to the dividend on his share capital and the right to share I the distribution of the net assets upon liquidation is extinguished proportionately to the extent of reduction in the capital. Such reduction of the right in the capital asset would clearly amount to a transfer within the meaning of that expression in section 2(47) of the Income-tax Act, 1961."

The Tax Publishers

Uday K. Pradhan v. ITO [ITA No. 4669/Mum/2014, dt. 6-4-2016] : 2016 TaxPub(DT) 1900 (Mum-Trib)

Redemption of preference shares post conversion of firm into company to shareholder/partner--Whether dividend under section 2(22)(d)

Facts:

Assessee was partner in a firm which was converted into a Private Limited company called M/s. Enviro Control Associate Pvt. Ltd. on 31-3-2001 and assessee had a capital balance of INR 38,74,178 against which he received 200,000 equity shares and 207,417 preference shares @ Rs. 10 each (it is not known from the decision how the two adds up to the partners capital balance). The said preference shares were redeemed by the company at par i.e at INR 20,74,170 on 18-6-2004. This was read as dividend under section 2(22)(d) as distribution out of reduction of capital by the assessing officer, also upheld by the Commissioner (Appeals). By an ITAT order the case was remanded to Commissioner (Appeals) for fresh adjudication. In the second round as well the same reading was adopted which had to be appealed by the assessee to the ITAT. The grounds of the assessee were:

The said redemption of shares arose out of shares allotted for valid consideration i.e. the share of capital in the erstwhile firm and was not gratuitous as read by the assessing officer. The redemption of preference shares at par does not bring in any distribution of profits. Redemption of preference shares is not reduction of capital as per section 80(3) of the Companies act, 1956 read with section 100 thus held in Parle Biscuits Pvt. Ltd. in ITA Nos. 5318 & 5319/Mum/2006 and ITA 447/Mum/2009 & Ors., dtd. 19-8-2011 by Mumbai ITAT wherein after considering the very same issue of the effect of sale of preference shares on reduction of share capital, the Coordinate Bench had held that by virtue of section 80(3) of the Companies Act the redemption of preference shares cannot be considered as reduction of the company's authorised share capital.

To trigger section 2(22) (d) there has to be distribution of profits by way of reduction of capital.

Even if 2(22) (d) was read still the dividend would be exempt under section 10(34) in the hands of the shareholder.

Held in favour of the assessee that section 2(22)(d) was triggered. Following paragraphs are good read from the ITAT:

"37. We have considered the issue. As far as redeeming preference shares are concerned, the Hon'ble Supreme Court in the case of Anarkali Sarabhai v. CIT 224 ITR 422 has examined the provisions of section 77 of the Companies Act, section 80 of that Act and also definition of transfer under section 2(47) of IT ACT and has held that the difference between the sum received by the assessee on redemption of shares and the sum earlier paid by for purchasing them was taxable as capital gain. The decision of the Hon'ble Supreme Court is as under: - "When a preference share is redeemed by a company, what the shareholder does in effect is to sell the hare to the company. The company redeems its preference shares only by paying the preference shareholders the value of the shares and taking back the preference shares. In effect, the company buys back the preference shares from the shareholders. If redemption of preference shares did not amount to sale, it would not have been necessary, in section 77 of the Companies Act, 1956, to specifically provide that the restriction imposed upon a company in respect of buying its own shares will not apply to redemption of shares issued under section 80 of that Act. The redemption of preference shares by a company, therefore, is a sale and squarely comes within the phrase "sale, exchange or relinquishment" of an asset in section 2(47)(i) of the Income-tax Act, 1961."The definition of "transfer" in section 2(47) of the Income-tax Act, 1961, is not an exhaustive definition. Sub-clause (i) of clause (47) of section 2 speaks of "sale, exchange or relinquishment of the asset" and implies parting with any capital asset for gain which will be taxable under section 45 of the Act. When preference shares are redeemed by the company, the shareholder has to abandon or surrender the shares, in order to get the amount of money in lieu thereof. There is, therefore, also a relinquishment which brings the transaction within the meaning of section 2(47)(i) of the Income-tax Act. The appellant had purchased preference shares in a company at less than their face value and held them as capital assets. The company redeemed them at their face value:

38. Similar issue was also considered by Hon'ble Supreme Court in the case of Kartikeya Sarabhai vs. CIT 228 ITR 163 where there is reduction in face value of shares, the definition of transfer were discussed and held as under :--

"Section 2(47) of the Income-tax Act, 1961, defines "transfer" in relation to a capital asset. It is an inclusive definition which, inter alia, provides that relinquishment of an asset or extinguishment of any right therein amounts to a transfer of a capital asset. It is not necessary for a capital gain to arise, that there must be a sale of a capital asset. Sale is only one of the modes of transfer envisaged by section 2(47) of the Act. Relinquishment of the asset or extinguishment of any right in it, which may not amount to a sale, can also be considered as a transfer and any profit or gain which arises from the transfer of a capital assist is liable to be taxed under section 45. A company, under section 100(1)(c) of the Companies Act, 1956, has a right to reduce the share capital and one of the modes which can be adopted is to reduce the face value of the preference shares. Section 87(2)(c) of the Companies Act, inter alia, provides that "where the holder of any preference share has a right to vote on any resolution in accordance with the provisions of this sub-section, his voting right on a poll, as the holder of such shares, shall, subject to the provisions of section 89 and sub-section (2) of section 92, be in the same proportion as the capital paid up in respect of the preference share bears to the total paid-up equity capital of the company". Hence, when as a result of the reducing of the face value of the share, the share capital is reduced, the right of the preference shareholder to the dividend on his share capital and the right to share I the distribution of the net assets upon liquidation is extinguished proportionately to the extent of reduction in the capital. Such reduction of the right in the capital asset would clearly amount to a transfer within the meaning of that expression in section 2(47) of the Income-tax Act, 1961."