High Court Upholds Assessee's Capital Gains Claim, Dismisses Revenue's Appeal

Case Name:

Principal Commissioner of Income Tax Vs Pavitra

ITA 146/2018 & CM APPL. 5059/2018

ITA 149/2018

ITA 150/2018 & CM APPL. 5080/2018

Key Takeaways

1. The court emphasized the importance of considering the entirety of circumstances when determining whether income is business income or capital gains.

2. The court outlined five broad tests to determine the character of income from share transactions.

3. The court upheld the principle that companies have the prerogative to decide whether to earn income as capital gains or business income from share sales.

4. The "real income" principle was applied in the context of reporting mercantile interest on doubtful debts.

Issue:

1. Whether the ITAT was correct in affirming the Appellate Commissioner's view that the assessee's income from share sales should be treated as capital gains rather than business income?

2. Whether the ITAT was justified in holding that under the mercantile system of accounting, interest income accrued on the basis of the assessee's contention that recovery and interest on deposits were doubtful?

Facts:

- The assessee was engaged in the business of investment and securities.

- The assessee maintained a distinct portfolio for stock in trade and investments

- For the assessment year in question, the assessee acquired shares in companies that underwent amalgamation

The assessee shifted some shares to its investment account and later sold them during the Assessment Year.

- The Assessing Officer (AO) rejected the assessee's claim of capital gains and treated the profits as business income.

- The Commissioner of Income Tax (Appeals) [CIT(A)] and the Income Tax Appellate Tribunal (ITAT) ruled in favor of the assessee.

Argument:

Assessee's arguments:

- The company had a consistent policy of maintaining separate portfolios for investments and stock in trade.

- The shares in question were held as investments, not as stock in trade.

- The company has the prerogative to decide whether to earn income as capital gains or business income from share sales.

Revenue's arguments:

- The entire income earned by the assessee on sale of shares and mutual funds should be taxable as business income.

- The AO based his opinion on the notes to the audited accounts, which indicated that the amalgamating companies were engaged in trading of shares.

Key Legal Precedents:

1. Dalhousie Investment Trust Co. Ltd. v. CIT, Central Calcutta, (1968) 68 ITR 486 (SC):

The AO relied on this Supreme Court judgment to support treating the income as business income.

2. Commissioner of Income Tax Vs. Vasisth Chay Vyapar Ltd. (ITA 552/2005 and connected cases decided on 29.11.2010):

This High Court decision applied the "real income" principle to uphold the assessee's contention regarding mercantile interest on doubtful debts.

JudgementL:

The High Court dismissed the Revenue's appeals, upholding the ITAT's decision. The court found that:

1. The ITAT and CIT(A) had correctly applied the relevant tests and considered all circumstances in determining the nature of income.

2. The AO's approach of focusing solely on the shifting of some shares to treat the income as business income was erroneous.

3. The findings of the ITAT and CIT(A) were factual and sound, based on appreciation of facts at two levels and application of settled law.

4. On the question of mercantile interest on doubtful debts, the court applied the "real income" principle, following its earlier decision in the Vasisth Chay Vyapar Ltd. case.

FAQs:

Q1: What are the five tests the court mentioned for determining whether income is business income or capital gains?

A1: The court mentioned: (1) whether the company is authorized to deal with shares in its Memorandum, (2) whether shares are shown under "Investment", (3) whether own funds were used to acquire shares, (4) the nature of infrastructure, and (5) whether the objective is obtaining dividends rather than trading.

Q2: Why did the court disagree with the Assessing Officer's decision?

A2: The court found that the AO's approach of focusing solely on the shifting of some shares was too narrow. The court emphasized the need to consider all circumstances and apply the five broad tests.

Q3: What is the significance of the "real income" principle mentioned in the judgment?

A3: The "real income" principle was applied to uphold the assessee's contention regarding the reporting of mercantile interest on doubtful debts. This principle suggests that income should be taxed only when it is real and not merely hypothetical or notional.

Q4: Does this judgment set a precedent for similar cases?

A4: While each case is unique, this judgment emphasizes the importance of considering all circumstances and applying established tests when determining the nature of income from share transactions. It may be referred to in similar cases involving disputes over capital gains versus business income.

In these appeals, the questions of law urged for various years

are, as follows :

1) Whether the decision of the ITAT affirming the Appellate Commissioner’s view with respect to the assessee’s claim of capital gain – rather than business income as held by the Assessing Officer is justified?

2) Whether the ITAT was justified in holding that under the mercantile system of accounting, interest income accrued on basis of the assessee’s contention that recovery as well as interest (on such deposits) is doubtful?

2. On the first question, this Court notices that the AO brought to tax substantial amount for the concerned Assessment Year rejecting the assessee’s claim of capital gains. The assessee was engaged in the business of investment and securities and had at the relevant time maintained a distinct portfolio in respect of stock in trade and investment. For the particular year, the assessee acquired shares in certain companies that underwent amalgamation. Those companies, which had investment portfolio containing shares of the companies in which the assessee had holdings, were treated as stock in trade. The assessee shifted some of the shares to its investment account and later sold them during the Assessment Year. The AO rejected the assessee’s claim and held the profits to be business income. In doing so, the AO relied upon the judgment of the Supreme Court in Dalhousie Investment Trust Co. Ltd. v. CIT, Central Calcutta, (1968) 68 ITR 486 (SC) and other rulings. The CIT(A) upon re-appraisal of the facts and consideration of the authorities, held as follows :

“4.3 I have carefully considered the facts of the case, order of the AO and submissions made by the ld. AR. The central point of dispute in this ground of appeal is regarding the head of income under which the profit earned on shares/mutual funds is taxable. The appellant has vehemently claimed that as per the regular consistently followed policy of the company, the appellant had certain share portfolio under the category of investments on which long term and short terms capital gains have been disclosed, whereas on the sale of shares held as stock in trade profit earned have been disclosed as business income.

On the other hand the AO is of the view that the entire income earned by the appellant on sale of shares and mutual funds is taxable as business income. It is noted that the finding of the A0 is primarily based on the notes of audit, wherein it is stated that during the year the appellant company has acquired the amalgamating companies which were engaged in the trading of shares. The appellant is pleading that the observation of the ld. AO is misconceived as it is a matter of record that the companies which have been amalgamated the appellant company were also holding these shares as investment. It is further emphasized by the ld. AR that the AO has misinterpreted the general terminology of the notes of the accounts/audit wherein even the sale of investments are termed as trading in shares.

After considering the rival submissions and various case laws quoted by the AO as well as relied upon by the ld. AR, I am of the considered view that in the facts and circumstances of the instant case the view taken by the AO does not appear correct, it is seen from the records of the appellant that the appellant company had distinct portfolio of shares and mutual funds under two categories i.e investments and stock in trade. The contention of the ld. AR, that it is not open for the AO to summarily reject the decisions of the Board of directors of the company as it is their prerogative to decide as to whether the company would earn income under the head capital gains or business income from sale of shares, also appears correct.

In the instant case during the last few years too, the appellant company had followed the same practice of holding certain shares under the head investments and some shares as stock in trade. Therefore, under these circumstances the action of the AO treating the entire income as business income is not justified, hence addition made by him on this account is deleted.”

3. The ITAT’s findings are, as follows :

“12. From the above observations by Ld. CIT(A) observed that Ld. AO has based his opinion on the basis of Notes to audited account. Two distinct portfolio maintained by assessee in respect of shares held for the purposes of trading and for investment has not been observed by him.

13......The summary of reconciliation of shares has been reproduced hereunder:

“PAVITRA COMMERCIALS LTD ASSESSMENT YEAR 2005-06

RECONCILIATION OF SHARES HELD AS STOCK IN TRADE PARTICULARS NO. OF SHARES AMOUNT (In Rs.)

Opening Stock (Refer Annexure-I)

8,056,059.710 117,602,153.77

Add :

Shares of Vindhyachal Holdings transferred on amalgamation 4,889,109.883 54,007,145.72

Total stock of shares after amalgamation

12,945,169.593 171,609,299.49

Purchase of Shares 85,926.000 2,393,674.01

Stock of Shares 13,031,095.593 174,002,973.50 Less:

Shares held as stock converted into investment (of Pavitra Commercials Ltd.) transferred to Capital Reserve (Refer Annexure-2)

2,078,066.000 32,767,348.61

Transferred to Capital Reserve on Amalgamation

287,500.000 662,500.00

Sale of Shares (on cost) (Refer Annexure-3)

2,244,050.254 41,425,034.89 Closing stock of Shares held as Stock (Refer Annexure-4)

8,421,487.000 99,149,290.00

14. There is absolutely no allegation by Ld. AO regarding these facts as observed by Ld. CIT(A). We are therefore, of considered opinion that Ld. AO proceeded to compute sale of shares as business income merely on the basis of notes provided to Audited Accounts. We have perused the account at page 19 of paper book. From these Notes, it is clear that nature of business in respect of amalgamating companies has been held to be purchase and sale of shares, debentures stocks, properties and other similar activities. Ld. CIT(A) on the basis of these factual observation deleted the addition. We, therefore, do not find any infirmity in findings of ld. CIT(A) . On the basis of the above discussion, we dismiss this ground raised by revenue.”

4. The decision of Revenue as to whether the claim of the assessee with respect to the income reported by it and whether it constitutes business income, is dependent on the entirety of the circumstances. The decisions of the Court have emphasized five broad tests whether the income bears the character of business income or capital gain – firstly, whether the company or concern is authorized in its Memorandum of constituting documents to deal with shares; (2) whether the entity had shown the shares under the head “Investment”; (3) whether the assessee/entity utilized its own funds and had not borrowed funds for the purpose of acquiring shares; (4) whether the nature of infrastructure – whether it is small, represents investment activity rather than the trading activity that would require larger infrastcuture; and lastly, whether the behaviour of the assessee is such as to disclose income/earning has objective i.e. “obtaining dividend” rather than trading.

5. This Court notes that all the tests and the relevant rulings were noticed by both the authorities below, who had applied their mind and held that the AO’s approach in singular fixing scrutiny to the shifting and regulations of some shares to treat as business income, was erroneous. In the opinion of the Court, these findings are not only factual but sound, as they are based upon appreciation of facts at two levels and application of the settled law. No error of law is apparent; no question of law arises.

6. As far as the question with respect to reporting of mercantile interest of doubtful debts is concerned, the question is covered by the decision of this Court in Commissioner of Income Tax Vs. Vasisth Chay Vyapar Ltd. (ITA 552/2005 and connected cases decided on 29.11.2010). The Court had applied “real income” principle to uphold the assessee’s contention. Those observations are squarely applicable in the present case.

7. The appeals are dismissed. All the pending applications also stand disposed off.

S. RAVINDRA BHAT, J

A. K. CHAWLA, J

FEBRUARY 09, 2018