The question of taxability on conversion of compulsorily convertible preference shares (CCPS) has come up for consideration quite a few times in the recent past. There seemed to be ambiguity regarding whether an event of conversion amounts to 'transfer' under Section 2(47) of the Income Tax Act, 1961 (the "Act"), thereby triggering capital gains tax under Section 45 of the Act.
As early as 12 May 1964, the Central Board of Direct Taxes (CBDT) in its Circular F. No. 12/1/64-IT(A) (the "Circular") had stated that where one type of share is converted into another type of share, there is no 'transfer' of capital asset within the meaning of Section 2(47) of the Act. However, there have been many instances when assessments have still been framed adversely. The matter of Periar Trading Company Limited v Income Tax Officer1 (the "Periar Case") is one such instance where the conversion of preference shares was sought to be taxed and the above question again came up for consideration. The decision in this case pronounced by the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) further consolidates the position that CCPS would not attract any capital gains tax upon conversion. In this post, we look into the facts of the Periar Case and the reasoning adopted by Hon'ble Justice Mahavir Singh for pronouncing the judgment.
Factual Matrix of the case:
- Perirar Trading Company Pvt Ltd (the "Assessee") was engaged in the business of investment activities.
- During the financial year 2010-11 relevant to the assessment year 2011-12, the Assessee had made investment in 51,634 CCPS of Series A of Trent Ltd. on a rights issue basis. The entire issue price of the said CCPS was paid on application itself.
- As per the terms of the scheme for issue of CCPS, one CCPS of Series A would compulsorily and automatically get converted into one fully paid up equity share. Accordingly, on 10 September 2011, the Assessee was allotted one equity share of Trent Ltd. for every preference share held in Trent Ltd., i.e. 51,634 CCPS. The conversion was compulsory and automatic.
- The Assessing Officer (the "AO") noted from the schedule of non-current investment forming part of the balance sheet of the Assessee for the previous year 2011-12 that the Assessee company had its 51,634 CCPS Series A of Trent Ltd into equity shares and thus, during the assessment year 2012-13, sought to tax the Assessee, treating the conversion of CCPS into equity shares as a 'Transfer' within the meaning of the definition provided in section 2(47)(i) of the Act.
- The Assessee brought the matter before the Commissioner of Income Tax (Appeals) [the "CIT(A)"], which accepted the AO's arguments and relied on rulings in Re: The Nizam's Second Supplementary Family Trust2 and CIT v Santosh L Chowgule3 to reject the Assessee's appeal holding that the conversion of the CCPS amounted to a 'transfer' by way of exchange.
- Aggrieved by the same the Assesee preferred appeal to the Mumbai bench of the ITAT.
Main Issue before the ITAT:
The ITAT was primarily faced with the question of, "Whether the action of CIT in confirming the action of AO to treat the conversion of Cumulative Compulsory Convertible Preference Shares (CCPS) into equity shares as transfer within the meaning of section 2(47) of the Act on the said conversion, was proper in law?" In dealing with the issue the decision also touches upon the following points:
- Modality of calculating period of holding in the case of conversion and subsequent sale/transfer of the converted CCPS? and
- The distinction between exchange and conversion of shares.
Arguments of the Assessing Officer (AO):
It was contended by the AO that the difference of,
- (i) the market value of converted number of equity shares of Trent Ltd. and
- (ii) the cost of the acquisition of equal number of CCPS Series A of Trent Ltd
is taxable as capital gains on account of transfer of shares by way of exchange of 'assets'. The AO also relied on the definition of 'exchange' as per the Black's Law Dictionary in support of his reasoning.
Reasoning adopted by the CIT(A):
Before the CIT (A), the AO relied on the case of Re: The Nizam's Second Supplementary Family Trust4, in which Hon'ble Andhra Pradesh High Court categorically held that conversion of preference shares into equity shares is nothing but a barter, which constitute transfer by way of exchange within the meaning of Section 45 of the Act. The CIT-A therefore held that the ratio of the above case should be applicable to the case of the Assessee and that the Assessee must pay the amount as long term taxable capital gain.
Arguments of the Assessee before the ITAT:
The Assessee contended that the legislative scheme emanating from the provisions of the Act also did not require such transaction to be taxable. The Assessee relied on section 55(2)(b)(v)(e) of the Income Tax Act which states that where the newly converted share is transferred at a later date, then, the cost of acquisition of such share for the purpose of computing the capital gain tax shall be calculated with reference to the cost of acquisition of the original share from which it is derived. Thus, the legislative intent seems to be clear that conversion ought to be regarded as tax neutral.
Rulings of the ITAT:
The ITAT held that the CBDT vide the Circular has clarified the position that where one type of share is converted into another type of share, there is no transfer of capital asset within the meaning of Sec. 2(47) of the Act. It also noted that the provisions of the circular have also been adopted in the tribunal's earlier judgment in ITO v Vijay M Merchant5.
The ITAT further relied on the ruling in Gillanders Arbuthnot & Co6 and Texspin Engineering and Manufacturing Works7 to hold that the market value of the converted equity shares on the date of conversion shares resulting from the conversion cannot be treated as 'full value of consideration' of the CCPS, even if such conversion was treated as a transfer, for the purpose of determining capital gains under section 48 of the Income Tax Act, 1961. The Supreme Court in Gillanders8 faced a similar case where the value of asset transferred in lieu of shares was sought to be the 'full value of consideration', the Apex Court had observed that 'full value of consideration' is inherently different from 'fair market value of the capital asset transferred'. Further in Texspin9, the Bombay High Court had held that one has to read the expression 'full value of consideration' under section 48 dehors section 45 and that the expression cannot be used to mean the market value of the capital asset on the date of the transfer.
The ITAT further observed that the present case was not a case where "one form of share has been exchanged, bartered, swapped for other form of share. In the present case, one type of share was converted into other type and the earlier type of share has ceased to exist. Thus, there is no exchange of any share as the pre-conversion security has ceased to exist. From the above, it is evident that mere conversion of one type of share to other type of share will not be a transfer of a capital asset within the meaning of Sec. 2(47) of the Act." ITAT further pointed out that AO's reliance on the ruling of the Hon'ble Supreme Court in the CIT v Motors & General Stores Pvt Ltd10 was unfounded, as the Court therein had held the exchange of cinema house to preference shares is to be considered as a transfer for the purpose of taxability. The facts of the matters are, therefore, entirely different.
The ITAT accepted the interpretation of the Assessee, claiming this to be in furtherance to the legislative intention, that mere conversion of one type of share to other type of share will not be a transfer of a capital asset within the meaning of Sec. 2(47) of the Income Tax Act, 1961, which would also make the provision of capital gains work smoothly, in synchronization with other provisions, without any conflict with other provisions. If the view is adopted that capital gain tax liability arose upon conversion, then the same would be not only against the legislative intention but also would make the composition of capital gains unworkable and would bring conflict with other provisions of the Act. In fact, it would lead to instances of double taxation, as having taxed the capital gain upon such conversion, at the time of computing capital gain upon sale of such converted shares, the Assessee would be still taxed again, as the cost of acquisition would still be adopted as the issue price of the CCPS and not the consideration adopted while levying capital gain upon such conversion. The tribunal in this regard noted "by no stretch of imagination, such interpretation process is permissible".
Although now there is a specific provision in the form of Section 47(xb) (with effect from 1 April, 2018), the decision comes as a boon for matters where conversion took place even before the Finance Act, 2017 came into force. Further, to consolidate the mandate under Section 55(2)(b)(v)(e), the Finance Act, 2017 has also introduced new provisions in form of Sections 2(42A)(hf) and 49(2AE) that provide that holding period of equity shares resulting from conversion of preference shares start from the date of acquisition of original preference shares. The position of law with respect to taxability of conversion events now seems to be well settled therefore.
 ITA No. 1944/Mum/2018 decided on 09 November 2018
 (1976) 102 ITR 248 (Andhra Pradesh)
 (1998) 234 ITR 787 (Bombay), wherein the Bombay High Court held that preference shares and equity shares are different.
 Supra note 2
 (1986) 12 ITD 510 (Bombay)
 66 ITR 622 (Supreme Court)
 263 ITR 345 (Bombay)
 Supra note 6
 Supra note 7
 (1967) 66 ITR 692 (SC)
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