India: Tribunal: Conversion Of Compulsorily Convertible Preference Shares Not A Taxable Transfer

Last Updated: 18 February 2019
Article by Joachim Saldanha and Ashish Sodhani
  • Conversion of CCPS into equity shares is not a taxable transfer
  • Conversion does not involve an 'exchange' as the preference shares cease to exist.
  • Sale of the resulting equity shares on conversion will be a taxable transfer
  • Gains on sale to be calculated on the basis of cost of the original preference shares

Recently, on November 9, 2018, the Mumbai Bench of the Income Tax Appellate Tribunal ("Tribunal") held1 that conversion of compulsorily convertible preference shares is not a taxable transfer.

Background

Periar Trading Company Private Limited (the "Taxpayer") participated in a rights issue of Trent Limited ("the Company") and subscribed to 1,634 compulsorily convertible preference shares ("CCPS") of the Company at INR 550 per share for a total consideration of INR 2,83,98,700 (approx. USD 400,000). The CCPS were automatically convertible into equity shares of the Company in ratio of 1:1.

The Assessing Officer ("AO") treated the conversion as a taxable transfer and taxed INR 2,85,01,968 (approx. USD 400,000), being the difference between the fair market value of resulting equity shares of the Company and cost of acquisition of the CCPS, as long-term capital gains.

The first appellate authority (the "CIT(A)"), relying on rulings of the Bombay High Court in CIT v. Santosh L Chowgule2 and the Andhra Pradesh High Court in ACIT vs. Trustees of H.E.H. The Nizam's Second Supplementary Family Trust3, rejected the Taxpayer's appeal and held that the conversion of the CCPS was nothing but a transfer by way of 'exchange' under section 2(47)4 of the Income Tax Act, 1961 ("ITA") taxable under section 455 of the ITA.

Aggrieved, the Taxpayer appealed to Tribunal against the order of the CIT(A).

Issue

Whether the conversion of the CCPS constituted a taxable transfer under the ITA.

Ruling

The Tribunal followed its earlier decision in the case of ITO v. Vijay M Merchant6 where, on the basis of a circular7 (the "Circular") issued by the Central Board of Direct Taxes ("CBDT") explaining the rationale behind the introduction of section 55(2)(b)(v)8, the Tribunal had ruled that conversion of preference shares into equity shares would not be a taxable transfer. The Circular provides that:

"... Section 14 of the Finance Act, 1964, introduces a new clause (v) in sub-section (2) of section 55 of the Income-tax Act, 1961, laying down the method for determining the cost of acquisition of a new share which becomes the property of the assessee on conversion of one type of share into another type of share. A question has been raised whether the transaction of conversion of one type of share into another attracts the capital gains tax under Section 45(1) .... The position in this regard is as follows:

(1) Where one type of share is converted into another type of share (including conversion of debentures into equity shares), there is, in fact, no "transfer" of a capital asset within the meaning of section 2(47) of the Income-tax Act, 1961. Hence, any profits derived from such conversion are not liable to capital gains tax under section 45(1) of the Income-tax Act. However, when such newly converted share is actually transferred at a later date, the cost of acquisition of such share for the purposes of computing the capital gains shall be calculated with reference to the cost of acquisition of the original share of stock from which it is derived."

The Tribunal acknowledged that treating the conversion as a taxable transfer by way of an exchange would give rise to undesirable double taxation – because section 55(2)(b)(v) would have the effect of denying the taxpayer a step-up in basis, and that the conversion did not constitute an exchange since, on conversion, the CCPS ceased to exist.

The Tribunal distinguished the cases relied on by the tax authorities in support of their argument on the ground that neither case had considered neither section 55(2)(b)(v) of the ITA nor the Circular.

The Tribunal also relied on a Supreme Court ruling in Gillanders Arbuthnot & Co.9 and a Bombay High Court ruling in Texspin Engg. & Mfg. Works10 to hold that section 4811 of the ITA did not allow for the market value of the resulting equity shares to be treated as the 'full value of consideration' for the purpose of determining capital gains, and therefore the conversion was not a taxable trasnfer. In Texspin, the Bombay High Court, following the landmark Supreme Court ruling in BC Srinivasa Setty12, held that in the absence of a prescribed method to determine the 'full value of consideration' for the purpose of computing capital gains, a transaction (in Texspin, it was a conversion of a partnership firm into a private limited company) could not be regarded as having been intended to fall within the scope of the charging provision i.e., section 45.

Analysis

Until very recently, because of the wide definition of the word 'transfer' under the ITA, taking the position that conversion of preference shares into equity shares was not a taxable transfer was a position fraught with risk. In order to avoid costly and time-consuming litigation, taxpayers often ended up treating the conversion as a taxable transfer (despite the existence of the Circular and the potential double taxation risk).

However, Finance Act, 2017 amended section 47 of the ITA (Transaction not regarded as Transfer) with effect from April 1, 2018 to insert clause (xb) which provides that the conversion of a preference shares into an equity shares will not be regarded as a taxable transfer. Further amendments13 were introduced to provide that the holding period of the resulting equity shares would commence from the date of acquisition of the original preference shares, and that the cost basis of the resulting equity shares would be that of the original preference shares.

The amendments were welcomed by the private equity and venture capital investor community (who frequently structure investments through the use of CCPS), and are a strong step in the direction of introducing certainty to India's tax laws. The Tribunal's ruling will likewise be welcomed, especially by investors who undertook conversions prior to April 1, 2018 and took the position that the conversion was not a taxable transfer.

Footnotes

1 Periar Trading Company Private Limited v. ITO, ITA No.1944/Mum/2018

2 [1998] 234 ITR 787 (This case dealt with the question of whether the conversion of optionally convertible redeemable preference shares ("OCRPS") into equity shares constituted taxable transfer by way of an exchange. Holding in the affirmative, the High Court held that capital gains accruing on such conversion are liable to be taxed.)

3 (1976) (102 ITR 248) (This case dealt with the question of whether the holding period of preference shares issued to a shareholder in lieu his equity shareholding in a company, pursuant to a re-organization of that company's share capital, would commence from the date on which the post-reorganization preference shares were issued, or the date on which the original equity shares were issued. The High Court held that the re-organization did not entail merely a change in nomenclature of the shares but was an exchange of one kind of shares by another kind of shares, having different rights and liabilities, and accordingly, the holding period of the preference shares would commence from the date of issue of the preference shares.)

4 Section 2(47) of the ITA. Section 2(14) defines 'transfer', in relation to a capital asset, to include a sale, exchange or relinquishment of a capital asset, or the extinguishment of any rights therein.

5 Section 45 of the ITA. Section 45 provides for the charge of a capital gains tax on gains arising from a transfer of a capital asset.

6 [1986] 19 ITD 510

7 Circular dated May 12, 1984 vide F.No. 12/1/64-IT(A)

8 Section 55(2)(b)(v). Section 55 supplies the meaning of 'cost of acquisition' in certain special cases. Section 55(2)(b)(v) provides that where a taxpayer receives shares of a company on the conversion of one kind of shares into another kind, the cost of acquisition is to be calculated with reference to the cost of acquisition of the original shares.

9 66 ITR 622

10 263 ITR 345

11 Section 48 of the ITA. Section 48 provides machinery to compute gains arising from a transfer of a capital asset. In short, gains are computed by deducting, from the 'full value of consideration" received or accruing as a result of the transfer of the capital asset, (a) its cost of acquisition and (b) any expenditure incurred wholly and exclusively in connection with the transfer.

12 (1981) 128 ITR 294 (SC)

13 Section 2(42A)(hf) & section 49(2AE) of the ITA

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions