One of the most significant developments in 2017 and 2018 has been the nation-wide investigation into Shell Companies and Penny Stock companies. Several thousands of cases have been re-opened citing bogus capital gains and penny stocks. This has even led to the Government introducing a provision that Sec 10(38) can only be enjoyed if STT has been paid on purchase of the share, as well, with certain exceptions. Dr. Abhishek Murali (Chartered Accountant, Partner, Victor Grace & Co.) in his 2- Part article makes a comprehensive analysis of taxation of Penny Stocks and Shell Companies. The author points out that the Department has three significant assessment points in the process viz., (i) Issue of shares at a premium by Shell companies, (ii) Benefit of business loss on sale of shares purchased at inflated prices and (iii) Benefit of Capital gains exemption on sale of shares at a high price.

Issue of shares at a premium by Shell companies

In Part-I, the author discusses the nitigrities of the first limb i.e., Issue of shares at a premium by Shell companies. The author studies some of the most recent decisions on this aspect such as Bangalore ITAT decision MK Rajeshwari vs ITO reported in [TS-9007-ITAT-2018(BANGALORE)-O]  where after studying the financial worth and share price movement of the company, ITAT held that it was not worth investing in and upheld Revenune’s stand that unaccounted money was introduced in the form of long-term capital gains. Referring to the different views by ITAT in different jurisdictions, author signs off stating “It appears a solution will only be obtained when the Apex Court considers the matter and provides a judgement on the same, that can help resolve the issue pan-India.”

Introduction

One of the most significant developments in 2017 and 2018 has been the Investigation into Shell Companies and Penny Stock companies by The Directorate of Investigation, Kolkatta. As a result of the nation-wide investigation efforts of the Investigation Wing of the Income Tax Department, several 1000s of cases have been re-opened stating Capital Gains are Bogus and such stocks are penny stocks. The efforts of the Department have even led to the Government introducing a provision that Sec 10(38) can only be enjoyed if STT has been paid on purchase of the share, as well, except where the Department deems it genuine and fit, to consider otherwise.

The Assessments and Appeals of several penny stock cases are today being heard. This article will break-down in a simple and easy to understand manner, the issues regarding penny stocks, shell companies and handling the assessments and appeals of the same.

Penny Stocks / Bogus Capital Gains in a Nut-Shell

The web of Shell Companies, Penny Stocks, Capital Gains and Business Loss are so strongly intertwined that they can be broken into 3 significant assessment points which will be considered by the Income Tax.

a. Shell Company – Issues Share at Premium – Acquires unexplained capital funds:

Establishment of Companies with little or no assets and no regular business operations, merely for the purpose of issuing shares at inflated premium prices.

b. Purchaser of Inflated Share – Enjoys benefit of Loss on sale:

Purchaser of Shares of Shell Companies at inflated prices – Normally a person who is regularly in the business of share trading. He buys the share at inflated prices from the company or open market and then sells the same after the price falls.

c. Sells Low Price Shares at High Rate– Enjoys Benefit of Tax Free Capital Gains on Inflation of Share:

The third limb of this web of transaction is the buyer who buys the share in the open market at a low price, holds the share for over a year and then subsequently sells the shares at a high price (a price which is normally artificially created by share brokers or traders). Thus, this person enjoys tax free Capital Gains u/s 10(38).

In Part-I of the article, we shall discuss the first limb. Let us read on to understand the critical issues and potential reasons why the Assessee need not necessarily be a person who has indulged in these bogus transactions.

(1) Penny Stocks – Capital Gains on Sale of Inflated Shares

Most Common Cases now being Re-Opened and Assessed:

The first significant tax point, and most commonly seen, is the benefit obtained by the person who purchases penny stocks at a low rate and then subsequently proceeds to sell the shares, in the open market, at a very high inflated rate. The rate of this share usually is a temporary high, before it reverts to its old low share price.

The Modus-Operandi varies from case to case, but the common trend is the Assessee buys the share of a company vide private placement. The company then gets taken over or merged with a listed entity (one with little or no assets or business operations) and the Assessee is allotted shares of the listed company at a specified ratio. The Assessee holds this share for a period of 12 months or more.

Subsequently, the price of the share is increased, either by the brokers or share traders, vide circular trading. The Assessee then sells his/her shares when the price of the share is at this high in the open market. All capital gains earned by the Assessee is, therefore, exempt by virtue of Sec 10(38).

The stand of the Income Tax Department is that the entire operations of purchasing the share, sale of share and the capital gains is entirely bogus and are planned sham transactions. The Department takes the ground that the Assessee has routed cash through the stock brokers to the buyers and has merely use the securities to re-route the unaccounted money through exempted capital gains.

In [TS-6310-HC-2017(BOMBAY)-O], the Hon’ble Bombay High Court upheld the order of the ITAT that the purchase and sale of shares did not qualify an investment and rather it was an adventure in the nature of trade.

In [TS-9007-ITAT-2018(BANGALORE)-O], the Hon’ble Single Member Bench of the Bangalore ITAT held that the financial worth of the company was very meager and not worth to be invested in. The price of these shares saw phenomenal rise and were constantly traded near the circuit limit (of 5%) so as to avail maximum price rise without hitting and triggering the circuit limit, and thereby avoid surveillance. Revenue has brought sufficient material on record to demonstrate that unaccounted money was introduced in the books of account through long-term capital gain by adopting such method.

In the case of reported in [TS-5-ITAT-2019(PUN)], the Hon’ble Pune ITAT held that sale proceeds on sale will be undisclosed income and mere furnishing of contract notes does not inspire any confidence and cannot be a ground to delete an addition, which is otherwise made on the solid bedrock of detailed enquiries.

Presumption of Guilt must be examined in the Facts and Circumstances of Each Case

The Income Tax Department takes a stand of universal guilt among all persons connected to the sale of penny stocks, which have featured in the report of the DIT, Kolkatta team. The addition is usually made as an unexplained credit, u/s 68 of the Income Tax Act and penalty is swiftly levied on the same.

One of the fundamental challenges Assessing Officers face is the fact that most of the information relied upon, for framing the Assessment Order, is based on second hand information. Very select officers personally have cross-examined the Shell Company Directors or Brokers in question. The Assessee or Appellant is also not given an opportunity to cross examine the persons providing the statements, which is opposed to the principles of natural justice.

In [TS-5928-ITAT-2017(Mumbai)-O], the Hon’ble Mumbai Income Tax Appellate Tribunal held that purchase and sale of shares cannot be treated as fake transactions by merely relying upon statements of the Director of a firm alleged to have provided accommodation entries, ignoring evidence proving genuineness of the transaction and also without allowing the assessee an opportunity to cross-examine such person. Similarly, in [TS-5928-ITAT-2017(Mumbai)-O] and in [TS-5928-ITAT-2017(Mumbai)-O] is also in the Assessee’s favour.

In [TS-7041-ITAT-2018(Chennai)-O], the Hon’ble Chennai Income Tax Appellate Tribunal held that “the reports of investigation wing, relied on by the ld. Assessing Officer, as well as the statement recorded are put to the Assessee, before deciding whether these are relevant in the assessment of the assessee”.

In [TS-6134-ITAT-2018(Chennai)-O], the Hon’ble Chennai Bench of ITAT held that statements recorded from the broker was not provided to the Appellant and the matter needs to be reconsidered by the Officer. This was also held in  [TS-9432-ITAT-2018(Chennai)-O].

Bottom Line:

Several jurisdictions have conflicting decisions regarding the taxability of Penny Stocks, in their respective jurisdiction. While the High Court order should be binding on the Tribunals, CIT(A) and Assessing Officers, it is found that facts and circumstance of each case is different and it may not be squarely applicable.

It appears a solution will only be obtained when the Apex Court considers the matter and provides a judgement on the same, that can help resolve the issue pan-India.

In Part-II, we shall discuss the second and third limbs of the Penny Stock transaction viz., Business loss on sale of shares and Shell companies