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Comprehensive Analysis of Taxation of Penny Stocks and Shell Companies - Part II

Jan 25, 2019

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

Introduction

After discussing the nitigrities of the first limb i.e., Issue of shares at a premium by Shell companies in Part-I, the author discusses the nuances of the other two limbs. While discussing circumstances which the AO must consider before denying the benefit of business loss on sale of shares holding it as bogus, the author refers to 2 recent ITAT decisions in cases of Late Ugama Kavar and Abhimanyu Soin and points out that the number of years of assessee’s engagement, history of profits/losses, Income Tax Returns and genuineness of the transactions must be considered. Further, author contemplates that in 2019, taxation of Shell Companies will be a priority. The author also discusses the recent decision in case of Shaan Constructions wherein while rejecting assessee’s stand that assessee is not required to prove ‘source of the source’, Delhi ITAT concluded that depositors were mere entry providers and the balance sheets and income tax returns of depositor companies do not inspire any confidence in the whole transaction. Further discussing the basics of spot transactions, the author signs off with a remark that “It appears there is no quick solution for Penny Stock cases and only a detailed order of the Supreme Court will help in settling the matter.”

Article

In Part-I, we discussed how shares of a small company is purchased and its share price driven up to be sold in open market for a good price and capital gains exemption is claimed u/s. 10(38). In this Part, we shall discuss the subsequent steps in the Penny Stocks transactions viz., loss on sale of the shares and issuance of shares by Shell Companies.

(II)    Penny Stocks – Business Loss on Sale of Shares

The second limb of the Penny Stocks transactions is the person who buy the Penny Stocks at the inflated prices and then proceeds to sell them after the prices crash.

It was found that certain persons engaged in the business of trading shares, used the huge loss on sale from such penny stocks transactions and set-off the same against the profits of other businesses or other heads of income.

While on the face of it, it may appear every transaction is bogus, the Assessing Officers should take a considerate call based on the facts and circumstances of each case. Proliferation of exchange of information on trading of shares today has become very easy. Not necessarily every purchase of a penny stock is a colourable device to avoid tax, but could simply be an investor attempting to make a large profit, based on advice of others.

In the landmark case of [TS-9433-ITAT-2018(Chennai)-O], the Hon’ble Chennai ITAT held that the reason for disbelieving the details furnished by the Assessee is not valid. The Assessment Order ought not to be cryptic and details order should be passed keeping in mind the facts and circumstances of the case of the Assessee.

In [TS-8147-ITAT-2018(CHANDIGARH)-O], the Hon’ble ITAT held that due to the facts and circumstances of the type of shares sold and the specific peculiarity of the instant case, the order of the CIT(A) was upheld and the Assessee appeal was dismissed.

Bottom Line:

It is evident that the decisions are irregular due to the immense difference in the facts and circumstances of each case. Every case should be looked into as various factors will determine the genuineness of the transaction. Some of the important circumstances to be considered are:

a) How many years Assessee has been engaged in the share trading business

b) History of profits and losses

c) Current year profits/losses from other businesses or other heads of income

d) Genuineness of the transactions and whether everything is through the market and documentation is correct

e) History of income tax returns filed by the Assessee

Hence, these factors and more should be considered before concluding that the nature of the loss is sham or bogus.

(III) Shell Companies –

Taxation of Shell Companies will be priority in 2019

The third and final limb of the penny stock web is the shell company issuing the share itself. The company issuing the share usually increases the authorised capital or issues shares to the extent of the authorised capital before issuing shares to specified individuals. The shares are issued for a significant premium, over the face value of the share.

Eg.: If the Face value of the share is Rs.10, it will be issued for Rs.100 (Rs.10 FV and Rs.90 will be accounted as share premium). However, it is important to note that in most of the cases of the Shell Companies, the subscribers are persons who are re-routing cash deposits from various parties and consolidating them into the share premium of the main Shell Company.

In compensation of the same, they are issued shares at an inflated value, not reflective the genuine financial condition of the company itself.

The Company enjoys funds from multiple parties as a form of Capital Receipt (share premium) and hence is not taxed for these receipts. The receipts have come in from various parties, usually through cash deposits made just before the application for issue of shares, by these persons.

In [TS-7572-ITAT-2018(DELHI)-O], the Hon’ble Delhi ITAT held that depositors were mere entry providers and the balance sheets of depositor companies as well as income tax returns do not inspire any confidence in the whole transaction. The Tribunal further went on to reject stand that Assessee is not required to prove ‘source of the source’.

The Supreme Court in [TS-5156-SC-1971-O] held:

It is true that an apparent must be considered real until it is shown that there are reasons to believe that the apparent is not the real. In a case fo the present kind a party relied on a recital in a deed has to establish the truth of those recitals, otherwise it will be very easy to make self-serving statements in documents either executed or taken by a party and rely on those recitals.

If all that an assessee who wants to evade tax is to have some recitals made in a document either executed by him or executed in his favour then the door will be left wide open to evade tax. A little probing was sufficient in the present case to show that the apparent was not the real.

The taxing authorities were not required to put on blinders while looking at the documents produced before them. They were entitled to look into the surrounding circumstances to find out the reality of the recitals made in those documents”.

In [TS-5039-SC-2002-O], the Supreme Court observed that a glib explanation tendered by the assessee, teeming with improbabilities and strenuous on credulity cannot be accepted.

Bottom Line:

Taxation of Shell Companies is likely to be a contentious issue for both the Assessee and the Revenue. The order of the Delhi ITAT is the first in what is expected to be a series of orders for various companies. The action, however, does over-rule several settled observations of various courts, in favour of the Assessee, and could raise significant questions of law that need to be dealt with by the Courts.

It is important to keep documents, bank statements, invoices and various evidences handy for any transactions that could be construed to be colourable devices, like Shell Companies.

Important Points to Keep Prepared:

The department will likely seek the following information and details with regard to penny stocks

a) Proving the scrip is devoid of basic fundamentals in a share

b) Business and operations of the company traded

c) Fixed assets and other current assets of the Company

d) Steep Bell Curve share price of the company over time

e) Any history of trading ban or blocks placed on the company by NSE/BSE/SEBI

While each case is different, the Assessee being prepared with experience on this kind of matters is recommended as it is critical to sift through this information and identify the necessary points of contention.

The Basics of Spot Delivery Contract

A Spot Delivery contract which in one where:

(a) actual delivery of securities and the payment of a price therefore either on the same day as the date of the contract or on the next day

(b) transfer of the securities by the depository from the account of a beneficial owner to the account of another beneficial owner when such securities are dealt with by a depository

These concepts have further been discussed in the cases of [TS-5030-SC-2005-O], where the Hon’ble Supreme Court held that “shares do not fall under definition of securities being not marketable since they are shares of unlisted company - Tenability - Held, free transferability of shares is essential requirement for them to become a security - Statutory prohibitions restricting marketability of shares is not the criterion - Shares of public limited company though not listed on stock exchange, are capable of being bought and sold in market, thus, fall within definition of securities - Hence, provisions of 1956 Act apply equally to shares of public limited companies not listed on stock exchange.”

Conclusion

The path to determining the taxation of Penny Stocks and Shell Companies has been a long road and there have been several conflicting decisions across the country. This further strengthens the argument that every case of penny stocks cannot be concluded to be in favour of the revenue, but must be looked into. The Facts and Circumstances of each case will prove to be the determining factor for the treatment as unexplained income.

It appears there is no quick solution for Penny Stock cases and only a detailed order of the Supreme Court will help in settling the matter. We are indeed set for an interesting course of events over the upcoming months.

 

Click here to read Part-I of the Article 

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by Dr. Abhishek Murali, CA
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