1. This is a reference under section 66(1) of the Indian Income-tax Act, 1922.
2. The relevant assessment year is 1960-61, the accounting year being the year ended 31st March, 1960. The assessee is an individual. The assessee was carrying on business as a share-broker. He also dealt in shares on his own account and those dealings he used to regularly by shares of stock-in-trade. In the beginning of the relevant accounting year he held amongst others, 1,750 ordinary shares of the Tata Iron and Steel Co. Ltd., which he had purchased before the beginning of the accounting year. They from year to year is to show the shares held by him as his stock-in-trade. The assessee's practice the actual cost. In other words, he does not value the holding of his stock-in-trade at the end of each year at the market price, but continues to carry forward his holding from year to year at its original cost.
3. During the accounting year the Tata Iron and Steel Co. Ltd. made what is known as 'rights issue' of ordinary shares. The company offered its existing shareholders for subscription one new share of the right issue for every five existing old shares. The assessee had, under the terms of the offer, a right to himself subscribe for 350 new shares of the right issue offered to him by paying Rs. 75 for the face value of each of the new shares or to renounce the right and sell his right to the new shares which were offered to him. The assessee exercised the option to sell his right to subscribe to the 350 new shares offered to him and did not himself subscribe to any of these 350 new shares. By this sale he realised a sum of Rs. 27,500.
4. In the assessment of his income for the above assessment year 1960-61 the assessee claimed, firstly, that the amount of Rs. 27,500 was exempt from tax because it was a capital gain as it was the realisation of an accretion to his original stock-in-trade. He contended, in the alternative, that if the realisation was his revenue profit, then to the extent that the value of his existing stock-in-trade, being the 1,750 original shares, had fallen as a result of the right issue, that fall of depreciation should be set off against the said sum of Rs. 27,500 and that if it was so done, there would be a loss of Rs. 39,250. He contended that, therefore, in either alternative, there was no profit which accrued to him as a result of the sale of his right to the 350 new shares.
5. The Income-tax Officer and the Appellate Assistant Commissioner held that the said sum of Rs. 27,500 was business profit and was liable to tax. The Income-tax Appellate Tribunal, however, upheld the second contention of the assessee and held that, as against the said realization of Rs. 27,500 by sale of his rights shares, it was necessary to set off the fall in the value of the original 1,750 shares and that on that basis there was a loss and no profit.
6. The decision of the Tribunal being against the department, this reference has been made at the instance of the Commissioner of Income-tax, Bombay City I, Bombay.
7. The questions of law referred are :
'1. Whether, on the facts and in the circumstances of the case, the amount of Rs. 27,500 was the assessee's clear profit liable to tax ?'
8. If the answer to question No. 1 be in the negative :
'2. Whether, on the facts and in the circumstances of the case, the assessee was entitled to claim the sum of Rs. 39,500 as a revenue loss ?'
9. There is no dispute that the original 1,750 shares were held by the assessee as his stock-in-trade. The assessee has given up his contention that Rs. 27,500 was a capital gain. There is therefore no dispute that the profit, if any, made by reason of the sale of the assessee's 350 shares of the rights issue would be his business profit and taxable as such. The only question is as to the method of calculating the profit, if any, bearing in mind his second contention. There is no dispute that in view of the fact that the assessee had all along maintained his stock at its original cost without revaluing it at the end of every year, the actual cost of 1,750 shares would be as shown in his books of account. There is no dispute that the new shares be as shown in his books of account. There is no dispute that the new shares offered under the rights issue were to rank pari passu with the existing old ordinary shares and that a shareholder who exercised his right to subscribe to the appropriate number of shares offered to him would have to pay Rs. 75 per shares to the company, that being the face value of each share.
10. To help us to decide the questions arising in this reference four judgments of the Supreme Court have been brought to our notice. The first judgment is that in Commissioner of Income-tax v. Dalmia Investment Co. Ltd. In that case bonus ordinary shares were issued in in respect of ordinary shares held in the company by the assessee in that case. He was a dealer in shares. The bonus shares were to rank pari passu with the original or old shares. It was held that the real cost of the bonus shares to the assessee cannot be taken to be nil, nor its face value. Hidayatullah J., in delivering the judgment on behalf of the majority, has observed in his judgment :
' It will be seen from the above that there are four possible methods for determining the cost of bonus shares. The first method is to take the cost as the equivalent of the face value of the bonus shares. This method was followed by the assessee-company in making entries in its books. The second method adopted by the department is that as the shareholder pays nothing in cash for the shares, cost should be taken at nil. The third method is to take the cost of the original shares and to spread it over the original shares and bonus shares taken collectively. The fourth method is to find out the fall in price of the original shares on the stock exchange and to attribute this to the bonus shares. Before us the assessee-company presented for our acceptance the first method and the department the third method.'
11. The majority judgment holds that the bonus shares have to be valued by spreading the cost of the old shares over the old shares and the new shares, being the bonus shares, taken together if they rank pari passu, and if they do not, the price may have to be adjusted either in the proportion of the face value they bear if there is no other circumstance differentiating them or on equitable considerations based on the market price before and after the issue of the bonus shares. The principle laid down in Dalmia's case has been approved and followed by the Supreme Court in two subsequent judgments relating to the issue of bonus shares in Commissioner of Income-tax v. Gold Mohore Investment Co. Ltd. and Commissioner of Income-tax v. Gold Mohore Investment Co. Ltd.
12. The fourth judgment is that of Miss Dhun Dadabhoy Kapadia v. Commissioner of Income-tax. In that case the assessee, who was not a dealer in shares, held by way of investment 710 ordinary shares in the Tata Iron and Steel Co. Ltd. The company made an offer to her by which an option of either taking the shares or renouncing them, wholly or partly, in favour of others. The assessee renounced her right to all the 710 new shares and realised Rs. 45,262.50. The department sought to tax the whole sum of Rs. 45,262.50 as a capital gain. The assessee, however, contended that on the issue of the new shares the value of her old shares depreciated, since the market quotation of the old shares which was Rs. 253 per share immediately before the issue of the new shares fell to Rs. 198.75 immediately after the issue of the new shares and that as a result of this depreciation she suffered a capital loss in the old shares to the extent of Rs. 37,630 and that she was entitled to set off that loss against the capital receive the new shares was a right which was embedded in her old shares and consequently, when she realised the sum of Rs. 45,262.50 by selling her right, the capital gain should be computed after deducting liquidated. The Supreme Court held that the assessee was entitled to deduct from the sum of Rs. 45,262.50 the loss suffered by way of depreciation in her holding of the old shares. The judgment in this case observes at pages 654-55 of the report as follows :
'At the time, therefore, when the appellant renounced her right to take these new shares, the capital asset which she actually possessed consisted of her old 710 shares plus this right to take 710 new shares. At the time of her transaction, her old shares were valued at Rs. 253 per share, so that the capital asset in her possession can be treated to be the obtain new shares. After she had transferred this right to obtain new which became valued at Rs. 198.75 per share, together with the sum of Rs. 45,262.50. The net capital gain or loss to the appellant obviously would be the difference between the value of the capital asset and the cash in her hands after she had renounced her right and realised the cash value in respect of it, and the value of the capital asset including the right which she possessed just before these new shares were issued and before she realised any cash in respect of the right by renouncing it in favour of some other person. As we have indicated above, the value of the capital asset, of Rs. 45,262.50 while the value of the asset, immediately before the renouncement, would be 710 multiplied by Rs. 253. There being no cash value at that time of the right to be taken into account. Thus, the capital gain or loss would be worked out at Rs. 45,262.50 after deducting from it the sum worked out at 710 multiplied by the difference between Rs. 253 and Rs. 198.75. This last amount comes to a little more than the sum of Rs. 37,630 which the appellant claimed should be deducted from Rs. 45,262.50 in computing her capital gain. The claim made by the appellant was thus clearly justified because the net capital gain by her in the transactions, which consisted of issue of new shares and make some money thereby, could only be properly computed in the manner indicated by us above.
13. In the alternative, the case can be examined in another aspect. At the time of the issue of new shares, the appellant possessed 710 old shares and she also get the right to obtain 710 new shares. When she sold this right to obtain 710 new shares and realised the sum of Rs. 45,262.50 she capitalised that right and converted it into money. The value of the right may be measured by setting off against the appreciation on the face value of the new shares the depreciation in the old shares and, consequently, to the extent of the depreciation in the value of her original shares, she must be deemed to have invested money in acquisition of this new right. A concomitant of the acquisition of the new right was the depreciation in value of the old shares, and the depreciation may, in a commercial sense, be deemed to be the value of the right which she subsequently transferred. The capital gain made by her would, therefore, be represented only by the difference between the money realised on transfer of the right, and the amount which she lost in the form of depreciation of her original shares in order to acquire that right. Looked at in this manner also, it is clear that the net capital gain by her would be represented by the amount realised by her on transferring the right to receive new shares, after deducting therefrom the amount of depreciation in the value of her original shares, being the loss incurred by her in her capital asset in the transaction in which she acquired the right for which she realised the cash. This method of looking at the transaction also leads to the same conclusion which we have indicated in the preceding paragraph.
14. The view that we have taken finds support from the principle laid down by this court for valuation of bonus shares issued by a company to holders of original shares in the case of Commissioner of Income-tax v. Dalmia Investment Co. Ltd.
15. The above observations of the Supreme Court appearing at page 654 hold that the correct method for evaluating the capital gain was to find out the aggregate of the ex-right value of the holding of the old shares and th actual cash received by the sale of the right to the new rights shares page 655 of the report the observations put it in a different way when it is stated that the capital gain has to be ascertained by ascertaining the excess of the amount of appreciation in the face value of the new shares - which would be the sale proceeds of the right to the new right shares - over the amount of depreciation in the old shares - which would be the same as the difference between the cum-right market value and the ex-right market value of the old shares.
16. The first three of the above cases relate to bonus shares, but the last refers to the shares of a rights issue. In cases where bonus shares are issued, the bonus shares can be sold only after they are actually issued. In the case of rights shares, however, the right itself to apply for the new shares offered to a particular shareholder can be sold and the sale would be the obtain the right shares. In the case of issue of bonus shares, the bonus shares would be given to the holders of the then existing shares, i.e., the old shares, and the working out of the cost to the shareholder would be simple. The working out of the cost would be to add the number of bonus shares to the number of the old shares and spread out the cost of the old shares over the aggregate of the old and the bonus shares and the result would be the average price of each share of the combined lot of the old and the bonus shares. If at some subsequent time some shares out of this combined lot are sold, the profit or the capital gain, as the case may be, would be easy to ascertain by deducting the average cost per share obtained as above from the sale proceeds of each share, be the share the old share or the bonus share.
17. Mr. R. J. Joshi, the learned counsel for the department, contended that would appear that even in the case of issue of rights shares, if the shareholder to whom the shares are offered himself pays the amount payable to the company and obtains the rights shares, the position would be similar to that as decided by the Supreme Court in respect of the bonus shares. We are, however, not considering in this case such a situation, because the assessee in our case did not himself apply for any of the 350 right shares offered to him, but sold out the right to obtain all the 350 shares in the open market. Mr. Joshi, however, contented that in cases where the right to apply for the new shares of the rights issue is sole the correct method would be first to ascertain a shareholder's actual cost in respect of the old shares, then add to it the amount payable by him to the company for the new rights shares, then spread the aggregate amount over the aggregate of the old and new shares and so ascertain the average price which would be his payable in respect of those shares was added in the first step, only notionally, and therefore the second step would be to deduct the amount payable to the company per new share from the above average cost price per share the difference would be his profit or capital gain, as the case may be, but if the amount is larger the difference would be his loss. According to Mr. Joshi this method would take into account all different cost prices of all shareholders. He pointed out that if this method is followed, as a consequence, as and when the shareholders sells his old shares, the above average cost price will be the basis for calculating his resulting profit or loss. He argued that if the method adopted by the Supreme Court in its judgment in Dhun Kapadia's case is applied to the case of a rights issue, where the right is sold by the shareholder entitled to it, it would result in the profit or capital gain, as the different holders of old shares, totally irrespective of the actual cost of the different holders, however high or low such actual cost per share would be.
18. To illustrate his point he gave several hypothetical examples. He stated that suppose, as common data for all his examples, the face value of a share to be Rs. 100 and the shares are issued as rights shares at par, the offer being of one new right share for every one old share held and suppose the cum-right price of the old share is Rs. 180 to its ex-right price is Rs. 160 and that the sale of the right to one new share realises Rs. 25. He pointed out that if the same principle which is laid down in Dhun Kapadia's case were be applied, the profit or the capital gain, as the case may be, would be Rs. 5, being the balance arrived at by deducting from Rs. 25, being the sale proceeds of the right, Rs. 20, being the depreciation in the value of the old share from its cum-right price of Rs. 180 to its ex-right price of Rs. 160. He pointed out that this profit of Rs. 5 per share would have to be held to be the profit of each and every shareholder, even though the actual cost of different shareholders for each old share may have been Rs. 105 or Rs. 200. He then illustrated the result of applying the above principles canvassed for by giving two examples on the same data mentioned above.
Example No. I :
Take Rs. 105 as being the actual cost price of one old share.
Rs. 105 cost price of one old share.
Add Rs. 100 payable to the company for one new rights share.
Total Rs. 205 for two shares (one old and one new).
Therefore, Rs. 102.50 average cost price per share.
Deduct Rs. 100.00 taken above as paid to company for one new share,
but only notionally, though not in fact.
Rs. 2.50 cost price, on averaging as above, of one new share.
Rs. 25.00 sale proceeds of the right to one new share.
Deduct Rs. 2.50 actual cost of one new share as above.
Rs. 22.50 profit or capital gain, as the case may be, liable to
be brought to tax.
Example No. 2 :
Take Rs. 200, as being the actual cost price of one old share.
Rs. 200.00 cost price of one old share.
Add Rs. 100.00 payable to the company for one new rights share.
Therefore Rs. 150.00 average cost price per share.
Deduct Rs. 100.00 payable to the company for one new share, but
only notionally, though not in fact.
Rs. 50.00 cost price, on averaging as above, of one new share.
Rs. 25.00 being the sale proceeds of the right to one share of
the rights issue is actually less than the above
cost price of Rs. 50 and therefore there is a
loss of Rs. 25.
19. He pointed out that if the principle in Dhun Kapadia's case is held applicable in each of these two examples, what would be taxable would be Rs. 5, though in example No. 1 the profit is Rs. 22.50 and in example No. 2 there is a loss of Rs. 50.
20. Mr. Dastur, the learned counsel for the assessee, tried to explain that the difficulties and anomalies, sought to be pointed out by Mr. Joshi to exist, arise by reason of ignoring what according to Mr. Dastur is the correct position. He pointed out that when bonus shares are issued what a shareholder gets by way of bonus is a share, but when rights shares are issued, what the shareholder gets is an option either to accept the offer and by paying the necessary amount to the company actually obtain the share, or, in the alternative, to sell his right to apply for the rights share, He pointed out that the two modes available under this option are totally different and independent of each other. In the first case he exercises his option and gets the actual share itself. In the latter case, however, he does not get any share at all, but sells the right to obtain a share, the right to obtain a share being different from the obtaining of the share itself. He contended that when a shareholder sells his right, he effects a totally different and independent transaction uncorrelated to his holding of the original or old share. He contended that the real profit or loss and the amount thereof resulting in the case of each holder of the old share should be ascertained at the time when he sells his old shares but, of course, after the actual cost of the old shares is reduced by the depreciation suffered in respect of the old share at the time of the sale of the right which sprang out of the old share, the depreciation being the shortfall ascertained by deducting the share, the depreciation being the shortfall ascertained by deducting the ex-right price from the cum-right price at the time of the issue of the rights shares. Mr. Dastur contended that the method suggested by Mr. Joshi, which is the method of averaging out as laid down in the said there cases dealing with bonus shares, may, with some reservations, apply only if, in the case of a rights issue, the shareholder actually applied for the share offered to him, pays to the company the money payable in respect of these shares and obtains the shares from the company.
21. We had pointed out to Mr. Joshi that the facts of our case were not only similar, but identical, to those before the Supreme Court in Dhun Kapadia's case Mr. Joshi made various attempts to distinguish our case from the case of Dhun Kapadia; but, in our opinion, he could not point out any effective distinction. One of the distinctions he sought to make was that Dhun Kapadia's case was a case of capital gains whereas the case before us is of business profits. Now, in our opinion, it is a distinction which does exist, but it makes no difference, because in the case of both capital gains and revenue profit the amount is ascertained by deducting the cost price form the sale proceeds. In the case of capital gains the excess is a gain in the capital, whereas in the case of business profits, the excess is a revenue profit, but none the less, basically, both are profits. Of course, the fact whether it is capital gain or business profit merely affects the incidence and the rate of tax and the actual amount of tax may very because of that reason, but the method of calculating the actual amount does not very and is the same.
22. We do not see any distinction which makes a difference between the facts in the case before us and those before the Supreme Court in Dhun Kapadia's case. We are, therefore, bound by the principles laid down by the Supreme court in that case and we propose to decide this reference on the basis of those principles.
23. As the principle in Dhun Kapadia's case requires that the amount realised by the sale of the right should be set off by the amount of the depreciation in the old shares, but the Tribunal has not done so, we answer question No. 1 in the negative.
24. The amount of Rs. 39,250 mentioned in question No. 2 has not been worked out on the basis of the principles laid down in Dhun Kapadia's case. That amount has been obtained by deducting from Rs. 3,22,000 the sum of Rs. 2,82,750. The former amount is worked out on the basis of the market rate per share on 1st April, 1959, and letter on the basis of the market rate per share on 31st March, 1960, the two dates being the first and the last date of the accounting year relevant to the assessment year in respect of which the assessee was being assessed. The principles laid down in Dhun Kapadia's case show that the rates of these two dates are totally irrelevant. What ought to have been done was to have ascertained the market rates of the Tata ordinary shares cum-right and ex-right immediately before and after the issue of the rights shares. The question No. 2, however, does not take into account those principles and we, therefore, answer question No. 2 also in the negative.
25. On the facts of the case, we are of the opinion that the fairest order as to costs would be no order as to costs and we makes an order accordingly.