JAGADISAN J. - At the instance of the Commissioner of Income-tax, Madras, the Appellate Tribunal has referred the following question to this court under section 66(1) of the Indian Income-tax Ac :
'Whether, in the circumstances and on the facts of the case, capital gains of Rs. 7,269 on the sale of shares computed by the Income-tax Officer is not correct and in accordance with the law?'
The facts are thes : The assessee is a Hindu undivided family. He is not a dealer in shares. He is deriving income from interest on securities, property, business and dividends from shares held in limited companies. The assessee held shares in a bank called the Karur Vysia Bank Limited. In the year 1957, the bank issued bonus shares to the assessee in proportion to the shares already held by him in the bank. During the year of account ended 13th April, 1959, relevant to the assessment year 1959-60, the assessee sold 94 bonus shares for Rs. 7,268.94 nP. The Income-tax Officer was of the opinion that the original cost of these bonus shares was nil and therefore assessed the entire sale proceeds of Rs. 7,269 to tax as capital gains under section 12B of the Act. The assessee contended that the cost of the bonus shares should be fixed by adopting the 'average cost' in respect of each share, taking into account the total number of shares held by him, original shares plus the bonus shares. But the Income-tax Officer did not accept this contention. The assessee preferred an appeal to the Appellate Assistant Commissioner, who, however, affirmed the decision of the Income-tax Officer. The view of the Appellate Assistant Commissioner was that the assessee had not incurred any expenditure for acquiring these shares and that the original cost must be deemed to be nil. There was a further appeal by the assessee to the Income-tax Appellate Tribunal. The Tribunal disagreed with the view of the department and held that the original cost of the bonus shares should not be taken as nothing. The Tribunal referred to the decision of the Supreme Court in Emerald and Co. Ltd. v. Commissioner of Income-tax, where, however, the question of valuing the bonus shares at the time of the acquisition was left open. Having reached this conclusion the Tribunal went on to observe as follow :
'We hold that the sale proceeds of Rs. 7,299 of the 94 shares sold by the assessee does not in entirely represent capital gains as has been held by the income-tax authorities. It is however open to the Income-tax Officer to recompute the profit if so advised and found worthwhile. If it is re-done, the closing stock has to be valued at the original cost of the holding averaged for the original and bonus scrips since issued or at the market price whichever is lower.'
It is very difficult to follow the reasoning of the Tribunal. The value of the bonus shares, at the time of the issue, would either be the market value or the face value, if the view of the department that they were of nil value were not to be accepted. Anyhow, on the basis of this conclusion arrived at by the Tribunal, the Income-tax Officer has been directed to amend the assessment already made. The question now before us is whether the Tribunal is right in directing the department to value the bonus shares on the basis of the average value or the market price whichever is lower.
Mr. S. Ranganathan, learned counsel for the department, contended that the bonus shares were got by the assessee purely by way of gift, as an addition or accretion to the original shares held by him, and that it could not be said that the assessee paid any consideration for these bonus shares. He supported the view taken by the department that the original cost of the bonus shares should be taken as of nil value.
The issue of bonus shares by a company is now a common feature. When a company is prosperous and accumulates a large surplus, it converts this surplus into capital, and divides the capital among the members in proportion to their rights. This is done by issuing fully paid shares representing the increased capital. Bonus shares are issued out of the credit balance of profit and loss account, and out of reserves, and the shareholders, to whom the shares are allotted, have to pay nothing. The purpose is to capitalise profits which may be available for division or to utilise quasi-capital gains. 'Bonus shares' go by the modern name 'capitalisation shares'. If the articles of association empower, the company can capitalise profits or reserves, and issue fully paid shares of a nominal value equal to the amount capitalised to its shareholders. But in some cases, the articles provide for an option to the shareholders to take cash instead of shares. This would make no difference in the position, except of course to the extent to which the option is exercised (Inland Revenue Commissioners v. Fishers Executors and Commissioner of Income-tax v. Mercantile Bank of India). Where the articles authorise the satisfaction of a dividend or bonus in fully paid shares the declaration of the dividend or bonus makes the shareholder a creditor of the company for the amount of his proportion; the release of his claim against the company for this amount is a good and valuable consideration or set-off so as to make the shares fully paid, even though the release is compulsory.
Spicer and Pegler in their book Book-keeping and Accounts state that a bonus issue of shares adds nothing to the net assets of the company, and its effect is merely to divide the capital employed in the business into a larger number of shares. How the shares are actually issued is thus set out by the learned authors at page 26 :
'When a company has a large amount of undistributed profits, either on Reserve Account or on Profit and Loss Account, the real capital employed in the business tends to be obscured. Usually, such accumulations will have been employed in the acquisition of fixed assets, and as working capital, which will be required permanently. To bring the issued share capital into a truer relationship with the capital actually employed in the business, the accumulations can be capitalised and applied in paying up the amounts due on shares to be issued to the members as bonus shares.
No cash passes between the company and its members in respect of these transactions, the resolution to pay the bonus being so framed as to give the company authority to apply the bonus in paying up the shares.'
The authors also point out that it is usual to find that, where the shares are quoted on the stock exchange, the issue of bonus shares is a bull point, which forces up the market value of the shares and enables the shareholders, who wish to do so, to realise an immediate profit.
It is thus clear that the idea behind the issue of bonus shares is to bring the nominal share capital into line with the true excess of assets over liabilities. A company would like to have more working capital; but it need not go into the market for obtaining fresh capital by issue of further shares. The necessary money is available with it, and this money is converted into shares, which really means that the undistributed profits have been permanently 'ploughed back' into the business and converted into share capital.
It is obvious that bonus shares are not obtained by the shareholders free of any consideration. They get these shares only in lieu of dividends which might otherwise have been paid by the directors of the company. What they would have got in the shape of cash after dividends have been declared and distributed, they got in the shape of bonus shares. Gore-Brown in his book on Joint Stock Companies states thus at page 2 :
'Fully paid bonus shares are not a gift, they are merely a distribution of capitalised undivided profits.'
Palmer in his book on Company Law is also of the opinion that bonus shares are not gifts in the hands of the shareholders. At page 193, he observe :
'Shares issued for past consideration or by way of a gift cannot be treated as paid up and the allottees can be made liable to pay for them. Different is the position where bonus shares are issued because in that case the shares are fully paid up out of profits of the company available for distribution by way of dividend or otherwise available.'
Pennington in his book on Company Law states that the issue of bonus shares must be treated as an issue for a consideration other than cash. At page 276, he observe :
'It is common, however, for articles to contain a power for the company to capitalise profits or reserves, and to issue fully paid shares or debentures of a nominal value equal to the amount capitalised to its shareholders. These new shares or debentures are known as bonus shares or debentures, but the name is misleading in that it implies that they are a gift from the company. If they were a gift, they would not be paid up at all, and in the case of bonus shares, the company could call on their holders to pay for them in cash. In fact, they are not a gift, and they are paid for in full by the capitalised profits or reserves which would otherwise have been distributed to the shareholders as a cash dividend.'
It seems to us that it would be a misnomer to call the recipients of bonus shares as being donees of shares from the company. The machinery by which the bonus shares are issued is not a simple process of converting the surplus available from profit and loss account or other reserve account into capital by debiting the revenue account and by crediting the capital account. It is not a mere book entry of debit and credit that results in the issue of bonus shares. It is true that ultimately only book adjustments are made, but before this is or can be done, there must be a resolution by the shareholders by which this conversion of income or revenue of the company is transformed into capital. It may be that, as a result of the permanent acquisition of capital by drawing out from the revenue account, it would result in a great advantage and a pecuniary benefit to the company itself. It may even be that there is no law that would compel directors of a company to distributed dividends at a particular rate or percentage. But in substance and in effect, these shareholders pay for the bonus shares by agreeing to forgo what would otherwise have enured to their favour by way of distribution of dividends.
Learned counsel for the department laid considerable stress on a decision of the Bombay High Court in Emerald & Co. Limited v. Commissioner of Income-tax, in support of his contention that bonus shares are gifts, pure and simpliciter. In that case, the assessee held 350 shares in a company which included 50 free bonus shares of the face value of Rs. 250 each. The assessee sold 300 shares and claimed a loss of Rs. 35,801 by valuing the bonus shares at their face value. The department arrived at a loss of Rs. 27,766 by adopting the method of averaging the price of the shares. The Tribunal suggested a method by which the 50 bonus shares were completely ignored and the loss was arrived at by considering the purchase value of the 300 shares and the proceeds realised by their sale. On a reference to the High Court, Chagla C.J. held that, as the assessee paid nothing for the bonus shares, the price of Rs. 250 could not be put on these shares, that the method suggested by the Tribunal was erroneous, that the proper profit and loss could only be arrived at by averaging the cost of 350 shares taking into consideration the fact that 50 bonus shares were received free and that the method of valuation adopted by the department was right. At page 817, the learned Chief Justice observed as follow :
'The contention of Mr. Kolah is that although the bonus shares were given free if these shares had not been given he would have received a larger dividend and these bonus shares have been paid out of profits of the company. We are not concerned with the reason which induced the company to issue these bonus shares. The fact remains that the bonus shares were received free and the assessee-company paid nothing for the bonus shares.'
This decision was taken up on appeal to the Supreme Court and their Lordships reversed the judgment of the Bombay High Court in Emerald & Co. Ltd. v. Commissioner of Income-tax. Their Lordships held that, for the purpose of assessing the loss for the accounting year, the question of the proper method of valuing the bonus shares was not relevant, as they were not sold and were still retained in the hands of the assessee, and that the method of valuation adopted by the Appellate Tribunal was the correct method and the loss as calculated by the Tribunal was correct and according to law. The question whether bonus shares should be deemed to be gifts was, however, left open. At page 260, His Lordship Hidayatullah J. observed thu :
'He submitted that, in view of the fact that the bonus shares were still retained by the assessee-company, the profit and loss could be calculated on the basis of the cost of the other shares and their sale price, and the valuation of the bonus shares, whether at face value or at market value, or at nil or even at a notional value, did not enter into the question of the calculation of the loss in the transactions which were gone through with respect to shares actually bought and sold. He accordingly pressed us to leave the question, - whether the issuance of the fully paid bonus shares involved an expenditure on behalf of the assessee-company, - open for consideration till the bonus shares were actually sold. Till that time, he stated, the valuation in the account books of the company would be adjusted on debit and stock sides by equal entries, whatever they might be.'
In our opinion, the question as regards the value of bonus shares in the hands of the shareholders at the time of the issue, - whether it should be taken as nil or whether it should be taken as the face value or market value, - did not arise for consideration in the case before the Supreme Court as it was found that all the shares were not sold by the assessee, and that they had retained some shares even during the relevant year of account. With great respect to the learned judges of the Bombay High Court, we disagree with the view that the bonus shares are obtained free by the shareholders and that the original cost of acquisition of these shares is nothing. Having regard to the principles governing the issue of bonus shares to which we have already adverted, we have no doubt in our minds that the bonus shares are not issued free or ex gratia as the company gets an adequate quid pro quo from the shareholders.
The case of Steel Barrel Co. Ltd. v. Osborne is instructive on the question whether bonus shares can be said to have been acquired for nil value. The facts are somewhat complicated, and it is not necessary to set them out. It is enough to refer to the following observation of Lord Greene, Master of the Rolls, at page 30 :
'It was strenuously argued on behalf of the Crown that if a company acquired stock in consideration of the issue of fully paid shares to the vendor, that stock must, for the purpose of ascertaining the companys profits, be treated as having been acquired for nothing, with the result that when it comes to be sold, the revenue is entitled to treat the whole of the purchase price obtained on the sale as profit. This is a remarkable contention and it would require conclusive authority before we could accept it. The cases relied on in its support were Commissioners of Inland Revenue v. Blott and Lowry v. Consolidated African Selection Trust Ltd. neither of which, in our view, has any bearing on the point. The argument really rests on a misconception as to what happens when a company issues shares credited as fully paid for a consideration other than cash. The primary liability of an allottee of shares is to pay for them in cash; but when shares are allotted, credited as fully paid, this primary liability is satisfied by a consideration other than cash passing from the allottee. A company, therefore, when in pursuance of such a transaction agrees to credit the shares as fully paid, it is giving up what it would otherwise have had, namely, the right to call on the allottee for payment of the par value in cash.'
This case clearly supports the conclusion arrived at by us that the bonus shares cannot be called gifts in the hands of the shareholders.
It is now settled law that a bonus issued in the form of fully paid shares of the company is not income for income-tax purposes. In Commissioners or Inland Revenue v. John Blott the assessee, who was a shareholder in a limited company, obtained, in satisfaction of bonus declared out of the companys undivided profits, certain shares. The shareholders had no option to receive cash in lieu of shares in satisfaction of the bonus. The House of Lords by a majority decision (two of the Law Lords dissenting) held that the shares credited to the assessee in respect of the bonus, being distributed by the company as capital, were not income in the hands of the respondent taxable to income-tax or super-tax. The observations of Viscount Haldane appropriately described the process of the issue of bonus shares. At page 125, the learned Law Lord state :
'A shareholder is not entitled to claim that the company should apply its undivided profits in payment to him of dividend. Whether it must do so or not is a matter of internal management to be decided by the majority of the shareholers. He cannot sue for such a dividend until he has been given a special title by its declaration...... But if, acting within its powers, it disposes of these profits by converting them into capital instead of paying them over to the shareholders, that, as I conceive it, is conclusive as against all the outside world including the Crown, and the form of the benefit which the shareholder receives from the money in the hands of the company is one which is for determination by the company alone.'
This observation of Viscount Haldane was quoted with approval by Viscount Cave in Fishers case. The Judicial Committee in a case arising under the Indian Income-tax Act quoted the same observation with approval. That is the case of Commissioner of Income-tax v. Mercantile Bank of India. The facts of that case were as follow : An investment company was carrying on business in India and it capitalised its accumulated undistributed profits and issued to its shareholders bonus debentures, which were subsequently redeemed. It was held that the shareholders did not, as a result of those transactions, receive any taxable income, profits or gains within the meaning of section 4 of the Indian Income-tax Act, 1922. The personal motive or purpose of the individual shareholders, even though they held controlling interest in the company, was held to be irrelevant, if it was made out that the company had in fact capitalised the accumulated profits. The view of the Judicial Committee, therefore, was that undistributed profits of the company applied and appropriated for the issue of bonus shares would never become profits in the hands of the shareholder at all. The bonus share was held to be something in the nature of extra share certificate in the company. Indeed, this position, that bonus shares allotted to a shareholder would not represent taxable income in his hands, is conceded by learned counsel for the department.
The case of Malam v. Hitchens was relied upon by the learned counsel for the assessee for the purpose of showing that bonus shares really partook of the character of the original shares held by a shareholder. We are, however, unable to appreciate the relevancy of this citation. The question in that case was whether the bonus shares should enure in favour of a life-estate-holder to whom the shares had been given for enjoying the income from the dividend therefrom for his lifetime. On the termination of the estate-holder, there was to be a reversion in favour of other individuals. A number of cases have arisen and have been decided in England, as regards the destination of the value of the bouns shares when they are sold, whether it should go to the life-estate-holder on the footing that they represented undistributed profits of the original shares, or to the remainderman as forming part of the corpus of the original shares. In each case, the question was held to be a question of fact, whether or not profits have been capitalised. In In re Bouc : Sproule v. Bouch Fry L.J. set out the true position thu :
'When a testator or settlor directs or permits the subject of his disposition to remain as shares or stock in a company which has the power either of distributing its profits as dividend, or of converting them into capital, and the company validly exercises this power, such exercise of its power is binding on all persons interested under him, the testator or settlor, in the shares, and consequently what is paid by the company as dividend goes to the tenant for life, and what is paid by the company to the shareholder as capital, or appropriated as an increase of the capital stock in the concern, enures to the benefit of all who are interested in the capital.'
Those are cases in which there were rival claimants in respect of the proceeds of the bonus shares, the life-estate-holder claiming that the shares represented only the income, and the remainderman claiming that they represented only the capital. Such a question is wholly foreign to the scope of the present discussion. Here, the only question is as regards the quantum of capital gain realised by the assessee in disposing of the bonus shares.
Now the question is, what is the value of the bonus shares in the hands of the shareholder at the inception when they were issued and allotted to him. Capital gains represent the excess realisation made by the assessee over and above the cost of acquisition. Taking the allotment of bonus shares, it might plausibly be contended that the price paid by the shareholder is the amount of undistributed profits which he would have got if they had been distributed as dividends. But we do not think that it would be a sound way of ascertaining the true value of the bonus shares. The moment shares are issued, the recipient obtains the scrips which have a face value. Whether the shares were issued by the company at a premium or a discount, the actual share is only of the value denominated therein. There is thus a good deal to be said in favour of the view that the cost of acquisition of the bonus shares is really the face value. The other alternative is to find out the market value of the shares. On the date of the issue of the bonus shares, the original shares may have a market value. How far the issue of bonus shares would operate as a 'bull' in the market is not easy to determine. Of course, it can be safely assumed that the shares of a company, which is in a position to issue bonus shares, would normally be selling at a premium and not at a discount. We have already extracted a passage from Spicer and Peglers book on Accountancy, which expresses the view that the share value in general may go up. Gower in his book, Modern Company Law, however, observes as follows at page 10 :
'This operation can be undertaken by means of a bonus issue, that is, by issuing more shares to the existing holders and using the funds available for dividend but retained by the company to pay for them. By this means the reserve or share premium account, or some part of them, are capitalised or converted into share capital. The only result, from the shareholders point of view, is that his proportion of the capital of the business is now represented by a greater number of shares, each of which is, therefore, worth less and this may make them more readily marketable.'
In the foot-note, the following observation occur :
'Shareholders frequently do not realise this but think that they are being given a true tax-free bonus which they encash by selling the bonus shares. The word bonus is itself misleading and totally different from the sense in which it is used in America where this type of issue is described as a stock dividend. Certain English newspapers are now trying to popularise the description plough-shares, and the stock exchange now refer to capitalisation issues.'
It is therefore not possible to say with any definiteness that the value of the bonus shares is really equivalent to the value of the original shares on the date of issue. The introduction and circulation of bonus shares themselves bring about an uncertainty in the value of the shares; and, in our opinion, it is not possible to investigate the actual market value of the bonus shares eo instanti they are issued. It must also be remembered that the market value of the shares, if that would be the true cost of acquisition of the shares by the shareholders, should be that at that the time of the issue. The state of affairs at the time of the issue is that the company has in circulation only the original shares. The fresh issues in the shape of bonus shares would of course have a titling effect on the equilibrium of the value of the shares of the company in general. For example, let us take the following illustration. The share capital of a company is Rs. 1,00,000 in one rupee shares. The revenue resources available for declaration of dividend amount to Rs. 50,000. Cum-dividend the share will be worth each Rs. 1.50 nP. If bonus shares are issued at par the share capital will be increased to Rs. 1,50,000 but there will be corresponding increase of shares to 1,50,000 from 1,00,000. Each share will be worth rupee one but each shareholder will be having fifty per cent. more shares. The shareholder gains nothing. He gets more shares but the pecuniary advantage is nil. The stock market might quote a higher value for the one rupee shares on the basis of a good percentage of dividend declared in the past. After capitalisation of the profit it is reasonable to except that only a lesser dividend would be declared. This must bring down even the market quotation. But yet people might gamble on the dividend not dropping down much and stimulate a value in excess of the real value. The position on the issue of bonus shares becomes very uncertain, and the so-called market value is really a fiction. Surely, it cannot be said that the market value of the shares of the company as a whole, the original shares as well as the bonus shares obtaining a few shares after the issue, should be deemed to be the market value of the bonus shares, when they were allotted or issued to the shareholders. In these circumstances, we are clearly of opinion that it would be safe to hold that the real value of the bonus shares, as on the date of issue, would only be the face value of the shares.
We find that that is the view taken by the Patna High Court in Dalmia Investment Co. Ltd. v. Commissioner of Income-tax. The facts of that case were as follow : The assessee company dealt in shares and also held investment of shares. On January 1, 1948, the assessee had 1,10,747 shares of Rohtas Industries valued at Rs. 15,57,902. Of these shares 31,909 were bonus shares issued by the Rohtas Industries in 1945 at the face value of Rs. 10 each, and the assessee had debited the share account in respect of the bonus shares by Rs. 3,19,090 with a corresponding entry in the capital reserve account for the same amount. On January 29, 1948, the assessee sold the entire lot of 1,10,747 shares for Rs. 15,50,458 and claimed a loss of Rs. 7,444. The Appellate Tribunal valued the bonus shares at nil and held that the assessee had made a profit of Rs. 3,11,646. On a reference, the Patna High Court held that the bonus shares were not issued by the company free to it s shareholders, as the consideration for the issue of the bonus shares was the dividend or bonus which was provided and declared by the company out of its undistributed profits. The High Court, further, held that the real cost of the bonus shares to the assessee was the face value of the shares and the Tribunal was wrong in holding that the assessee had made a profit of Rs. 3,11,646. The Patna High Court dissented from the view of the Bombay High Court in Emerald & Co. v. Commissioner of Income-tax . We respectfully agree with the view taken by the Patna High Court.
In our opinion, the Tribunal is in error in directing a fresh computation of capital gain by valuing the closing stock as the original cost of the holding averaged for the original and bonus scrips since issued or at the market price whichever is lower. The true criterion is to take the face value of the bonus shares and to ascertain the excess, if any, realised by the assessee by the sale of these shares in the year of account. We, therefore, answer the question referred to us in the following manne : The sum of Rs. 7,269 cannot be taxed in its entirety as capital gains under section 12B of the Act. What could be brought to tax under that provision is only the excess of Rs. 7,269, if any, over the face value of the 94 bonus shares held and disposed of by the assessee. The reference is answered accordingly. There will be no order as to costs.
Reference answered accordingly.