[Unnati Ghia is a 4th year BA LLB (Hons.) student at National Law School of India University, Bangalore]
There is no steadfast rule or statutory provision governing the taxation of bonus shares, save for its statutory exclusion from the category of ‘dividends’. This category of shares has presented a dilemma to both the Revenue and the judiciary in multiple instances, given that determining costs, ownership and character in the context of bonus shares depends solely on the facts and circumstances of a particular case.
This is not to say that the legislature and Department of Revenue have not made attempts to regulate this field. For example, in 1964, bonus shares were made taxable as capital gains at their fair market value by way of amendments to section 45 of the Income Tax Act, 1961. However, this was quickly abolished by 1966. These attempts continue today, with a case in point being the 2017 Central Board of Direct Taxes notification that exempts bonus shares from payment of long term capital gains tax, despite there being no payment of securities transaction tax on the same.
However, the principles governing bonus shares have also been supplemented by judicial reasoning. One such instance is the oft-cited decision of the Supreme Court in CIT v. Madan Gopal Radhey Lal ([1969] 73 ITR 652). This post argues that reasoning of the Supreme Court in Madan Gopal Radhey Lal is inadequate in that it does not clarify the character of bonus shares and how one may obtain their cost of acquisition.
Background to the case
The assessees dealt in shares and securities and, in the relevant assessment years, they had held certain shares as stock-in-trade. The assessees also received bonus shares proportionate to their holdings, which they sold from time to time. The Income Tax Officer held that the sale proceeds were receipts that formed a part of the assessees’ income from their share trading, and this order was upheld by the Appellate Assistant Commissioner and Income Tax Tribunal.
The question posed to the Supreme Court was whether the sale proceeds of bonus shares, which were a part of the assessees’ stock-in-trade shares, are to be included within the assessees’ incomes as profits of the share dealing business.
Bonus shares and business income
Bonus shares can be taxed in two ways. First, if they have been held as an investment, any profit from the sale of these shares could be taxed as capital gains under sections 45 and 48 of the Income Tax Act. Second, if the business of the assessee is to trade in shares and securities, then the sale could be taxed as business income under section 28.
More importantly, in the context of shares, the profit or loss on the sale of shares of shares would be capital if the seller is an investor capitalizing on its holding, but revenue if it carries on a business in shares or its dealing constitutes an activity in the nature of trade.[1] In this context, the Supreme Court’s reasoning in Madan Gopal Radhey Lal is unclear, because it classified bonus shares as capital rather than an accretion to the stock-in-trade despite the fact that the assessee was a dealer in shares. The rationale applied was that a dealer in shares could have acquired the bonus shares apart from its business, and there is no presumption that every commodity acquired is for the purpose of the business. In doing so, the Court shifted the burden of proof to the Revenue to prove that the assessee had treated the shares as stock-in-trade, with the default assumption being that the bonus shares were capital. The case referred to was Commissioner of Inland Revenue v. John Blott [1921] 8 TC 101 (House of Lords) which may be relied upon to say that bonus shares are generally capital and not revenue, but it cannot hold true in situations in which the assessee is dealing in shares with a view of short term profits and gains.
Subsequent Developments
The decision of the Delhi High Court in Commissioner of Income Tax, Delhi v. Om Prakash Arora (2014 Indlaw DEL 1507) clarified in which situations bonus shares would be business income. The Court relied on the factors determinative of whether income gained from the purchase or sale of shares is business income or capital gains, as laid down by the Supreme Court in decisions such as Raja Bahadur Visheshwara Singh v. Commissioner of Income Tax, Bihar ([1961] 41 ITR 685) and Commissioner of Income Tax, Calcutta v. Associated Industrial Development Company ([1971] 82 ITR 586), which had subsequently been encapsulated into CBDT Circular No. 4/2007. These factors included:
(i) The intention of the assessee at the time of purchase,
(ii) Whether the money to purchase the shares had been borrowed (which would be indicative of trade and not investment),
(iii) The frequency and volume of dealing in shares,
(iv) Whether the purchase/sale was made for the purpose of realizing profit, and
(v) Whether the items were valued at cost or market value.
Relying on these factors, the Court held that there was no factor that pointed towards the assessee engaging in share trading, and therefore the proceeds were short term capital gains.
These observations were absent in Madan Gopal Radhey Lal, which raises question as to how the Supreme Court was able to decide on the fact that the bonus shares in that case were taxable as business income under the Income Tax Act.
The cost of acquisition of bonus shares
For both kinds of taxation (capital gains and business income), determining the cost of acquisition of these shares is crucial. In case of capital gains, to determine whether there has been a gain made from the transfer of the capital asset under sections 45 and 48 of the Income Tax Act, and in the context of business income to determine profits under section 28(1). The Supreme Court in Madan Gopal Radhey Lal makes no observation on this question, but there have been both prior and subsequent cases that have discussed how to determine the cost of acquisition.
In Commissioner of Income Tax, Bihar v. Dalmia Investment Company Limited ([1964] 52 ITR 567), the assessee was holding the original and bonus shares as an investment but also as a stock in trade for his business. The question arose whether the Appellate Commissioner’s characterization of the value of the bonus shares as nil was correct. The Supreme Court in this case considered multiple methods of finding the cost of bonus shares. First is the method adopted by the Bombay High Court in the case of CIT v. Maneklal Chunilal and Sons Ltd, which is a method of averaging the cost across both the original and bonus shares collectively. Alternative methods included taking the face value of the bonus shares, as entered into the company’s books of account, taking the cost at nil and, lastly, finding the fall in the price of the original shares and attributing that fall to the issue of bonus shares (as suggested by the Revenue). However, the Court noted that the assessee had made no payment for the same, yet the cost could not be taken to be nil, for that would mean that the entire sale proceeds would be taxable.
Ultimately, the Court decided the cost in line with the rationale laid down by the Supreme Court in the Commissioner of Income Tax v. Bai Shirinbai K. Kooka ([1962] Supp. 3 SCR 391)where the Court held that profits must be determined keeping in mind the accounts of business and commercial principles. In this context, it held that the valuation should be carried out by the averaging method, if the shares ranked pari passu, and if they did not, then the price would have to be adjusted accordingly.
This principle has been extended to cover other situations concerning bonus shares. In Commissioner of Income Tax, Madras v. T.V.S. and Sons Ltd ([1983] 143 ITR 644), the Madras High Court held that in a situation where the entire block of shares have been sold, there was no reason behind determining the cost of the bonus share specifically and, instead, the cost of the original shares is to be taken as the total cost of acquisition in the case of capital gains.
An anomalous situation arose in the case of Shekhawati General Traders Limited v. Income Tax Officer, Company Circle I, Jaipur ([1971] 82 ITR 788) in the context of capital gains derived from bonus shares. The Supreme Court relied on sections 48 and 55(2)(i) of the Income Tax Act for the definition of the ‘cost of acquisition’ as the fair market value of the asset on the 1st day of January 1954. The Court distinguished the present case from Dalmia Investment to hold that bonus shares acquired subsequent to the statutory cut off date would not be taken into consideration on a strict application of section 55(2)(i). This case ostensibly removed the application of the averaging method in the context of capital gains, until another decision of the Supreme Court with an identical factual scenario in Messrs Escorts Farms (Ramgarh) Limited v. Commissioner of Income Tax, New Delhi ([1996] 222 ITR 509). Here, the Supreme Court distinguished Shekhawati by stating that, in that case, the assessee was bound by and had opted for the statutory cost of acquisition in which case the subsequent issue of bonus shares would not impact the issue. The Court went on to state that, as a general principle, the ratio in Dalmia Investment would continue to apply to cases where the assessee did not opt for the statutory cost of acquisition. It also stated that in such a general scenario there is no distinction between the character of the owner of the shares- either as an investor or a dealer.
Therefore, across a variety of factual scenarios, the cost of acquisition has been an important factor in the computation of profits or gains in relation to bonus shares, and the silence of the Supreme Court in Madan Radhey Gopal Lal on this specific point is problematic.
– Unnati Ghia
[1] Kanga, Palkhivala and Vyas, The Law and Practice of Income Tax, (Dinesh Vyas ed., 9th edn., Lexis Nexis, 2004) Volume I, 234-236.