REPORTABLE

IN THE SUPREME COURT OF INDIA

CIVIL APPELLATE JURISDICTION

CIVIL APPEAL NO.  6654  OF 2008 (arising out of S.L.P. (C) No. 19926/07)

Khoday Distilleries Ltd. … Appellant

            versus

Commissioner of Income Tax and Anr.          … Respondent

J U D G M E N T

S.H. KAPADIA, J.

Leave granted.

2. This civil  appeal filed by the assessee seeks to challenge judgment

and order passed by the Karnataka High Court dated 1.8.2007 in Gift Tax

Appeal No. 2/02. In this civil appeal we are concerned with the assessment

year 1987-88.

3. Two questions arise for determination in this civil appeal, which are

as follows:

(i) Whether any “gift” arose in terms of Section 2(xii) of  the  Gift-tax  Act,  1958  (“1958  Act”)  on  the allotment of rights issue by the appellant company

to its shareholders vide Board’s Resolution dated 29.1.1986?

(ii) Whether  there  was  any  element  of  “gift”  as defined  under  Section  2(xii)  in  the  appellant issuing  Bonus  shares  in  the  ratio  of  1:23  in April/May, 1986?

Answer to Question No. 1:

4. On 29.1.1986 the appellant company, on the other shareholders not

exercising the option given to them to take up the right shares issued by the

appellant, allotted them to the seven investment companies, who were the

shareholders in the appellant’s company. At this stage, it may be stated, that

in all  there were twenty-seven shareholders.  Twenty shareholders did not

subscribe  to  the  rights  issue  and  consequently  the  appellant-company

allotted them to the remaining existing shareholders. The A.O. held that the

said allotment by way of rights issue was without adequate consideration

within the meaning of Section 4(1)(a) of the 1958 Act. He further held that

the modus operandi was an attempt to evade taxes; that it was a colourable

transaction  and  since  the  shares  allotted  were  without  adequate

consideration, there was a deemed gift under Section 4(1) of the 1958 Act.

Accordingly, the difference between the value of the shares on yield basis

and the face value of Rs. 10/- at which the shares were allotted was sought

to be brought to tax under the said section. Aggrieved by the decision of the

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A.O., the appellant carried the matter in appeal to CIT(A). It was held that

the entire  exercise  undertaken by the  appellant  was to evade payment of

wealth tax by the individual  shareholders  of the appellant-company. This

finding  was  given  by  the  CIT(A)  on  the  ground  that  right  shares  were

allotted  because  20  existing  shareholders  out  of  27  shareholders  of  the

company did not subscribe for the rights. However, according to the CIT

(A), gift tax proceedings had to be initiated by the Department not against

the appellant  company but  it  ought to have initiated gift  tax proceedings

against the existing shareholders who had renounced their rights. Having so

held, the CIT(A) came to be conclusion that the entire exercise undertaken

by the appellant was to avoid payment of wealth tax and, therefore, it was

held  that  the  company was  liable  to  pay gift  tax  for  transfer  of  the  said

shares  to  the  seven  investment  companies.  This  decision  of  the  CIT(A)

stood  reversed  by  the  Tribunal  which  decided  the  appeal  filed  by  the

company against the Department. The Tribunal came to the conclusion that

the allotment of rights  by the appellant did not constitute “transfer” as it did

not involve any existing property at the time of such allotment. According

to the Tribunal, the seven investment companies made payment towards the

face value of the shares and, consequently, it cannot be said that the contract

was without consideration. It was further held that in this case there was no

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element of gift under Section 4(1)(a) as there was no transfer of property as

defined under Section 2(xxiv) of the 1958 Act. Aggrieved by the decision of

the Tribunal, the Department preferred Gift Tax Appeal No. 2/02, which,

vide the impugned judgment, stood disposed of in favour of the Department,

hence, this civil appeal.

5. Shri Soli J. Sorabjee, learned senior counsel appearing on behalf of

the appellant, submitted that gift tax is not attracted on initial allotment of

shares  because  there  is  no  transfer  of  any  existing  movable  property,

namely, the shares. According to the learned counsel, till allotment is made,

shares did not exist. It is only on allotment that shares come into existence.

In this connection, learned counsel placed reliance on the judgment of this

Court  in the case of  Sri Gopal Jalan & Company  v.  Calcutta Stock

Exchange Association Ltd. reported in 1964 (3) SCR 698. He also relied

upon the judgment of this Court in the case of Sangramsinh P. Gaekwad

and ors.   V.  Shantadevi  P.  Gaekwad (Dead)  through LRs.  and ors.

reported  in  (2005)  11  SCC 314.  Learned  counsel  further  submitted  that

there is a vital difference between tax planning and tax evasion. According

to  the  learned  counsel,  it  is  perfectly  legitimate  and  permissible  for  an

assessee to so arrange his affairs with a view to reduce its tax liability and

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such tax planning cannot be equated with tax evasion. In this connection,

learned counsel submitted that the transaction in question was not sham or

fictitious but real and it was given effect to. Moreover, it was contended that

the stand taken by the Department, in this case, was conflicting inasmuch as

according to the A.O. what was intended to be evaded was income-tax by

the Directors of the appellant-company whereas, according to the CIT(A),

the exercise undertaken by the appellant-company was to evade wealth tax.

Learned  counsel  submitted  in  the  alternative  that  even  assuming  whilst

denying that there was an intention to evade income tax or wealth tax, the

correct course open to the Department was to include the income or wealth

in the income tax or wealth tax assessment of the concerned assessee. For

the  aforestated  reasons,  learned  counsel  submitted  that  the  High  Court

should not have interfered with the decision of the Tribunal.

6. Shri  Mohan  Parasaran,  learned  Additional  Solicitor  General,

appearing on behalf of the Department submitted that allotment of shares on

rights  basis  under  Section  81  of  the  Companies  Act,  1956  would  come

under the concept of “deemed gift” under Section 4(1)(a) of the Gift-tax

Act. According to the learned counsel, no sooner a declaration is made by

the Board of Directors announcing issue of  rights,  a right  accrues to the

existing shareholders either to opt for rights or to renounce it in favour of

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existing shareholders. In this connection, learned counsel submitted that no

sooner  the  Board  of  Directors  decide  to  issue  rights,  the  existing

shareholders who are offered rights get a tangible right to opt for allotment

or they could renounce it in favour of existing shareholders and as and when

said option is exercised, the right gets crystallized and, therefore, in such

cases where renouncement takes place on exercise of the option in favour of

the existing shareholder(s) there would be a transfer of an existing interest,

which  transfer  would  attract  Section  4(1)(a)  of  the  Gift-tax  Act.  In  this

connection, learned counsel placed heavy reliance on the judgment of the

Madras  High  Court  in  the  case  of  S.R.  Chockalingam  Chettiar   v.

Commissioner of Gift-Tax reported in (1968) 70 ITR 397.

7. At the outset, we may state that none of the above arguments have

been considered by the High Court in its impugned judgment. In the case of

Sri Gopal Jalan & Company (supra) a question arose as to the meaning of

the  word  “allotment”.  It  was  held  that  in  Company  Law  the  word

“allotment” means appropriation out of previously unappropriated capital of

a  company,  of  a  certain  number  of  shares,  to  a  person  and  till  such

allotment, the shares do not exist as such. It is only on allotment that the

shares  come  into  existence  and  in  every  case  the  words  “allotment  of

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shares” have been used to indicate the creation of shares by appropriation

out of the unappropriated share capital to a particular person.

8. In  our  view,  the  judgment  of  this  Court  in  Sri  Gopal  Jalan  &

Company (supra)  squarely  applies  to  the  present  case.  There  is  a  vital

difference  between  “creation”  and  “transfer”  of  shares.  As  stated

hereinabove, the words “allotment of shares” have been used to indicate the

creation of shares by appropriation out of the unappropriated share capital

to a particular person. A share is a chose in action. A chose in action implies

existence of some person entitled to the rights in action incontradistinction

from rights in possession. There is a difference between issue of a share to a

subscriber and the purchase of a share from an existing shareholder. The

first case is that of creation whereas the second case is that of transfer of

chose in action. In this case, when twenty shareholders did not subscribe to

the  rights  issue,  the  appellant  allotted  them  to  the  seven  investment

companies, such allotment was not transfer. In the circumstances, Section 4

(1)(a) was not applicable as held by the Tribunal.

9. Since  heavy  reliance  is  placed  by the  learned  Additional  Solicitor

General  on  the  judgment  of  the Madras  High  Court  in  the case  of  S.R.

Chockalingam Chettiar (supra), we may state that the said judgment has

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no application to the facts of the present case. In that case, the facts were as

follows. Appellant was a shareholder of S.R.C.M. Ltd.. Appellant was an

assessee. Appellant was entitled to apply for 800 equity shares in a fresh

issue  of  capital  by the  company with  a  option  to  renounce  the  same as

provided  for  in  Section  81  of  the  Companies  Act,  1956.  On  15.6.1957,

appellant  renounced  these  shares  in  favour  of  S,  who  applied  for  those

shares on the strength of the renunciation. The Gift-tax Officer held that the

renouncement involved the gift of a valuable right and, evaluating the value

of the gift as the difference between the market value of the shares on the

date of renunciation (15.6.1957) and the value at which they were issued to

the existing shareholders, levied gift tax on the total amount. On Reference

to the High Court, it was held that the right to obtain a specified number of

right shares under Section 81 of the Companies Act in the fresh issue of

capital is a tangible right and is not an interest in future property but it is

existing property as defined in the Gift-tax Act and, therefore, Tribunal was

right  in  directing  the  Gift-tax  Officer  to  levy  gift  tax  on  the  market

quotations of the rights. This judgment has no application to the facts of the

present  case.  In  the  case  of  S.R.  Chockalingam  Chettiar (supra),  the

assessee was an individual shareholder, who was held to be a donor. In that

case, the company allotting the shares was not treated as an assessee under

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the Gift-tax Act. The liability under the Gift-tax Act to pay the gift tax is on

the donor. In the present case, one fails to understand how the appellant-

company  could  be  treated  as  donor.  S.R.  Chockalingam Chettiar  was  a

shareholder of S.R.C.M. Ltd. and he was sought to be assessed under the

Gift-tax and not S.R.C.M. Ltd.. Therefore, judgment in S.R. Chockalingam

Chettiar has no application.

10. There is a difference between “renunciation” and “allotment”. In this

case, the Department has confused the two concepts. The judgment of the

Madras High Court in the case of  S.R. Chockalingam Chettiar  (supra)

dealt  with  the  case  of  renunciation  in  which  case  under  certain

circumstances the renouncer could be treated as a donor liable to be taxed

under Section 4(1)(a) of the Gift-tax Act,  1958. That  is  not  the situation

here. In the present case, the Department has sought to tax the appellant-

company  as  a  donor  under  the  1958  Act  for  making  allotment  of  right

shares. The Department has not taxed the renouncer shareholders despite the

decision  of  CIT(A).  Allotment  is  not  a  transfer.  Moreover,  there  is  no

element of existing right in the case of allotment as required under Section 2

(xii)  of  the  1958  Act.  In  the  case  of  renunciation  for  inadequate

consideration  in  a  given  case  Section  4(1)(a)  could  stand  attracted.

However,  in  such  a  case,  the  Department  has  to  proceed  against  the

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renouncer (shareholder). For the above reasons, the judgment of the Madras

High Court in S.R. Chockalingam Chettiar  case has no application.

11. One more aspect needs to be mentioned. As stated above, in this case,

even  according  to  CIT(A),  the  right  shares  were  allotted  to  the  seven

investment  companies  because  the  other  existing  shareholders  did  not

subscribe  for  the  shares.  According  to  CIT(A),  the  gift  tax  proceedings

ought  to  have  been  initiated  against  the  existing  shareholders,  who  had

renounced their rights. We are surprised that despite the orders passed by

CIT(A), the Department did not initiate proceedings under the Gift-tax Act

against the shareholders who had renounced their rights, particularly when

the CIT(A) has specifically said so in her order. For the aforestated reasons,

we  hold  that  the  word  “allotment”  indicates  creation  of  shares  by

appropriation out of the unappropriated share capital to a particular person

and  that  such  creation  did  not  amount  to  transfer.  That,  in  any  event,

liability to pay gift tax would be on the donor (shareholder) who exercises

the  option  to  renounce  and  not  on  the  appellant-company.  Accordingly,

question  no.  1  is  answered  in  favour  of  the  appellant  and  against  the

Department.

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Answer to Question No. 2:

12. The second issue to be decided is whether there is element of “gift” in

the appellant issuing bonus shares in the ratio of 1:23 in April/May, 1986.

In addition to the levy of gift tax on the allotment of right shares, the A.O.

levied gift tax on the bonus shares issued later by the appellant.

13. When a company is  prosperous and accumulates  a large surplus,  it

converts  this  surplus  into  capital  and  divides  the  capital  amongst  the

members in  proportion to their  rights.  This is done by issuing fully paid

shares  representing  the  increased  capital.  The  shareholders  to  whom the

shares are allotted have to pay nothing. The purpose is to capitalize profits

which may be available for division. Bonus shares go by the modern name

of  “capitalization  shares”.  If  the  Articles  of  a  company  empowers  the

company, it can capitalize profits or reserves and issue fully paid shares of

nominal value, equal to the amount capitalized, to its shareholders. The idea

behind the issue of bonus shares is to bring the nominal share capital into

line with the 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 issuing fresh shares. The necessary money is available with it and

this  money  is  converted  into  shares  which  really  means  that  the

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undistributed  profits  have  been  ploughed  back  into  the  business  and

converted into share capital. Therefore, fully paid bonus shares are merely a

distribution of capitalized undivided profit. It would be a misnomer to call

the recipients of bonus shares as donees of shares from the company.

14. Our  aforesaid  view,  namely,  that  bonus  shares  go  by  the  modern

name of “capitalization shares” finds support in the judgment of this Court

in the case of Hunsur Plywood Works Ltd.  v.  Commissioner of Income-

tax reported in (1998) 229 ITR 112. The relevant portion of which reads as

under:

“…The issuance of bonus shares was nothing but mere capitalisation of the profits of the Company in respect of which certificates  are  issued  to  the  shareholders  entitling  them  to participate in the amount of the reserve but only as part of the capital.

The mechanism and effect  of issuance of bonus shares have  been  explained  by  the  English  courts  in  a  number  of cases.

Lord Haldane in the case of IRC v. Blott (1921) 2 AC 171 (HL) held (page 184):

“My Lords, for the reasons I have given I think it is, as matter of principle, within the power of an ordinary joint stock company with articles  such as those in the case before us to determine conclusively against the whole world whether it will withhold  profits  it  has  accumulated  from distribution  to  its shareholders  as  income,  and  as  an  alternative  not  distribute them at all, but apply them in paying up the capital sums which shareholders  electing  to  take  up  unissued  shares  would otherwise  have  to  contribute.  If  this  is  done,  the  money  so applied is capital and never becomes profits in the hands of the

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shareholder at all. What the latter gets is no doubt a valuable thing. But it is a thing in the nature of an extra share certificate in the company.”

In that  case, Viscounts  Haldane,  Finlay and Cave held that an amount equal to the face value of the shares could not be regarded as received by the shareholders. A contrary view was taken by Lord Dunedin and Lord Sumner who held that the word “capitalisation” was somewhat hazy and the amount that was capitalised had to be treated as to have been paid to the shareholders.

In  the  case  of  Commissioners  of  Inland  Revenue  v. Fisher’s Executors (1926) AC 395 (HL), Viscount Cave dealt with  the  case  of  a  company  which  had  large  undistributed profits.  It  decided  to  capitalise  a  part  of  these  profits  and distribute  it  pro  rata  among  the  ordinary  shareholders  as  a bonus in the form of five per cent debenture stock. The stock was duly issued, conditions providing that the Company might redeem the stock after a certain time and in certain events. The question that came up for decision was whether the bonus paid in the form of debenture stock was income in the hands of the shareholders and was, therefore, liable to super tax. Viscount Cave held (page 404):

“The  whole  transaction  was  ‘bare  machinery’  for capitalizing profits and involved no release of assets either as income or as capital.”

In coming to this conclusion, Viscount Cave relied upon the following observation of Lord Finlay in Blott’s case:

“The  general  scope  and  effect  of  these  transactions  is beyond  dispute.  There  was  an  increase  in  the  capital  of  the company  by  the  retention  of  the  amounts  available  for dividends.... The use of the sums which had been available for dividend to increase capital would enable the company to carry on  a  larger  and  more  profitable  business,  which  might  be expected  to  yield  larger  dividends.  The  dividends,  however, were to be in the future. So far as the present was concerned there  was  no  dividend  out  of  the  accumulated  profits;  these were  devoted  to  increasing  the  capital  of  the  company.  The company  had  power  to  do  what  it  pleased  with  any  profits which it might make. It might spend the accumulated profits in the improvement  of  the company’s works  and buildings  and

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machinery.  These  improvements  might  lead  to  a  great accession of business and increase of profits  by which every shareholder  would  benefit,  but  of  course  it  could  not  for  a moment  be  contended  that  such  a  benefit  would  render  him liable to super tax in respect of it. The benefit would not be in the  nature  of  income,  and  super  tax  can  be  levied  only  on income.”

In our  view,  the principle  stated by Lord Finlay really resolves the controversy raised in this case. The profits made by the Company may be distributed as dividends or retained by the  Company  as  its  reserve  which  may  be  used  for improvement  of  the  Company’s  works,  buildings  and machinery.  That  will  enable  the  Company  to  make  larger profits. There cannot be any dispute that the shareholders will benefit  from the  improvements  brought  about  in  the  profit- making  apparatus  of  the  Company.  Likewise,  if  the accumulated  profits  are  capitalised  and  capital  base  of  the Company is enlarged, this may enable the Company to do its business more profitably. The shareholders will also benefit if the share capital is increased. They may benefit immediately by issue of bonus shares. But neither in the case of improvement in the profit-making apparatus nor in the case of expansion of the  share  capital  of  the  Company,  can  it  be  said  that  the shareholders  have  received  any  money  from  the  Company. They may have benefited  in  both  the cases.  But  this  benefit cannot be treated as distribution of the amount standing to the credit of any reserve fund of the Company to its shareholders.

In fact, the transfer of the amounts standing to the credit of  development  rebate  reserve  to  the  share  capital  account, does not involve any disbursement of money by the Company. Nothing  comes  out  of  the  till  of  the  Company  to  the shareholder.  The  entire  amount  of  money  shown  as development  rebate  reserve  is  retained  by  the  Company  in another account.  It  cannot be said that by the issue of bonus shares,  the  Company  had  distributed  its  reserve  fund  to  the shareholders even though it had retained the entire amount with it in the share capital account.

It must also be noted that while dealing with the question of  valuation  of  bonus  shares  in  the  case  of  CIT  v.  Dalmia Investment Co. Ltd. (1964) 52 ITR 567 (SC),  Hidayatullah, J. (as  His  Lordship  then  was),  after  referring  to  Blott’s  case, preferred the view expressed by Viscounts Haldane, Finlay and Cave to the dissenting view taken by Lord Dunedin and Lord

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Sumner.  Dealing  with  the  effect  of  issue  of  bonus  shares, Hidayatullah,  J.  held  that  “the  floating  capital  used  in  the Company which formerly consisted of subscribed capital  and the  reserves  now  becomes  the  subscribed  capital”  of  the Company.  The  certificates  in  the  hands  of  the  shareholders were property from which income will be derived in future.

Hidayatullah  J.,  in  Dalmia  case,  also  quoted  with approval a passage from a decision of the Supreme Court of the United States, Eisner v. Macomber (1920) 252 U.S. 189:

“A stock dividend really takes nothing from the property of  the  corporation,  and  adds  nothing  to  the  interests  of  the shareholders. Its property is not diminished, and their interests are  not  increased.  ...  The  proportional  interest  of  each shareholder  remains  the  same.  The  only  change  is  in  the evidence which represents that interest, the new shares and the original  shares  together  representing  the  same  proportional interest that the original shares represented before the issue of the new ones. ... In short, the corporation is no poorer and the stockholder is no richer than they were before. ... If the plaintiff gained any small advantage by the change, it certainly was not an  advantage  of  £  417,450  the  sum  upon  which  he  was taxed.  ...  What  has  happened  is  that  the  plaintiff’s  old certificates have been split up in effect and have diminished in value to the extent of the value of the new.”

When a shareholder gets a bonus share the value of the original share held by him goes down. In effect, the shareholder gets two shares instead of the one share held by him and the market value as well as the intrinsic value of the two shares put together will be the same or nearly the same as the value of the original share before the bonus issue.

It appears from the various decisions cited hereinabove, that issuance of bonus shares does not amount to distribution of accumulated  profit  of  a  company.  The  shareholder  derives some benefit by the process of capitalising of the accumulated profits  but  at  the  same  time,  the  value  of  his  original shareholding goes down.”

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15. One of the points  raised on behalf  of the Department was that  the

entire  exercise  undertaken  by  the  appellant  constituted  tax  evasion.

According  to  the  Department,  by  a  paltry  investment  of  Rs.  10  lacs

(approximately)  the  seven  investment  companies  became  owners  of

24,00,168 shares  of  M/s  Khodey Distilleries  Ltd.  worth  Rs.  2,40,01,680.

According to the Department, the market value of the said shares and the

yield from the said shares were totally disproportionate to the investments

made  by  the  seven  investment  companies.  Therefore,  according  to  the

Department, the modus operandi adopted by the appellant was an exercise

in tax evasion.

16. As stated above, we do not know the reason why the Department had

not  proceeded  under  the  Income-tax  Act,  1961  if,  according  to  the

Department,  the  case  was  of  tax  evasion.  According  to  the  CIT(A),  the

appellant had undertaken an exercise to avoid wealth tax whereas according

to the A.O. the exercise undertaken by the appellant was to evade Gift Tax

and in the same breadth the A.O. states that the entire exercise was to evade

tax  by  allotting  shares  to  the  Directors  which  attracted  the  deeming

provisions  of  Section  2(22)  of  the  1961  Act  (see  page  35  of  the  Paper

Book). There is utter confusion on this aspect. Therefore, in our view, on

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the  question  of  evasion  of  tax,  the  contention  of  the  Department  is

conflicting.  In  fact,  as  stated  above,  the  Department  has  messed  up  the

entire case. The Department has not kept in mind the difference between

“allotment”  and  “renunciation”.  The  Department  has  not  invoked  the

provisions of the Gift-tax Act against the renouncer shareholder despite the

observation of the CIT(A) in that regard.

17. None of the above aspects has been dealt with by the High Court in

its impugned judgment.

18. For the aforestated reasons, the impugned judgment of the High Court

is set aside and the civil appeal filed by the assessee stands allowed with no

order as to costs.    

……………………………J.                                      (S.H. Kapadia)

……………………………J.                                                 (B. Sudershan Reddy)

New Delhi; November 14, 2008.

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