Revenue Can't Characterize Preference Shares As Debt Instrument Ignoring Legal Consequences: ITAT

The Bench of N.V. Vasudevan (Vice President) and Padmavathy S (Accountant Member) held that the revenue authorities cannot disregard the legal effect of issue of cumulative preference shares, and that they cannot ignore the legal consequences of a document by characterizing a share as a debt instrument.

Thus, the Tribunal set aside the additions made by the revenue department to the assessee's income, being the notional premium accrued on preference shares, by treating the preference shares as a debt instrument.

The assessee- M/s. Enzen Global Solutions Pvt. Ltd., invested an amount in the preference shares of a Private Limited Company. In its income tax return, the assessee declared an amount being the premium accrued on the redemption of preference shares under the head "Income from other sources". The assessee filed a revised return of income, reducing the amount of premium offered to tax. The assessee contended that only the premium actually received by it on redemption, is liable to be taxed at the time of redemption of preference shares under the head "Capital Gains".

The Assessing Officer (AO) opined that the preference shares issued to the assessee contained features of both an equity and a debt instrument, since the amount of dividend payable to the preference shareholders/assessee was fixed from the beginning.

The AO ruled that since the assessee was entitled to a fixed rate of premium/ dividend on the cumulative preference shares issued to it, the said shares were akin to a debt instrument. Hence, the AO held that the taxability of the premium accrued to the assessee did not depend upon its receipt by the assessee.

Accordingly, the AO passed an order, taxing the premium on preference shares accrued to the assessee, under the head 'Income from Other Sources'.

Against this, the assessee filed an appeal before the Commissioner of Income Tax (Appeals) (CIT(A)). The assessee submitted before the CIT(A) that the premium received by the assessee at the time of redemption is not a revenue receipt but a capital receipt, which is exigible to tax under the head 'Income from Capital Gains'. Further, the assessee submitted that the premium on the preference shares is not taxable on accrual basis and that it is liable to tax only when it is actually received on the redemption of the shares.

The CIT(A) held that the characteristics of the preference shares issued to the assessee gave it a nature of a hybrid instrument, i.e., a combination of both a debt and an equity instrument. Thus, the CIT(A) upheld the order of the AO, treating the non-convertible redeemable preference shares as a debt instrument and taxing the premium on accrual basis under the head 'Income from other sources'.

Against this, the assessee filed an appeal before the ITAT.

The assessee- M/s. Enzen Global Solutions, submitted before the ITAT that the preference shares cannot be treated as a debt of the company. The assessee added that though the preference shareholders have a preference over the equity shareholders with respect to the return of capital, however, the preference shareholders cannot be regarded as a debtor of the company and thus, the preference shares cannot be regarded as a debt.

To this, the revenue department averred that as per the share subscription agreement, the preference shares issued to the assessee were redeemable at a particular price and the premium on such shares accrued to the assessee on a year-to-year basis, which were payable to it on the redemption date. Hence, the department contended that the assessee was entitled to the dividend / interest income on accrual basis and thus, the premium attributable to the previous year ought to have been offered to tax by the assessee.

While holding that the assessee was only a preference shareholder, the ITAT ruled that the assessee cannot be called a debtor of the company that issued the redeemable preference shares and that the assessee was not entitled to claim the redemption premium as a matter of right.

"In our view the revenue authorities cannot disregard the legal effect of issue of cumulative preference shares and say that the same is akin to debt and therefore the cumulative preference shares which is a capital instrument is a debt or in the nature of debentures", the Tribunal held.

The Tribunal, referring to the decision of the Bombay High Court in CIT versus Enam Securities Pvt. Ltd. (2012), observed that the Income Tax Act, 1961 does not contain a definition of bonds or debentures, and that there is a clear distinction between bonds and debentures on one hand, and preference shares on the other.

Hence, the ITAT ruled that the revenue authorities cannot disregard the legal effect of a document that evidences the assessee as holding the shares of a limited liability company. The Tribunal added that the legal consequences of such a document cannot be ignored by the revenue department and a share cannot be recharacterized as a debt instrument.

"…the revenue authorities cannot disregard the legal effect of a document evidencing a debt and that which evidences holding shares in a limited liability company. The legal consequences thereof cannot be ignored and a share characterized as a debt instrument."

While holding that the premium on redemption of preference shares is exigible to tax under the head 'Income from Capital Gains', the ITAT held that the revenue authorities were not justified in making the additions to the assessee's income on the ground of notional premium receivable on preference shares. Hence, the ITAT allowed the appeal of the assessee.

Case Title: M/s. Enzen Global Solutions Pvt. Ltd. versus ITO

Dated: 19.09.2022 (ITAT Bangalore)

Representative for the Assessee/ Appellant: Mr. V. Chandrashekar, Advocate

Representative for the Revenue Department/ Respondent: Mr. Manjunath Karkihalli, CIT(DR)

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