MESSRS EBRAHIM BROS. VS COMMISSIONER OF INCOME-TAX, CENTRAL ZONE B', KARACHI
1991 P T D 374
[Karachi High Court]
Before Nasir Aslam Zahid and Mukhtar Ahmed Junejo, JJ
Messrs EBRAHIM BROS.
versus
COMMISSIONER OF INCOME-TAX, CENTRAL ZONE B', KARACHI
I.T.R. No.83 of 1982, decided on 10/01/1991.
Income-tax Act (XI of 1922)---
----Ss. 12-B & 66(1)---Capital gain---Bonus shares---Method of computing the cost of bonus shares---Cost price of business shares to the assessee was to be determined by spreading the cost of ordinary shares of the same company, held by the assessee and against which such bonus shares were issued, over the ordinary shares and the bonus shares---(Commissioner of Income-tax v. Umar Saigol 1973 PTD 450 dissented from].
Commissioner of Income-tax v. Umar Saigol 1973 PTD 450 dissented from.
The assessee, a private limited company, dealt in imported crockery, and local goods. For the year under consideration, the assessee declared capital gain of Rs.9,96,000 on sale of shares held by the assessee and sold during the year but the Income Tax Officer determined the capital gain of Rs.15,96,000.
The difference in valuation was on account of different basis of calculation of the cost of bonus shares adopted by the assessee and the Income Tax Officer. The assessee determined the cost of bonus shares at their face value whereas the Income Tax Officer worked out the cost of bonus shares by adopting the basis of average value i.e. by spreading the cost of old shares over the old shares plus the bonus shares taken together.
Against the order of the Income-tax Officer, the assessee preferred an appeal before the Income-tax Appellate. Tribunal. The Income-tax Appellate Tribunal, held that the cost of bonus shares was their face value.
The department made an application to the Tribunal for reference of the question of law arising out of the decision of the Tribunal to the High Court. The Tribunal refrained the question and referred the same to the High Court for opinion.
The following question was refrained and referred to the High Court for opinion:--
"Whether on the facts and in the circumstances of the case, the Tribunal was justified in holding that for computation of capital gain the cost of bonus shares should be taken as its face value and not the average cost of all shares including bonus shares."
A shareholder who is allotted bonus shares against his shareholding does not get the bonus shares as a gift or free. On allotment of bonus shares, value of his original shares goes down and he suffers a loss in respect of his original shareholding. Therefore, even if the share-holder has not' literally made any payment for the bonus shares, law will not presume that he got the bonus shares as a gift arid these be valued at zero value.
A dividend means a share in the profits and when profits are released in cash to the share-holder it can only then be said that dividend has been paid to the share-holder. But the conversion of reserves into capital does not involve the release of the profits to the snare-holder. Allotment of bonus shares to a share-holder cannot amount to or deemed to be payment of divided to the share-holder under the law or under the principles of business accountancy.
"A stock dividend (bonus shares) really takes nothing from the property of the corporation, and adds nothing to the interests of the share-holders. Its property is not diminished and their interests are not increased ...........
The proportional interest of each share-holder 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 ..........
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."
Face value of the bonus shares would not represent their correct cost to the share-holder.
The bonus shares can be valued by spreading the cost of old shares over the old shares and the new issue taken together, if the shares rank pari passu and where they do not rank pari passu, the price may have to be adjusted either in the proportion of the face value they bear or on equitable considerations based on the market price before and after the issue.
The average cost principle is equally applicable for computing the cost of bonus shares to determine the capital gain to their owner on sale of such shares by him.
Where bonus shares are issued in respect of existing shares held in a company by the assessee, their real cost to the assessee cannot be taken to be nil on their face value. Their cost should be determined by the process of averaging i.e., by spreading the cost of the old shares to the share-holder over the old shares and the new bonus shares taken together if the shares rank pari passu.
The cost of bonus shares to the assessee should not be taken as its face value for computation of capital gain.
Held, the cost price of tire bonus shares to the assessee should have been determined by spreading the cost of ordinary shares of the same company, held by the assessee and against which such bonus shares were issued, over the ordinary shares and the bonus shares.
Commissioner of Income-tax v. Dalmia Investment Co. Ltd. (1964 ) 10 Taxation 75 fol.
1972 PTD (Trib.) 8; Kanga and Palkhivala's Law and Practice of Income-tax, 7th Edn., Vol. I, p.876; Commissioner of Income-tax v. Gold Mohore Investment Company Limited 68 ITR 213; Commissioner of Income-tax v. Gold Mohore Investment Company Limited 74 ITR 62; Commissioner of Income-tax v. Gold Co. Limited 78 ITR 16; Eisner v. Macomber (1920) 252 O.S. 189; Enarald & Company v. Commissioner of Income-tax (1959) 36 ITR 257; Dalmia Investment Co. v. (1961) ITR 705; Bouche v. Sproule (1887) 12 App. Cases 385; C.I.T. v. Shirinbai Kooka (1962) 46 ITR 86; C.I.T. v. Mercantile Bank of India (1936) 4 ITR 239; Commissioner of Inland Revenue v. Blott (1921) 2 A.C. 171; Commissioner of Inland Revenue v Fisher's Execution (7926) A.C. 395; Enarald & Co. Ltd. v. C.I.T. (1956) 29 ITR 814; Nicholas v. Commissioner of Taxes (1941) 9 ITR 53; Osborne v. Steel Barrel Co. Ltd. (1942) 24 Tax Case 293 and Swan Brewery Co. Ltd. v. King 1914 AC 231 ref.
Nasrullah Awan for Appellant.
Nasim Ahmed Khan for Respondent.
Date of hearing: 22nd October, 1990.
JUDGMENT
NASIR ASLAM ZAHID, J: --By this application under section 66(1) of the Income Tax Act, 1922, the Commissioner of Income-tax, Central Zone, Karachi, has referred the following question to the High Court for opinion:--
"Whether on the facts and in the circumstances of the case, the Tribunal was justified in holding that for computation of capital gain the cost of bonus shares should be taken as its face value and not the average cost of all shares including bonus shares."
Respondent in this case is the assessee, Ebrahim Brothers Limited of Karachi, and the assessment year is 1972-73. As per the Statement of the Case, the respondent, a private limited company, dealt in imported crockary, a private limited company, dealt in imported crockery and local goods. For the year under consideration, the assessee declared capital gain of Rs.9,96,000 on sale of shares held by the assessee and sold during the year but the Income Tax Officer determined the capital gain of Rs.15,96,000. The difference in valuation was on account of different basis of calculation of the cost of bonus shares adopted by the assessee and the Income Tax Officer. The assessee determined the cost of bonus shares at their face value whereas the Income Tax Officer worked out the cost of bonus shares by adopting the basis of average value i.e. by spreading the cost of old shares over the old shares plus the bonus shares taken together. The Income Tax Officer had -followed the principle of valuation laid down by the majority opinion in the judgment of the Supreme Court of India in the case of Commissioner of Income Tax v. Dalmia Investment Co. Ltd. (1964) 10 Taxation 75. This view of the Indian Supreme Court had earlier been followed by the Income Tax Appellate Tribunal in Pakistan and reported in 1972 P T D (Trib.) 8.
Against the order of the Income-tax Officer, the assessee preferred an appeal before the Income-tax Appellate Tribunal. The Income-tax Appellate Tribunal, instead of following its previous view, held that the cost of bonus shares was their face value and for this changed view the Tribunal relied upon the decision of a Bench of the Lahore High Court in the case of Commissioner of Income Tax v. Umar Saigal 1973 P T D 450. The department made an application to the Tribunal for reference of the question of law arising out of the decision of the Tribunal to the High Court. The Tribunal refrained the question and referred the same (reproduced earlier) to this Court for, opinion. We have heard Mr. Nasrullah Awan, learned counsel for the department and Mr. Nasim Ahmed Khan, learned counsel appearing for the respondent/assessee.
2. Mr. Nasrullah Awan, learned counsel for the department, mainly relied upon the decision of 'the Supreme Court of India in the case of Dalmia Investment Co. Ltd. He also referred to the following passage in Kanga and Palkhivala's Law and Practice of Income Tax, 7th Edition Vo1.I at page 876:--
"Where bonus shares are issued in respect of existing shares held in a company by the assessee, their real cost to the assessee cannot be taken to be nil on their face value. Their cost should be determined by the process of averaging i.e., by spreading the cost of the old shares to the shareholder over the old shares and the new bonus shares taken together if the shares rank pari passu.
The aforesaid decision of the Indian Supreme Court supports the contention raised on behalf of the department that the Tribunal was not right in holding that the cost of bonus shares to the assessee should be taken as its face value for computation of capital gain.
3. Mr. Nasim Ahmed Khan, learned counsel for the assessee/respondent, on the other hand mainly relied upon the judgment of the Lahore High Court in the case of Umar Saigol. In that case, the question referred to the Lahore High Court for opinion was whether the Tribunal was right in holding that for computation of capital gain the cost of bonus shares should be placed at Rs.10 each instead of nil taken by the Income Tax Officer. The Lahore High Court answered the question in the affirmative for the following reasons:
"Share" as defined in Section 2(16) of the Companies Act, 1913 means "share in the share capital of the company, and includes stock except when a distinction between stock and shares is expressed or implied." Under the Companies Act, therefore, a share whether allotted on the basis of cash payment or on account of bonus stands on the same footing. Every share allotted by the company has to be paid for in cash or kind because the shares are shares in the share capital of the company. Every share, therefore, represents a part of the capital and is relatable to it. When a share is allotted a certain amount of money has to be credited to the capital account of the company on account of the price of that share. It is axiomatic that a company cannot deal in its own shares. It cannot purchase its shares in any case. It consequently follows that when a share of the company is allotted to somebody' it is not the company but the allottee or somebody else on its behalf who has to pay the corresponding amount for being credited to the capital account of the company.
When a company makes profit it divides a part of the profit amongst the share-holders in the shape of dividend. This dividend can b4 paid in cash or instead of making a cash allocation the company can allocate shares of the same value to the share-holder and credit the amount to the capital account of the company which would have otherwise been paid as dividend to the share-holder. Shares so allotted are known as bonus shares. They have perforce to be relateable to the capital of the company and the payment for it is, therefore, made by a person other than the company to it.
It is, therefore, incorrect to say that bonus shares are issued on a cost basis. Their face value is their cost.
The Tribunal based its finding upon the decision reported as C.I.T. Madras v. Athi v. Ramchandra Chettiar (1964) 52 ITA 96 wherein it was held that the valuation of the bonus shares for the purpose of computing the capital gain should be the face value and following this decision the Tribunal held that the cost of bonus shares should be fixed at Rs.10 each, The Department has placed reliance on the decision reported as Commissioner of Income Tax, Bihar v. Dalmia Investment Company Ltd. (1964) 10 Tax 75) which has also been reported in (A I R 1964 SC). We fully agree with the Tribunal that the decision in this case does not support the case propounded by the Department. It was not held in that case that the bonus shares were to be deemed to have been acquired at no cost. Their Lordships of the Supreme Court of India only laid down the criterion for determining the costs. That case, therefore, need not be referred to in detail."
Lahore High Court held that, for purposes of capital gain, the face value of the bonus shares is the cost to the assessee. As noticed, the Lahore High Court did not refer in detail to the decision of the Indian Supreme Court in the case of Dalmia Investment Co. Ltd. observing that the Indian Supreme Court had not held in that case that bonus shares were to be deemed to have been acquired at no cost and that it had only laid down the criterion for determining the costs.
4. The judgment of the Indian Supreme Court in the case of Dalmia Investment Co. Ltd. requires further examination as it dealt in depth with the different methods of valuation of bonus shares. M. Hidayatullah J. (as he then was), while considering the question how bonus shares must be valued by an assessee who carries on business in shares, observes 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 or it 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 ever the original shares and bonus shares taken collectively. The fourth method is to find out the fall in the price of the original shares on the stock exchange and to attribute this to the bonus shares."
M. Hidayatullah, J. then explained in the following words the process which is gone through for issuing bonus shares by a company:
"A limited liability company must state in its memorandum of association the amount of capital with which the company desires to do business and 'the number of shares into which that capital is to be divided. The company need not issue all its capital at the same time. It may issue only a part of. its capital initially and issue more of the un-issued capital on a later date. After the company does business and profits result, it may distribute the profits or keep them in reserve. When it does the latter, it does not keep the money in its coffers; the money is used in the business and really represents an increase in the capital employed. When the reserves increase to a considerable extent, the issued capital of the company ceases to bear a true relation to the capital employed. The company .may then decide to increase its issued capital and declare a bonus and issue to the shareholders in lieu of bonus, certificates entitling them to an additional share in the increased capital. As a matter of accounting the original shares in a win4ing up before the increase of issued capital would have yielded to the shareholder the same return as the old shares and the new shares taken together. What was previously held by the shareholder by virtue of. the original certificates is after the issue of bonus shares, held by them on the basis of more certificates. In point of fact, however, what the shareholder gets is not cash but property from which income in the shape of money may be derived in future. In this sense, there is no payment to him but. an increase of issued capital and the right of the shareholder to it is evidenced not by the original number of certificates held by him but by more certificates. There is thus no payment of dividend. A dividend in the strict sense means a share in the profits and a share in the profits can only be said to be paid to the shareholder when a part of the profits is released to him in cash and the company pays that amount and the shareholder takes it away. The conversion of the reserves into capital does not involve the release of the profits to the shareholder; the money remains where it was, that is to say, employees in the business. Thereafter the company employed that money not as reserves of profits, but as its proper capital issued to and contributed by the shareholder: If the shareholder were to sell his bonus shares, as shareholders often do, the shareholder parts with the right to participation in the capital of the company, and the cash he receives is not dividend but the price of that right. The bonus share-when sold may fetch more or may fetch less than the face value and this shows that the certificate is not a voucher to receive the amount mentioned on its face. To regard the certificate as cash or as representing cash paid by the shareholder is to overlook the internal process by which that certificate comes into-being."
It was observed by Hidayatullah, J. that though profits are profits in the hands of the company, when they are disposed of by converting them into capital instead of paying them over to the shareholders, no income can be said to accrue to the shareholder because the new shares confer a title to a large proportion of the surplus assets at a general distribution and the floating capital used in the company which formerly consisted of subscribed capital and the reserves now becomes the subscribed capital, and the amount said to be payable to the shareholders as income goes merely to increase the capital of the company and in the hands of the shareholders the certificates are property from which income will be derived. It was then observed as follows:--
"The Indian Income Tax Act defines "dividend" and also extends it in some directions but not so as to make the issue of bonus shares a release of reserves as profits so that they could be included in the term. The face value of the shares cannot, therefore, be taken to be dividend by reason of anything in the definition. The share certificate which is issued as bonus entitles the holder to a share in the assets of the company and to participate in future profits. As pointed out above, if/sold, it may fetch either more or less. The market price is affected by many imponderables, one such being the yield or the expected yield. The detriment to the shareholder, if any, must therefore, be calculated on some principle, but the method of computing the cost of bonus shares at their face value does not accord either with fact or business accountancy."
The method of computing the cost of bonus shares at their face value was, therefore, not accepted by the Indian Supreme Court. As regards the second method that as the shareholder pays nothing in cash for the shares, cost should be taken at nil, it was observed that the impact of the issue of the bonus shares has to be seen to realise that there is an immediate detriment to the shareholder in respect of his original holding and it follows that the bonus shares cannot be said to have cost nothing to the shareholder because on the issue of bonus shares, there is an instant loss to him in the value of his original holding. It was also observed that the earning capacity of the capital employed remains the same, even after the reserve is converted into bonus shares. The method of calculation which places the value of bonus shares at nil was, therefore, not accepted by the Supreme Court.
The Indian Supreme Court approved the third method of valuation of bonus shares. It was hold that the bonus shares can be valued by spreading the cost of old shares over the old shares and the new issue taken together, if the shares rank pari passu and where they do not rank pari passu, the price may have to be adjusted either in the proportion of the face value they bear or on equitable considerations based on the market price before and after the issue.
The Indian Supreme Court confirmed the aforesaid majority view in the case of Dalmia Investment Co. Ltd. in the following later decisions:
(a) Commissioner of Income Tax v. Gold Mohore Investment Company Limited 68 I T R 213.
(b) Commissioner of Income Tax v. Gold Mohore Investment Company Limited 74 I T R 62.
(c) Commissioner of Income Tax v. Gold Co. Limited 781 T R 16.
Mr. Hidayatullah J. had also referred to another method of valuation i.e. to find out the fall in the price of the original shares on the stock exchange and to attribute this to the bonus shares but accepted the averaging method explained earlier.
It may be stated here that the Indian Supreme Court while forming their opinion in the case of Dalmia Investment Co. Ltd. considered the following decisions:--
(i) Eisner v. Macomber (1920) 252 O.S.189.
(ii) Enarald & Company v. Commissioner of Income Tax (1959) 36 I T R 257.
(iii) Dalmia Investment Co. v. C.I.T. (1961) 411 T R 705.
(iv) Bouche v. Sproule (1887) 12 App. Cases 385.
(v) C.I. T. v. Shirinbai Kooka (1962) 46 I T R 86.
(vi) C.I.T. v. Mercantile Bank of India (1936) 4 I T R 239.
(vii) Commissioner of Inland Revenue v. Blott (1921) 2 A.C.171.
(viii) Commissioner of Inland Revenue v. Fisher's Execution (1926) A.C. 395.
(ix) Enarald & Co. Ltd. v. C.I.T. (1956) 291 T R 814.
(x) Nicholas v. Commissioner of Taxes (1941) 91 T R 53.
(xi) Osborne v. Steel Barrel Co. Ltd. (1942) 24 Tax Case 293.
(xii) Swan Brewery Co. Ltd. v. King (1914) A.C. 231.
5. The method of computing the cost of bonus shares approved by Hidayatullah J. in the case of Dalmia Investment Company Ltd. is in accord with principles of business accountancy and based on good reasoning as well. The basis that bonus shares be valued at nil or zero can be ignored without much debate. A shareholder who is allotted bonus shares against his shareholding does not get the bonus shares as a gift or free. On allotment of bonus shares, value ofhis original shares goes down and he suffers a loss in respect of his original shareholding. Therefore, even if the shareholder has not literally made any the bonus shares, law will not presume that he got the bonus shares as a gift and these be valued at zero value.
6. The method of computing the value of bonus shares at their face value finds some support from the decision of the Privy Council in Swan Brewery Co. Ltd. v. King (1914) A.C. 231. In that case, Lord Sumner held bonus shares to be dividend. According to Lord Sumner issuance of bonus shares involves two transactions-the creation and issue of new shares on the company's part and on the allottee's part the satisfaction of the liability to pay for them by acquiescing in such a transfer from reserve to share capital. In Blott's case (1921) 2 A.C. 171, the minority view of Lord Dunedin and Lord Sumner was that the issue of bonus shares involved a dual operation by which an amount was released to the shareholder but was, retained by the company and applied in payment of those shares. The majority view of Viscounts Haldane, Finlay and Cave, however, was that an amount equal to the face value of the bonus shares could not be regarded as received by the shareholder and it was a case of capitalisation of the profits of the company in respect of which certificates of bonus shares were issued to the shareholders entitling them to participate in the amount of the reserve but only as part of the capital.
We may here refer to the judgment of the United States Supreme Court which was cited with approval and followed by the Indian Supreme Court in Dalmia Investment Co. Ltd.'s case. In Eisner v. Macomber (1920) 252 U.S. 189, it was observed as follows:--
"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 stock holder is no richer than they were before ...If the Plaintiff gained any small advantage by the change, it certainly was not an advantage of h417,450 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 .
..........If a shareholder sells dividend stock, he necessarily disposes of a part of his capital interest, just as if he should sell a part of his old stock, either before or after the dividend. What he retains no longer entitles him to the same proportion of future dividends as before the sale. His part in the control of the company likewise is diminished."
7. We may now refer to the judgment in Umar Saigol's case by the Lahore High Court. That judgment referred to the definition of "share" in- Section 2 (16) of the Companies Act, 1913; that every share allotted by a company has to be paid for in cash or in kind and that dividend can be paid in cash or instead of making cash allocation, the company can allocate shares of the same value to the shareholder and credit the amount to the capital account of the company which would have otherwise been paid as dividend to the shareholder. With respect we find it difficult to subscribe to the view that bonus shares are in the nature of dividends and that the shareholder is deemed to pay the face value of the bonus shares to the company against which presumed payment bonus shares and issued to the shareholder. As explained by Hidayatullah J., a dividend means a share in the profits and when profits are released in cash to the shareholder it can only then be said that dividend has been paid to the shareholder. But the conversion of reserves into capital does not involve the release of the profits to the shareholder. Allotment of bonus shares to a shareholder cannot, amount to or be deemed to be payment of dividend to the shareholder under the law or under the principles of business accountancy.
What is the effect of issue of bonus shares? We may repeat what U.S. Supreme Court in very clear language expressed in Eisner v. Macomber:--
"A stock dividend (bonus shares) 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 ..........
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."
Perhaps there cannot be a better exposition of the effect of issue of bonus shares, with which we are in respectful agreement. It follows that face value of the bonus shares would not represent their correct cost to the shareholder.
8. As observed earlier, the correct method of computation of the cost of bonus shares for determining the profits on sale of such shares has been laid down in the case of Dalmia Investment Co. Ltd. Although in that matter the Indian Supreme Court was dealing with the case of profits made by a dealer in shares on sale of bonus shares by such dealer, in our view, the average cost principle is equally applicable for computing the cost of bonus shares to determine the capital gain to their owner on sale of such shares by him.
9. It has been presumed that the bonus shares involved in this reference application ranked pari passu with ordinary shares of the same company held by the assessee as neither in the statement of the case nor in, the arguments it was stated that such bonus shares did not rank pari passu with ordinary shares.
10. Our decision, therefore, is that the cost price of the bonus shares to the assessee should have been determined by spreading the cost of ordinary shares of the same company, held by the assessee and against which such bonus shares were issued, over the ordinary shares and the bonus shares. Our answer to the question referred to us is in the negative.
M.B.A./E-48/KQuestion answered in the negative.