ORDER
P.J. Goradia, Accountant Member
1. This appeal arises from the order dated 22-3-1988 passed by the Commissioner of Income-tax (Appeals)-XV, New Delhi and the controversy is in connection with the method of valuation of closing stock of shares held by the assessee.
2. The assessee is an individual and derived income by way of salary, business that is trading in shares as also share of profits/loss from partnership firms and other sources. He is regularly assessed to income-tax and wealth-tax. For the financial year ended on 31-3-1983, return was filed declaring loss of Rs. 8 lakhs plus. The main reason of loss shown by the assessee, was on account of valuation of closing stock of certain shares thus. The assessee held certain equity shares in two private companies namely M/s. Partap Steel Rolling Mills (P.) Ltd., Amritsar as also Ballabgarh. The equity shares in private company at Amritsar were valued on 31-3-1982 that is earlier year at Rs. 2,137 for some shares and Rs. 2,085 for some shares. The equity shares of Ballabgarh Private Ltd. Co. as on 31-3-1982 were valued at Rs. 150 each. It may be stated here that in the past on 31-3-1981 also these shares were valued plying same rate. These shares formed part of the opening stock on 1-4-1982. During the current year, these equity shares were converted into preference shares. The equity shares in Partap Steel Rolling Mills Pvt. Ltd., Amritsar of the face value of Rs. 1,000 each were converted at par into 4% fully paid up irredeemable accumulative preference shares of Rs. 1,000 each. Similarly, equity shares in M/s. PartapSteelRollingMills Pvt. Ltd., Ballabgarh were converted into 4% fully paid up irredeemable accumulative preference share of Rs. 100 each at par. Both the companies converted its entire equity capital to preference capital on 16th March, 1983. These preference shares were held by the assessee as stock in trade on 31-3-1983. The assessee has been following the method of cost or market value whichever is lower for valuation of closing stock. Accordingly to find out the market value of preference shares and since they were upquoted to find out the market value, the assessee valued the share as per Rule 1C of the Wealth-tax Rules. The values dropped down heavily. In respect of preference shares in Private Limited at Amritsar, the value as on 31-3-1983 was worked out at Rs. 500 as against Rs. 2,100 approximately adopted for equity shares on 31-3-1982. Similarly, in respect of Limited Preference Shares in Private Limited at Ballabgarh, the value was worked out at Rs. 50 on 31-3-1983 in place of Rs. 150 for equity shares held on 31 -3-1982. It may be clarified here that all the equity shares of these two private limited companies were converted into preference shares and there was no other preference shares capital issued by the company. In other words, the capital of these two companies after conversion, consisted only of the preference share capital converted from equity capital. The Assessing Officer initiated enquiries. It was firstly enquired from the assessee that why Rule 1C was adopted for the purpose of valuation of the preference shares. The assessee explained that in earlier years valuation of the shares in closing stock had been done on the basis of Rule 1D of the WT Rules for unquoted equity shares. Since there was no transaction in preference shares which could indicate market value, the assessee adopted the valuation as per Rule 1C, to justify this action, the assessee relied upon the judicial pronouncements as under:-
(i) CIT v. S. Balasubramanian [1985] 22 Taxman 595 (Mad.).
(ii) Shyamsukh Garg v. CED.
(iii) CED v. J. Krishna Murthy [1974] 96 ITR 87 (Mys.).
3. The Assessing Officer, however, was of the view that Rule 1C is not applicable to the income-tax proceedings, besides there had not been any tangible loss to the assessee, the stand taken by the assessee was not acceptable and, therefore, the Assessing Officer valued the shares adopting the same method which was adopted for the valuation of the equity shares as on 31-3-1982 and applied the same rate for the purpose of valuation of stock on 31-3-1983. This resulted in net addition to the value of the closing stock by Rs. 12,58,168. Consequently, the loss return of the assessee was converted into positive income at Rs. 4,27,660. The assessee preferred an appeal before the CIT(A).
4. The Commissioner (Appeals) asked the assessee to prove business necessity of the conversion of equity shares into preference shares. The assessee explained that it was only in order to keep the business running and in order to retain maximum funds with the concerned companies that it was decided to covert the whole of equity shares into preference shares. The CIT(A) found that the assessee was on the Board of Directors of these Companies and he did not resist passing of resolution regarding conversion even when the assessee was put to business loss by reduction in the value of the preference shares. According to the Commissioner (Appeals) the assessee was unable to state any reason why the assessee was a party to such conversion. Besides, the share-holders were only family members closely related to the assessee. Thus, according to him, the whole purpose of conversion was to take advantage of the different method of valuation prescribed for preference shares so as to incur huge business loss which would allow the assessee to wipe of all taxable income. This was not permissible for which guidance was drawn from the famous decision of the Supreme Court in the case of McDowell & Co. Ltd. v. CTO [1985] 154 ITR 148, observing that the Assessing Officer was justified in not allowing this loss disregarding the conversion of shares. The assessee is aggrieved.
5. Various contentions were raised and detailed submissions explaining various factual aspects were brought to our notice by the learned Chartered Accountant Shri Dinodia. In brief, his factual and legal contentions were as follows :-
(i) Conversion was beneficial to the company and then to share-holders obviously and, therefore, there was no motive of tax evasion/avoidance.
(ii) The transaction was not a sham transaction and, therefore, decision in the case of McDowell & Co. Ltd.’s (supra) was not applicable but decision in the case of CWT v. Arvind Narollam [1988] 173 ITR 479 : 39 Taxman 368 (SC).
(iii) Since Rule 1D was earlier followed for the purpose of valuation of equity shares, Rule 1C could be followed justifiably. Besides, in wealth-tax assessments, such valuations had been accepted.
6. The Senior D.R. emphasised an aspect that even before the Tribunal no case was made out as to how the assessee was benefitted. There was the only motive behind the conversion to lower the profit of the assessee. Guidance was drawn from K.R. Loganathan v. Union of India [1988] 174 ITR 645 (Mad.), where it was held that real intention behind transaction was required to be ascertained.
7. We have considered the submissions and the material to which our attention was drawn. It has to be emphasised here that the controversy is only under the Income-tax Act and that too with regard to the method for finding out market value of the shares held in stock. Admittedly, the assessee is following for the purpose of valuation of stock, the method of cost or market value whichever is lower. Even in the previous year under consideration, the same method is to be applied and this is. not in dispute. The cost of the preference shares is also not in dispute. But what is in dispute is the market value and the same is admittedly lower, even if assessee’s valuation is not accepted. Because no grievance is raised by stating that the assessee’s cost is lower than the value adopted by the Assessing Officer. It cannot be denied that there is a conversion of the equity shares held earlier. Rule 1C of the WT Rules prescribes method to find out market value of unquoted preference shares. The meaning of preference share is given in Section 85 of the Companies Act, 1956 and the same is reproduced below :
Section 85. Two kinds of share capital: (1) “Preference share capital” means, with reference to any company limited by shares, whether formed before or after the commencement of this Act, that part of the share capital of the company which fulfils both the following requirements, namely:-
(a) that as respects dividends, it carries or will carry a preferential right to be paid a fixed amount or an amount calculated at a fixed rate, which may be either free of or subject to income-tax; and
(b) that as respects capital, it carries or will carry, on a winding up or repayment of capital, a preferential right to be repaid the amount of the capital paid up or deemed to have been paid up, whether or not there is a preferential right to the payment of either or both of the following amounts, namely :-
(i) any money remaining unpaid, in respect of the amounts specified in Clause (a), up to the date of the winding-up or repayment of capital; and
(ii) any fixed premium or premium on any fixed scale, specified in the memorandum or articles of the company.
Explanation : Capital shall be deemed to be preference capital, notwithstanding that it is entitled to either or both of the following rights, namely :-
(i) that, as respect dividends, in addition to the preferential right to the amount specified in Clause (a), it has a right to participate, whether fully or to a limited extent, with capital not entitled to the preferential right aforesaid;
(ii) that, as respects capital, in addition to the preferential right to the repayment, on a winding-up of the amounts specified in Clause (b), it has a right to participate, whether fully or to a limited extent, with capital not entitled to that preferential right in any surplus which may remain after the entire capital has been repaid.
(2) “Equity share capital” means with reference to any such company, all share capital which is not preference share capital.
(3) The Expressions “preference share” and” “equity share” shall be construed accordingly.
8. Section 90 of the Companies Act, 1956, further states that nothing in Sections 85 to 89 shall apply to a private company unless it is subsidiary of a public company. The effect of the exemption of private companies from the provisions of Sections 85 to 89 is that such companies can issue shares with disproportionate voting rights besides they are also free from other restrictions imposed by this section which further means that the companies can create and issue any other kind of share capital with any terms as they think fit. Such companies can issue preference capital with disproportionate rights with regard to dividend and/or participation in extra profits and/or surplus on liquidation etc. In short, they can issue any class or classes of shares with various preferential rights which may be broadly classified as (a) cumulative or non-cumulative; (b) Redeemable or irredeemable; (c) participating preference shares; (d) preference shares with differential voting rights; (e) preference shares with right of conversion; and (f) redemption at par or at premium; and (g) such other variation in rights as may be found expedient by the companies seeking to issue preference shares. All these various categories of preference shares are not contemplated by Rule 1C of the WT Rules. It is almost impossible to frame rules for different classes of preference shares with such variety of preferential rights. Therefore, Rule 1C governs mode of valuation of unquoted preference shares only of certain classes of preference shares. For easy reference, Rule 1C is quoted :-
Market value of unquoted preference shares.
1C. (1) Subject to the provisions of Sub-rule (2) the market value of an unquoted preference share of any company shall-
(a) where the preference share is issued before the valuation date at a rate of dividend of not less than eight per cent, be the paid-up value of such share; and
(b) where the preference share is issued before the valuation date ata rate of dividend of less than eight per cent, be the adjusted paid-up value of such share.
(2) Where no dividend has been paid in respect of an unquoted preference share by any company continuously for not less than three accounting years ending on the valuation date or in a case where the accounting year of that company does not end on the valuation date, for not less than three continuous accounting years ending on a date immediately before the valuation date, the paid-up value or the adjusted paid-up value, as the case may be…
(b) in the case of a cumulative preference share, one-half of the rates specified in the aforesaid table.
Explanation : For the purposes of this rule, “adjusted paid-up value”, in relation to a preference share, means an amount which bears to the paid-up value of the preference share, the same proportion as the stipulated rate of dividend (being the rate of dividend on the preference share specified in the terms of issue of such share, and in a case where such dividend is required to be increased under the provisions of Section 3 of the Preference Shares (Regulation of Dividends) Act, 1960 (63 of 1960), the rate of dividend as so increased) on such shares bears to the rate of eight per cent.
9. A plain reading of the language of Rule 1C gives an idea that it has prescribed method of valuation in respect of a class of preference share where the rate of dividend is fixed. The rule has left open the valuation of other classes of preference shares as mentioned above. That is why Rule 1C is directory only and not mandatory. Consequently, the valuation of the preference share shall have to be made on the basis of rights attached to each class of preference share. The assessee has not placed any material clarifying the rights attached to the preference share capital. Such rights could be found in the Memorandum of Article of Association. Therefore, it is not possible to ascertain the value of shares in question. For the sake of clarification, we would also mention here that a share to be called a preference share to which Rule 1C can be applied has to fulfil the conditions prescribed under Section 85 of the Companies Act, 1956. For this purpose also, unless the terms on which the preference shares were issued and rights attached to them are placed, it cannot be definitely said that the shares held by the assessee are preference shares within the meaning of Sub-rule (i) of Rule 1A of the Wealth-tax Rules, 1957 read with Section 85 of the Companies Act, 1956. Hence, in our opinion, the tax authorities were justified in rejecting valuation adopted by the assessee.
10. During the course of submissions, it was further brought to our notice by Shri Pradeep Dinodia that variation in the Valuation of shares of Ajay Foundary Private Limited, Pratap Rajasthan Special Steel Limited and Arvind Espat Limited shares, apparent mistakes have been committed by the Assessing Officer and, therefore, necessary directions be issued to the Assessing Officer to rectify the mistakes. There being no objection from the learned Senior Departmental Representative, we direct the Assessing Officer to remove mistakes, if any, committed while adopting the valuation in respect of shares of these three companies.
11. To the extent as above, the appellate order is modified and the Assessing Officer is directed to pass an appropriate consequential order.
12. In the result, for the purpose of statistics, the appeal is allowed in part.