Commissioner of Income Tax vs S. Balasubramaniam

M.N. Candurkar, C.J.—These are references u/s 256(1) of the Income Tax Act, 1961, in which at the instance of the Revenue, the

following two questions have been referred to this court :

Whether, on the facts and in the circumstances of the case, the Tribunal was right in holding that the value of each of the shares held by the

assessee as on January 1, 1954, should be ascertained by dividing Rs. 32,96,610 being the aggregate of the paid-up capital and the reserve as on

December 30, 1953, by 20,846 being the total number of shares ?

Whether the Tribunal was right in holding that further deduction of 15% should not be made on the value of the shares as on January 1, 1954 ?

M/s. Gemini Pictures Circuit Private Limited had an authorised capital of Rs. 25,00,000 divided into 25,000 shares of Rs. 100 each. Originally,

16,535 shares of the face value of Rs. 100 each had been issued and were fully paid and subscribed. On December 30, 1953, additional shares

amounting to 4,311 of the face value of Rs. 100 each were issued to five share-holders and in respect of each of these shares, only a sum of Rs.

10 was called for and paid. Thus, as on December 30, 1953, the subscribed capital of the company was Rs. 16,96,610 made up of 16,535 fully

paid up shares of Rs. 100 each and 4,311 shares of Rs. 100 each, but Rs. 10 being paid-up. As on December 31, 1953, the reserve had

accumulated to Rs. 16,00.000. Thus, the aggregate of the subscribed capital and the reserves as on December 30, 1953, was Rs 32,96,610. On

December 30, 1954, the board of directors of the company by a resolution called for the balance amount of Rs. 90 per share in respect of the

4,311 subsequently issued shares. It is not in dispute that this amount was later on paid by the shareholders.

The shareholders were members of a family and in a partial partition of the family of T.S. Srinivasa Iyer, whose business of distribution,

exhibition and exploitation of cine pictures was taken over by the private limited company, Balasubsamanian was allotted 7,518 shares of the said

company of the face value of Rs. 100 each fully paid-up.

During the previous year ending with March 31, 1965, Srinivasa Iyer sold to his grandchildren 1,250 shares for Rs. 2,56,250 at the rate of Rs.

205 per share. Out of these 1,250 shares, 195 shares were out of the initially issued 16,535 shares and 1,035 shares were out of 4,311 shares

subsequently issued. In the next year ending March 31, 1965, Srinivasa Iyer, sold 3,336 shares to his daughter and grandchildren for a sum of Rs.

4,95,720. Out of these, 1,989 shares were out of the initially issued shares and 1,047 shares were out of those allotted on December 30, 1953.

During the previous year ending with March 31, 1966, Balasubra manian also sold 4,720 shares to his wife and minor daughters for Rs.

7,95,600. These shares were out of the shares which were allotted to him on December 30, 1953.

For the assessment year 1965-66, Srinivasa Iyer disclosed a capital gain of Rs. 13,750 and the value of the shares sold was taken as Rs. 194

per share as on January 1, 1954. On the basis of this value, he claimed a capital loss of Rs. 93,264 for the assessment year 1966-67.

Balasubramaniam also claimed capital loss of Rs. 1,20,080 for the assessment year 1966-67. The assessee had taken all the shares to be of the

face value of Rs. 10 each fully paid-up and took the total number of shares as 1,69,661. The value of Rs. 194 per share was arrived at by dividing

the subscribed capital and reserve amounting to Rs. 32,96,610 by 1,69,661.

The Income Tax Officer did not accept the valuation shown by the assessee. In view of the fact that 1,047 shares sold by Srinivasa Iyer and

4,720 shares transferred by Balasubramanian had not been fully paid up as on January 1, 1954, he took the total paid-up value of the shares so

transferred as Rs. 30,050 and Rs. 2,09,370 in the case of Srinivasa Iyer and Rs. 47,200 in the case of Balasubramanian. The Income Tax Officer

arrived at a formula by which he worked out the market value of the shares as on January 1, 1954, by dividing the aggregate of the capital and the

reserves by the total value of these shares and multiplying the product by the total paid-up value of shares. It is enough to give one illustration of

computation, which is as follows :

The Income Tax Officer made a further reduction of 15 per cent of the total value in view of the fact that the shares were of a private limited

company. Originally, in order to ascertain the value as on January 1, 1954, he had added the call money which was paid after December 31,

1953.

As a result of the adoption of this Formula. the capital gains in the case of Srinivasa Iyer was computed at Rs 1,11,670 for the assessment year

1965-66 and Rs. 56,706 for the assessment year 1966-67. In the case of Balasubramaniam, the capital gains was computed at Rs. 16,045 for the

assessment year 1966-67.

The appeals filed by the assessee were rejected by the Appellate Assistant Commissioner. When the matter was taken further to the Tribunal

in appeal, the Tribunal relying on a decision of the House of Lords in Birch v. Cropper [1889] 14 AC 525, took the view that the fact that on

January 1, 1954, some of the shares sold by the assessee during the relevant previous years had been only partly paid-up was of no consequence

while considering their right to participate in the net assets of the company in the event of its being wound up. Applying the principle laid down in

Birch v. Cropper, [1889] 14 AC 525, the Tribunal held that the proper method for ascertaining the value of the shares sold by the assessee as on

January 1, 1954, was to divide the aggregate of the paid-up capital and the reserves, that is, Rs. 32,96,610, by the total number of shares, that is,

20,846, and the Tribunal directed that the capital gains arising to the assessees should be computed in this manner. The Tribunal also took the view

that rule D of the Wealth-tax Rules, 1957, had no application to the instant case and the Income Tax Officer was not justified in making a

reduction of 15 per cent from the value of the shares as on January 1, 1954. The correctness of these directions given by the Tribunal in the matter

of determining the value of the shares as on January 1, 1954, and with regard to deleting the reduction of 15 per cent is now the subject-matter of

the two questions referred.

The learned counsel appearing on behalf of the Revenue in support of the reference has contended before us that the Tribunal was in error in

treating the fully paid-up shares and The shares which were not fully paid-up alike. It is contended that there was intrinsic difference between the

fully paid-up shares and the shares which were partly paid-up and this difference is highlighted even in the manner of the right to claim dividend in

regulation 88(1) of Table A to the Companies Act, 1956. The learned counsel for the Revenue has contended that in the absence of a plausible

method of finding out the value If the shares, the value of the shares could properly be determined by applying break-up value method as provided

in rule lD of the Wealth-tax Rules-It was pointed out that the shares of a private limited company have intrinsic restrictions with regard to transfer;

they are not quoted on the stock exchange and, therefore, reduction of 15 per cent from the finding arrived at after applying the break-up method

was quite permissible for arriving at the market value of the shares of a private limited company. It was pointed out by the learned counsel that the

decision in Birch v. Cropper [1889] 14 AC 525, on which inherent reliance was placed by the Tribunal, would not be of assistance in ascertaining

the value of the share where it is not fully paid-up but is only partly paid.

On the other hand, the learned counsel for the assessee has argued that no distinction can be made with regard to the rights of the holder of a

share which is fully paid-up and the holder of a share which is partly paid-up and, in support of this proposition, the learned counsel wanted to rely

on the decision of the House of Lords in Birch v. Cropper [1889] 14 AC 525. It is argued before us that when a company is wound up, the right

of all the shareholders are the same notwithstanding the fact that some of them were holding fully paid-up shares and some of them were partly

paid-up holders. The learned counsel contended that once the holder of partly paid-up shares was called upon to remit the balance, of call money,

then all the equity share-holders were entitled to be treated equally when they were sharing the assets of the company in liquidation.

Now, it is common ground that for the purpose of the computation of capital gains when the cost of acquisition was to be enquired into, the

assessee had exercised his option as was contemplated by clause (i) of section 55(2) which defines the cost of acquisition in relation to a capital

asset. According to the assessee, he would abide by the fair market value of the assets on January 1, 1954. We are not, therefore, concerned in

this case with the actual cost of acquisition of the shares to the assessee. The attempt of the authorities has been to find out the fair market value of

the asset on January 1, 1954. Now, admittedly, the shares which have been issued prior to December 30, 1953, were fully paid-up shares and in

respect of the shares issued after December 30, 1953, only Rs. 10 was the call money paid. The memorandum and articles of association of the

assessee company which have been produced before us provided in article I, that the regulations for the management of the company shall be such

as are contained in the articles and Table A in the First Schedule to the Companies Act, 1956, shall be applicable in respect of all matters not

specifically provided for in these presents. We have referred to this article in the articles of association of the company because we find that there

are provisions in the Companies Act and Table A which in clear terms makes a distinction between holders of shares which are fully paid up and

holders of shares which are partly paid up. Section 93 of the Companies Act, 1956, provides as follows :

A company may, if so authorised by its articles, pay dividends in proportion to the amount paid up on each share, where a larger amount is paid

up on some shares than on others.

This section, therefore, provides that if there is a provision in the articles, the dividend to be paid to the shareholders has to be in proportion to

the amount paid up on each share, in case a large amount is paid-up on some shares than on others. Thus, if the articles so provided, the dividend

to be paid to shareholders holding fully paid-up shares and dividend to be paid to shareholders holding partly paid-up shares, is permissible. If,

however, there is no such provision in the articles, then irrespective of the paid-up amount of each share, the dividend will have to be paid in

proportion to the nominal value of their shares. The authorisation referred to section 93 is to be found in article 88(1) in Table A, which reads as

follows :

(1) Subject to the rights of persons, if any, entitled to shares with special rights as to dividends, all dividends shall be declared and paid

according to the amounts paid or credited as paid on the shares in respect whereof the dividend is paid, but if and so long as nothing is paid upon

any of the shares in the company, dividends may be declared and paid according to the amounts of the shares.

Article 88(1), therefore, clearly authorises the company that the dividends can be declared and paid only according to the amounts paid or

credited as paid on the shares in respect of which the dividend is to be paid. From a reading of section 93 and article 88 , it appeared obvious that

the dividend which is claimable or payable to a shareholder holding fully paid-up shares is not the same as the dividend payable to a holder of a

partly paid-up share.

Section 93 and the articles, therefore, make a distinction between the treatment and the rights of persons holding fully paid-up shares and

persons holding partly paid-up shares. It is true that the company can at any time make a call for the balance of the amount in respect of the value

of the share. We are in this case, however, concerned with the position as it stood as on January 1, 1954. The position as on January 1, 1954,

was that there were some ful1y paid-up shares and other partly paid shares because it was only after January 1, 1954, that a call was made in

respect of the balance of the amount of Rs. 90. The question which, therefore, falls for consideration is, when finding out the value of the share, is

the value of a share which is fully paid-up to be taken as the same as the value of a share which is partly paid up ? The share represents the

contribution made by the shareholders towards the capital of the company. In the case of fully paid-up shares, the contribution is the amount of the

total value of the shares held by the shareholders. In the case of a partly paid-up share, obviously, the contribution to the capital will not be the full

value of the shares but will only be the value which is actually paid. With this intrinsic difference between the holders of the fully paid share and

partly paid share, it is difficult to accept the contention that when we consider the question of determining the value of a share, the value of both the

kinds of shares must be determined as equal to one another. The anomaly, in our view, is apparent in this argument. The anomaly is that a share

capital of Rs. 100 for the purpose of valuation of the share is sought to be equated with a capital contribution of Rs. 10 for which there does not

seem to be any warrant in law.

We may make it clear that question No. 1 which has been referred to us does not relate to the propriety or legality of adopting the break-up

value method. It is common ground between the Revenue and the assessee that the value has to be ascertained by the break-up value method and

the difference in the approach lies in the working out of the break-up value method. Where all the shares are alike in the sense that they are fully

paid-up, there is not much difficulty in applying the break-up value method. By the application of this method, what is to be done, so far as the

instant case is concerned, is that the aggregate of the capital and the reserves has to be divided by the number of shares and we can get the value

of one share. The difficulty, however, which arises in the instant case is that some shares are fully paid-up and some of them are partly-paid up and

both, therefore, cannot be treated alike and the only other method of finding out the value of the shares would, in our view, be to divide the

aggregate of capital and the reserves by the total value of the shares whether they are totally paid-up shares or not. Once this formula is adopted,

then by multiplying the result by the total amount invested, we will get the total value of relevant shares. It is this method which has been adopted

by the Income Tax Officer and which, on facts, it appears to us, is the only equitable method.

Now when we come to the view taken by the Tribunal, it appears to us that the Tribunal lost sight of the fact that the question which fell for

consideration before the House of Lords in Birch v. Cropper [1889] 14 AC 525, was not identical to that which arises in the instant case. In that

decision, there were two kinds of shares. There were equity shareholders and there were preference shareholders. The Bridge Water Navigation

Company was taken over by another company, the Manchester Ship Canal Company and the facts show that after satisfaction of debts and

liabilities of the Bridge Water Navigation Company and after adjusting the rights of the shareholders inter se and after payment of costs of the

liquidation and repayment to the shareho1ders, of the capital respectively paid on their shares, a surplus pound 500,000 was left in the hands of the

liquidators. The question which arose in that case was how this surplus ought to be distributed amongst the ordinary and preference shareholders,

respectively. The Court of Appeal had taken the view that the distribution ought to be made in proportion to the amounts respectively paid up on

the ordinary and the preference shares. The appellant who represented the ordinary shareholders before the House of Lords contended that the

ordinary share-holders were entitled to the whole of the surplus. Their alternative contention was that if the whole of the surplus could not be

distributed between the ordinary shareholders, then the decision between the ordinary and the preference shareholders ought to be made

according to the capital subscribed and not according to the amount paid up on the shares. The House of Lords took the view that when the whole

of the capital has been returned, both classes of shareholders are on the same footing, equally members and holding equal shares in the company,

and, therefore, they ought to be treated as equally entitled to its property and that this was the best way of distribution of surplus assets of the

company in the instant case. Apart from this, Lord Herschell observed as follows (p. 538) :

It may be that the principle which I recommend your Lordships to adopt will not secure absolutely equal or equitable treatment in all cases, but I

think that it will in general attain that end more nearly than any other which has been proposed.

Thus, the facts of the decision of Birch v. Croper [1889] 14 AC 525, will show that the House of Lords were dealing with a company in

liquidation and the company having surplus assets after meeting all the liabilities and after paying of the capital contributed by the equity and the

preference shareholders. The decision in Birch v. Cropper [1889] 14 AC 525, has been commented upon in Gowe''s Principles of Modern

Company Law. The learned author in his fourth edition, at page 414, has observed that the decision in Birch v. Cropper [1889] 14 AC 525, has

left the law in a state of some confusion. Commenting on this decision, the learned author states under the caption ""Participation in Income and

Capital"" as follows (at page 414) :

As we have seen, the initial presumption is that all shares rank equally. Hence if shares are to be preferential at all, there must be some provision

to this effect in the documents under which they are issued. Until quite recently it was thought that this presumption of equality should be carried so

far that an express provision for preference should not derogate from a right to equal participation after the preference had been obtained; in other

words, that preference shares were presumed to be participating in both capital and income. This, indeed, appeared to be the inevitable conclusion

to be drawn from the decision of the House of Lords in Birch v. Cropper [1889] 14 AC 525.

However, Birch v. Cropper [1889] 14 AC 525, left the law in a state of some confusion.

The learned author then refers to the later decision of House of Lords in Will v. United Lankat Platlations [1914] AC 11, the decision of the

Court of Appeal in Re William Metcalfe Ltd. [1933] Ch 142 and then the later decision of the House of Lords in Scottish Insurance Corporation

v. Wilsons and Clyde Coal Co. [1949] AC 462. After referring to these decisions, the law, as it stands at present, is stated thus, by the learned

author (p. 415) :

The present position, therefore, as stated, in the subsequent judgments of the Court of Appeal in Re Isle of Thonet Electric Co. [1950] Ch

161, can be embodied in the two following propositions :

''First, that, in construing an article which deals with rights to share in profits, that is, dividend rights, and rights to share in the company''s property

in a liquidation, the same principle is applicable; and, second, that the principle is that, where the article sets out the rights attached to a class of

shares to participate in profits while the company is a going concern or to share in the property of the company in a liquidation, prima facie, the

rights so set out are in each case exhaustive.''

In other words, if preference shareholders are given preferential or other express rights to dividends or to a repayment of capital, the presumption

is that they are non-participating as regards further dividends or capital repayments.

We have extracted these passages exhaustively in order to highlight the fact that the decision in Birch v. Cropper [1889] 14 AC 525, was

specifically dealing with the rights of preferential shareholders and the observation in Birch v. Cropper [1889] 14 AC 525, could not be of any

assistance while determining as to how the value of a share has to be ascertained where some of the shares are fully paid-up shares and some of

them are partly paid-up shares. It appears to us that the Tribunal did not notice the distinguishing features of the decision in Birch v. Cropper

[1889] 14 AC 525, with the result that they arrived at an erroneous conclusion in so far as the fully paid-up shares and partly paid-up shares are

concerned, that they must be treated on the same footing for the purpose of break-up value method. The learned counsel for the Revenue had

cited before us some decisions where the break-up method has been adopted. However, having regard to what we said earlier, we do not think it

necessary to refer to these decisions because we have decided the matter more on principle than on application of any statutory rules which

necessarily are outside the Income tax Act.

Accordingly, so far as the first question is concerned, we must hold that the Tribunal was in error in holding that the value of each share sold by

the assessee should be ascertained by dividing Rs. 32,96,610 being the aggregate of the paid-up capital and the reserves as on December 30,

1953, by the total number of shares, namely, 20,846.

Now, so far as the second question is concerned, it can hardly be disputed that the shares of a private company have inherent restriction in the

matter of transfer. As observed by Gower in his book Gower''s Principles of Moder Company Law (fourth edition, page 256), in the case of

private companies, restrictions on the right to transfer shares are at present essential, and these obviously diminish their market value. Once the

value of the shares of the company is determined in accordance with the break-up method, some deductions have to be made because of the

restrictions in the matter of transfer. Such shares are not easily transferable and will, therefore, have restricted buyers. The Tribunal has observed

that the Income Tax Officer has deducted 15 per cent on the value arrived at by him, but had given no reasons. The Tribunal further observes that

presumably he was guided by rule lD of the Wealth-tax Rules. This has no application and we are of opinion that no such deduction should be

made. The Tribunal does not seem to have applied its mind to the fact that the shares of a private limited company have a restricted market. There

are constraints on their transfer which inevitably result in reduction in the value of such shares. It is true that rule lD of the Wealth-tax Rules is not in

terms applicable where the value of the share is to be ascertained for the purpose of the computation of capital gains. But, it is difficult to see why

rule lD cannot afford a good guideline which can be resorted to when the value of the share is to be determined. Rule lD of the Wealth-tax Rules

has been made with a view to find out the market value of the shares for the purposes of market value. In the instant case also, the market value of

the shares of the private limited company has to be ascertained as on January 1, 1954, and it is not, therefore, possible to take the view that the

Income Tax Officer has committed an error in accepting the guidelines of rule lD of the Wealth-tax Rules. Accordingly, it is not possible for us to

sustain the view taken by the Tribunal that no deduction should be made while determining the value of the share.

In the view we have taken, the first question has to be answered in the negative and in favour of the Revenue, and the second also is answered

in the negative and in favour of the Revenue.

The questions are answered accordingly. The assessee is directed to pay the costs of this reference. Counsel''s fee Rs. 500, one set.

The learned counsel for the assessee after the pronouncement of the above judgment has made an oral application for leave to appeal to the

Supreme Court. We do not think that this is a fit case where a certificate could be issued for leave to appeal to the Supreme Court. Accordingly,

the prayer for leave is rejected.