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Judgment
G.R. Jagadisan, J.—At the instance of the Commissioner of Income Tax, Madras, the Appellate Tribunal has referred the following question
to this Court, u/s 66(1) of the Indian Income Tax Act:
Whether in the circumstances and on the facts of the case, capital gains of Rs. 7,269 on the sale of shares computed by the Income Tax Officer is
not correct and in accordance with the law?
The facts are these. The assessee is a Hindu undivided family. He is not a dealer in shares. He is deriving income from interest on securities,
property, business and dividends from shares held in limited companies. The assessee held shares in a bank called the Karur Vysia Bank, Ltd. In
the year 1957, the bank issued bonus shares to the assessee in proportion to the shares already held by him in the bank. During the year of
account ended 13th April, 1959, relevant to the assessment year 1959-60, the assessee sold 94 bonus shares for Rs. 7,268-94 nP. The Income
Tax Officer was of the opinion that the original cost of these bonus shares was nil and therefore assessed the entire sale proceeds of Rs. 7,269 to
tax as capital gains u/s 12-B of the Act. The assessee contended that the cost of the bonus shares should be fixed by adopting the ""average cost''
in respect of each share, taking into account the total number of shares held by him, original shares plus the bonus shares. But the Income Tax
Officer did not accept this contention. The assessee preferred an appeal to the Appellate Assistant Commissioner, who, however, affirmed the
decision of the Income Tax Officer. The view of the Appellate Commissioner was that the assessee had not incurred any expenditure for acquiring
these shares and that the original cost must be deemed to be nil. There was a further appeal by the assessee to the Income Tax Appellate Tribunal.
The Tribunal disagreed with the view of the department, and held that the original cost of the bonus shares should not be taken as nothing. The
Tribunal referred to the decision of the Supreme Court in Emerald and Co. Ltd. Vs. Commissioner of Income Tax, Bombay, where, however, the
question of valuing the bonus shares at the time of the acquisition was left open. Having reached this conclusion the Tribunal went on to observe as
follows:
We hold that the sale proceeds of Rs. 7,269 of the 94 shares by the assessee does not in entirety represent capital gains as has been held by the
Income Tax Authorities. It is, however, open to the Income Tax Officer to recompute the profit if so advised and found worth while. If it is redone,
the closing stock has to be valued at the original cost of the holding averaged for the original and bonus scrips since issued or at the market prices
whichever is lower.
It is very difficult to follow the reasoning of the Tribunal. The value of the bonus shares, at the time of the issue, would either be the market value or
the face value, if the view of the Department that they were of nil value were not to be accepted. Anyhow, on the basis of this conclusion arrived at
by the Tribunal, the Income Tax Officer has been directed to amend the assessment already made. The question now before us is whether the
Tribunal is right in directing the Department to value the bonus shares, on the basis of average value or the market price whichever is lower.
Mr. S. Ranganathan, learned Counsel for the Department, contended that the bonus shares were got by the assessee purely by way of gift, as
an addition or accretion to the original shares held by him, and that it could not be said that the assessee paid any consideration for these bonus
shares. He supported the view taken by the Department that the original cost of the bonus shares should be taken as of nil value.
The issue of bonus shares by a company is now a common feature. When a company is prosperous and accumulates a large surplus, it converts
this surplus into capital, and divides the capital among the members in proportion to their rights. This is done by issuing fully paid shares
representing the increased capital. Bonus shares are issued out of the credit balance of profit and loss account, and out of reserves, and the
shareholders, to whom the shares are allotted, have to pay nothing. The purpose is to capitalise profits which may be available for division or to
utilise quasi-capital gains. '' Bonus shares '' go by the modern name '' capitalisation shares''. If the Articles of Association empower, the company
can capitalise profits or reserves, and issue fully paid shares of a nominal value equal to the amount capitalised to its shareholders. But in some
cases, the Articles provide for an option to the shareholders to take cash instead of shares. This would make no difference in the position, except
of course to the extent to which the option is exercised. Inland Revenue Commissioner v. Fisher''s Executors L.R. (1926) A.C. 395, and
Commissioner of Income Tax, Bengal v. Mercantile Bank of India L.R. (1936) A.C. 478 : L.R. 63 IndAp 457 : 71 M.L.J. 525 (P.C.). Where the
Articles authorise the satisfaction of a dividend or bonus in fully paid shares, the declaration of the dividend or bonus makes the shareholder a
creditor of the company for the amount of his proportion, the release of his claim against the company for this amount is a good and valuable
consideration or set-off, so as to make the shares fully paid, even though the release is compulsory.
Spicer and Pegler in their book "" Book-keeping and Accounts"" state that a bonus issue of shares adds nothing to the net assets of the company,
and its effect is merely to divide the capital employed in the business into a large number of shares. How the shares are actually issued is thus set
out by the learned authors at page 267:
When a company has a large amount of undistributed profits either on Reserve Account or on Profit and Loss Account, the real capital employed
in the business tends to be obscured. Usually, ''such accumulations will have been employed in the acquisition of fixed assets, and as working
capital, which will be required permanently. To bring the issued share capital into a truer relationship with the capital actually employed in the
business, the accumulations can be capitalised and applied in paying up the amounts due on shares to be issued to the members as bonus shares.
No cash passes between the company and its members in respect of these transactions, the resolution to pay the bonus being so framed as to give
the company authority to apply the bonus in paying up the shares.
The authors also point out that it is usual to find that where the shares are quoted on the Stock Exchange, the issue of bonus shares is a bull point,
which forces up the market value of the shares and enable the shareholders, who wish to do so, to realise the immediate profit.
It is thus clear that the idea behind the issue of bonus shares is to bring the nominal share capital into line with the true 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 issue of further
shares. The necessary money is available with it, and this money is converted into shares which really means that the undistributed profits have
been permanently "" ploughed back "" into the business and converted into share capital.
It is obvious that bonus shares are not obtained by the share-holders free of any consideration. They get these shares only in lieu of dividends
which might otherwise have been paid by the directors of the company. What they would have got in the shape of cash after dividends have been
declared and distributed, they get in the shape of bonus shares. Core-Browne in his book on Joint Stock Companies states thus at page 29:
Fully paid ''bonus'' shares are not a gift, they are merely a distribution of capitalised undivided profit.
Palmer in his book on Company Law is also of the opinion that bonus shares are not gifts in the hands of the share-holders. At page 193, he
observes:
Shares issued for past consideration or by way of a gift cannot be treated as paid up and the allottees can be made liable to pay for them. Different
is the position where bonus shares are issued because in that case the shares are fully paid up out of profits of the company available for
distribution by way of dividend or otherwise available.
Pennington in his book on Company Law states that the issue of bonus shares-must be treated as an issue for a consideration other than cash.
At page 276, he observes:
It is common, however, for Articles to contain a power for the company to capitalise profits or reserves, and to issue fully paid shares or
debentures of a nominal value equal to the amount capitalised to its shareholders. These new shares or debentures are known as bonus shares or
debentures''; but the name is misleading in that it implies that they are a gift from the company. If they were a gift, they would not be paid up at all
and in the case of bonus shares, the company could call on their holders to pay for them in cash. In fact, they are not a gift, and they are paid for in
full by the capitalised profits or reserves which would otherwise have been distributed to the shareholders as a cash dividend.
It seems to us that it would be a misnomer to call the recipients of bonus shares as being donees of shares from the company. The machinery
by which the bonus shares are issued is not a simple process of converting the surplus available from, profit and loss account or other reserve
account into capital by debiting the revenue account and by crediting the capital account. It is not a mere book entry of debit and credit that results
in the issue of bonus shares. It is true that ultimately only book adjustments are made, but before this is or can be done, there must be a resolution
by the share-holders by which this conversion of income or revenue of the company is transformed into capital. It may be, that as a result of the
permanent acquisition of capital by drawing out from the revenue account, it would result in a. great advantage and a pecuniary benefit to the
company itself. It may even be that there is no law that would compel directors of a company to distribute dividends at a particular rate or
percentage. But in substance and in effect, these shareholders pay for the bonus shares by agreeing to forego what would otherwise have enured to
their favour by way of distribution of dividends.
Learned Counsel for the Department laid considerable stress on a decision of the Bombay High Court in Emerald and Co. Ltd. Vs.
Commissioner of Income Tax, Bombay City, Bombay, in support of his contention that bonus shares are gifts, pure and simpliciter. In that case,
the assessee held 350 shares in a company which included 50 free bonus shares of the face value of Rs. 250 each. The assessee sold 300 shares
and claimed a loss of Rs. 35,801 by valuing the bonus shares at their face value. The Department arrived at a loss of Rs. 27,766 by adopting the
method of averaging the price of the shares. The Tribunal suggested a method by which the 50 bonus shares were completely ignored and the loss
was arrived at by considering the purchase value of the 300 shares and the proceeds realised by their sale. On a Reference to the High Court,
Chagla, C.J., held that, as the assessee paid nothing for the bonus shares, the price of Rs. 250 could not be put on these shares, that the method
suggested by the Tribunal was erroneous, that the proper profit and loss could only be arrived at by averaging the cost of 350 shares taking into
consideration the fact that 50 bonus shares were received free and that the method of valuation adopted by the Department was right. At page 817
the learned Chief Justice observed as follows:
The contention of Mr. Kolah is that although the bonus shares were given free if these shares had not been given he would have received a larger
dividend and these bonus shares have been paid out of profits of the company. We are not concerned with the reason which induced the company
to issue these bonus shares. The fact remains that the bonus shares were received free and the assessee company paid nothing for the bonus
shares.
This decision was taken up on appeal to the Supreme Court, and their Lordships reversed the judgment of the Bombay High Court in Emerald
and Co. Ltd. Vs. Commissioner of Income Tax, Bombay, Their Lordships held that for the purpose of assessing the loss for the accounting year,
the question of the proper method of valuing the bonus shares was not relevant, as they were not sold and were still retained in the hands of the
assessee, and that the method of valuation adopted by the Appellate Tribunal was the correct method and the loss as calculated by the Tribunal
was correct and according to law. The question whether bonus shares should be deemed"" to be gifts was, however, left open. At page 260, His
Lordship Hidayatullah, J., observed thus:
He submitted that, in view of the fact that the bonus shares were still retained by the assessee company, the profit and loss could be calculated on
the basis of the cost of the other shares and their sale price, and the valuation of the bonus shares, whether at face value or at market value, or at
nil or even at a notional value, did not enter into the question of the calculation of the loss in the transactions which were gone through with respect
to shares actually bought and sold. He accordingly pressed us to leave the question, whether the issuance of the fully paid bonus shares involved an
expenditure on behalf of the assessee company, open for consideration till the bonus shares were actually sold. Till that time, he stated, the
valuation in the account books of the company Would be adjusted on debt and stock sides by equal entries, whatever they might be.
In our opinion, the question as regards the value of bonus shares in the hands of the share-holders at the time of the issue, whether it should be
taken as nil or whether it should be taken as the face value or market value, did not arise for consideration in the case before the Supreme Court,
as it was found that all the shares were not sold by the assessee, and that they had retained some shares even during the relevant year of account.
With great respect to the learned Judges of the Bombay High Court, we disagree with the view that the bonus shares are obtained free by the
shareholders and that the original cost of acquisition of these shares is nothing. Having regard to the principles governing the issue of bonus shares
to which we have already adverted we have no doubt in our mind that the bonus shares are not issued free or ex gratia as the company gets an
adequate quid pro quo from the shareholders.
The case of Steel Barrel Co., Ltd. v. Osborne 24 T.C. 293 is instructive on the question whether bonus shares can be said to have been
acquired for nil value. The facts are somewhat complicated, and it is not necessary to set them out. It is enough to refer to the following
observation of Lord Greene, Master of the Rolls, at page 306:
It was strenously argued on behalf of the Crown that if a company acquired stock in consideration of the issue of fully paid shares to a vendor, that
stock must, for the purpose of ascertaining the company''s profits, be treated as having been acquired for nothing, with the result that when it
comes to be sold, the Revenue is entitled to treat the whole of the purchase price obtained on the sale as profit. This is a remarkable contention
and it would require conclusive authority before we could accept it. The cases relied on in its support were Commissioners of Inland Revenue v.
Blott 8 T.C. 101, and Lowry v. Consolidated African Selection Trusts Ltd. 23 T.C. 259, neither of which, in our view, has any bearing on the
point. The argument really rests on a misconception as to what happens when a company issues shares credited as fully paid for a consideration
other than cash. The primary liability of an allottee of shares is to pay for them in cash, but when shares are allotted credited as fully paid, this
primary liability is satisfied by a consideration other than cash passing from the allottee. A company, therefore, when in pursuance of such a
transaction agrees to credit the shares as fully paid, it is giving up what it would otherwise have had, namely, the right to call on the allottee for
payment of the par value in cash.
This case clearly supports the conclusion arrived at by us that the bonus shares cannot be called gifts in the hands of the share-holders.
It is now settled law that a bonus issued in the form of fully paid shares of the company is not income for Income Tax purposes. In
Commissioner of Inland Revenue v. John Blott 8 T.C. 101 the assessee, who was a share-holder in a limited company, obtained in satisfaction of
bonus declared out of company''s undivided profits, certain shares. The share-holders had no option to receive cash in lieu of shares in satisfaction
of the bonus. The House of Lords by a majority decision (two of the Law Lords dissenting) held that the shares credited to the assessee in respect
of the bonus, being distributed by the company as capital, were not income in the hands of the respondent taxable to Income Tax or super-tax.
The observations of Viscount Haldane appropriately described the process of the issue of bonus shares. At page 125, the learned Law Lord
states:
A shareholder is not entitled to claim that the company should apply its undivided profits in payment to him of dividend. Whether it must do so or
not is a matter of internal management to be decided by the majority of the shareholders. He cannot sue for such a dividend until he has been given
a special title by its declaration. But if, acting within its powers, it disposes of these profits by converting them into capital instead of paying them
over to the sharer-holders, that, as I conceive it, is conclusive as against all the outside world, including the Crown, and the form of the benefit
which the share-holder receives from the money in the hands of the company is one which is for determination by the company alone.
This observation of Viscount Haldane was quoted with approval by Viscount Cave in Fisher''s case L.R. (1926) A.C. 295. The Judicial
Committee in a case arising under the Indian Income Tax Act quoted the same observation with approval. That is the case of Commissioner of
Income Tax, Bengal v. Mercantile Bank of India L.R. (1936) A.C. 478 : L.R. 63. LA. 457 : 71 M.L.J. 525. The facts of that case were as
follows. An investment company was carrying on business in India and it capitalised its accumulated undistributed profits and issued to its
shareholders bonus debentures, which were subsequently redeemed. It was held that the share-holders, did not, as a result of those transactions,
receive any taxable income, profits or gains within the meaning of Section 4 of the Indian Income Tax Act, 1922. The personal motive or purpose
of the individual share-holders, even though they held controlling interest in the company, was held to be irrelevant, if it was made out that the
company had in fact capitalised he accumulated profits. The view of the Judicial Committee, therefore, was that undistributed profits of the
company applied and appropriated for the issue of bonus shares would never become profits in the hands of the share-holder at all. The bonus
share was held to be something in the nature of extra share certificate in the company. Indeed this position, that bonus shares allotted to a share-
holder would not represent taxable income in his hands, is conceded by learned Counsel for the Department.
The case of Malam v. Hitchens L.R. (1894) 3 Ch. 578, was relied upon by the learned Counsel for the assessee, for the purpose of showing
that bonus shares really partook of all the character of the original shares held by a share-holder. We are, however, unable to appreciate the
relevancy of this citation. The question in that case was whether the bonus shares should enure in favour of a life-estate holder to whom the shares
had been given for enjoying the income from the dividend therefrom for his lifetime. On the termination of the estate holder, there was to be a
reversion in favour of other individuals. A number of cases have arisen and have been decided in England, as regards the destination of the value of
the bonus shares when they are sold, whether it should go to the life-time estate holder on the footing that they represented undistributed profits of
the original shares, or to the remaindermen as forming part of the corpus of the original shares. In each case, the question was held to be a question
of fact, whether or not profits have been capitalised. In Bouch Sproule v. Bouch L.R. (1885) 20 Ch. D. 635, Fry, L.J., set out the true position
thus:
Where a testator or settlor directs or permits the subject of his disposition to remain as shares or stock in a company which has the power either of
distributing its profits as dividend or of converting them into capital and the company validly exercises this power, such exercise of its power is
binding on all persons interested under him, the testator or settlor, in the shares, and consequently what is paid by the company as dividend goes to
the tenant for life, and what is paid by the company to the share-holder as capital or appropriated as an increase of the capital stock in the
concern, enures to the benefit of all who are interested in the capital.
Those are cases in which there were rival claimants in respect of the proceeds of the bonus shares, the life-estate holder claiming that the
shares represented only the income, and the remainder man claiming that they represented only the capital. Such a question is wholly foreign to the
scope of the present discussion. Here the only question is as regards the quantum of capital gains realised by the assessee in disposing of the bonus
shares.
Now the question is what is the value of the bonus shares in the hands of the share-holder at the inception when they were issued and allotted
to him. Capital gains represent the excess realisation made by the assessee over and above the cost of acquisition. Taking the allotment of bonus
shares, it might plausibly be contended that the price paid by the share-holder is the amount of undistributed profits which he would have got if they
had been distributed as dividends. But we do not think that it would be a sound way of ascertaining the true value of the bonus shares. The
moment shares are issued, the recipient obtains the scrips which have a face value. Whether the shares were issued by the company at a premium
or at a discount, the actual share is only of the value denominated therein. There is thus a good deal to be said in favour of the view that the cost of
acquisition of the bonus share is really the face value. The other alternative is to find out the market value of the shares. On the date of the issue of
bonus shares, the original shares may have a market value. How far the issue of bonus shares would operate as a ''bull'' in the market is not easy to
determine. Of course, it can be safely assumed that the shares-of a company which is in a position to issue bonus shares, would normally be selling,
at a premium and not at a discount. We have already extracted a passage from Spicer and Pegler''s book on Accountancy, which expresses the
view that the share value in general may go up.
Gower in his book, ''Modern Company Law '' however, observes as follows at page 104:
This operation can be undertaken by means of a ''bonus issue'', that is, by issuing mere shares to the existing holders and using the funds available
for dividend but retained by the company to pay for them. By this means the reserves on share premium account, or some part of them, are
capitalised or converted into share capital. The only result, from the share-holder''s point of view is that his proportion of the capital of the business
is now represented by a greater number of shares, each of which is therefore worth less and this may make them more readily marketable.
In the foot-note the following observation occurs:
Share-holders frequently do not realise this but think that they are being given a true tax free bonus which they encash by selling the bonus shares.
The word '' bonus'' is itself misleading and totally different from the sense in which it is used in America where this type of issue is described as a
stock dividend. Certain English newspapers are now trying to popularise the description ''plough-shares'', and the Stock Exchanges now refer to ''
capitalisation issues ''
It is therefore not possible to say with any definiteness that the value of the bonus shares is really equivalent to the value of the original shares
on the date of issue. The introduction and circulation of bonus shares themselves bring about an uncertainty in the value of the shares ; and in our
opinion, it is not possible to investigate the actual market value of the bonus shares co instanti they are issued. It must also be remembered that the
market value of the shares, if that would be the true cost of acquisition of the shares by share-holders, should be that at the time of the issue. The
state of affairs at the time of the issue is that the company has in circulation only the original shares. The fresh issues in the shape of bonus shares
would of course have a tilting effect on the equilibirum of the value of the shares of the company in general. For example, let us take the following
illustration. The share capital of a company is Rs. 1,00,000--in one rupee shares. The revenue resources available for declaration of dividend
amount to Rs. 50,000--cum-dividend the share will be worth each Rs. 1,50 np. If bonus shares are issued at par the share capital will be increased
to Rs. 1,50,000 but there will be corresponding increase of shares to 1,50,000 from 1,00,000. Each share will be worth rupee one but each
share-holder will be having fifty percent. more shares. The shareholder gains nothing. He gets more shares but the pecuniary advantage is nil. The
stock market might quote a. higher value for the one rupee shares on the basis of a good percentage of dividend declared in the past. After
capitalisation of the profit it is reasonable to expect that only a lesser dividend would be declared. This must bring down even the market quotation.
But yet people might gamble on the dividend not dropping down much and stipulate a value in excess of the real value. The position on the issue of
bonus shares becomes very uncertain, and the so-called market value is really a fiction. Surely, it cannot be said that the market value of the shares
of the company as a whole, the original shares as well as the bonus shares, obtaining a few days after the issue, should be deemed to be the market
value of the bonus shares, when they were allotted or issued to the share-holders. In these circumstances, we are clearly of opinion that it would be
safe to hold that the real value of the bonus shares, as on the date of issue, would only be the face value of the shares.
We find that is the view taken by the Patna High Court in DALMIA INVESTMENT CO. LTD. (NOW SHRI RISHAB INVESTMENT
CO. LTD.) Vs. COMMISSIONER OF Income Tax, BIHAR., The facts of that case were as follows. The assessee company dealt in shares and
also held investments of shares. On 1st January, 1948, the assessee had 1,10,747 shares of Rohtas Industries, valued Rs. 15,547,902. Of these
shares 31,909 were bonus shares issued by the Rohtas Industries in 1945 at the face value of Rs. 10 each, and the assessee had debited the share
account in respect of the bonus shares by Rs. 3,19,090 with a corresponding entry in the capital reserve account for the same amount. On 29th
January, 1948, the assessee sold the entire lot of 1,10,747 shares for Rs. 15,50,458 and claimed a loss of Rs. 7,444. The Appellate Tribunal
valued the bonus shares at nil and held that the assessee had made a profit of Rs. 3,11,646. On a reference, the Patna High Court held that the
bonus shares were not issued by the company free to its shareholders, as the consideration for the issue of the bonus shares was the dividend or
bonus which was provided and declared by the company out of its undistributed profits. The High Court, further held that the real cost of the
bonus shares to the assessee was the face value of the shares and the Tribunal was wrong in holding that the assessee had made a profit of Rs.
3,11,646. The Patna High Court dissented from the view of the Bombay High Court in Emerald and Co. Ltd. Vs. Commissioner of Income Tax,
Bombay City, Bombay, . We respectfully agree with the view taken by the Patna High Court.
In our opinion, the Tribunal is in error in directing a fresh computation of capital gains by valuing the closing stock at the original cost of the
holding averaged for the original and bonus scrips since issued or at the market price whichever is lower. The true criterion is to take the face value
of the bonus shares and to ascertain the excess if any, realised by the assessee by sale of these shares in the year of account. We, therefore,
answer the question referred in the following manner. The sum of Rs. 7,269 cannot be taxed in its entirety as capital gains u/s 12-B of the Act.
What could be brought to tax under that provision is only the excess of Rs. 7,269, if any, over the face value of the 94 bonus shares held and
disposed of by the assessee. The Reference is answered accordingly. 1 here will be no order as to costs.