Saturday, December 19, 2015

Premium on Buyback: a Deductible Expenditure?

In an earlier post on this blog, Mr. Jayant Thakur had considered certain decisions of the Income Tax Appellate Tribunal (notably, Chemosyn v. ACIT) where the ITAT had held that “… premium paid by the company on buyback of shares of a warring shareholder group is deductible as business expenditure in the hands of the company…” It was pointed out in that post that the Tribunal had followed its own earlier decision in the case of Echjay Industries. It was further argued in that post:

“… when the Company buys back shares, it is generally returning the value of the shares in the form of face value as originally paid, accumulated reserves and value of assets like goodwill, etc. that is not recognized in the books. Such return can hardly be a business expenditure… The accounting treatment under accounting principles and also under Section 77A (and related provisions) of the Companies Act, 1956, clearly supports this. The face value of shares bought back is reduced from the paid up capital and the surplus (premium) is debited to reserves such as securities premium account or other reserves (other than revaluation reserve). These provisions generally do not permit debiting the amount paid to profit and loss account for the year… There is, however, merit in these decisions for a partial amount, to the extent the facts support them. There may be cases where shareholders may create such a nuisance value that it may seriously impact the working of the company (as what has happened in the above cited cases). The Company may end up buying back shares at a price higher than their fair value, just to get such hurdles out of the way so the Company can focus on its business. The excess may be deductible because it represents purely the amount paid on account of business expediency. But the fair value paid should, it is submitted, still not be deductible…
An appeal against the ITAT decision in Echjay was dismissed by the Bombay High Court. That appeal was not dismissed on the merits, though. The appeal was dismissed on account of the failure of the Revenue to remove the Registry’s ‘office objections’ – essentially, a dismissal for default. In two recent decisions, though, the Bombay High Court confirmed the decisions of the ITAT on the merits. The first was the appeal in the case of Chemosyn itself (CITv. Chemosyn, (2015) 371 ITR 427 (Bom]. The Court held:

An appeal from the order of the Tribunal in Echjay Industries Ltd. (supra) was also dismissed by this Court… We find that the impugned order records a finding of fact that the amounts which were paid by the respondent assessee for the purpose of purchase of its shares, to its shareholder for subsequent cancellation was an expenditure incurred only to enable smooth running of the business. Thus, the expenditure was incurred for carrying on its business smoothly and therefore, was a deductible expenditure. Thus, the impugned order of the Tribunal is essentially a finding of fact…

In CIT v. Bramha Bazar Hotels, (2015) 235 Taxman 195 (Bom), the question was reconsidered. The Department pointed out that the appeal in Echjay was not dismissed on merits. The Department also relied on the decision of the Supreme Court in Brooke Bond v. CIT, 225 ITR 798 (SC), to argue that expenditures in connection with share capital must necessarily be treated as capital expenditures. The Court rejected these arguments, followed its own order in Chemosyn, and held:

… expenditure so incurred by the Respondent-Assessee for purchase of shares and subsequent cancellation thereof was only for the purpose of enabling smooth running of its business... the aforesaid finding is essentially a finding of fact and the Revenue was not able to show that the finding is in any manner perverse and/or arbitrary…  The decision of the Apex Court in the case of Brooke Bond  relied upon by the Revenue deals with the situation where the assessee therein issued shares to the general public with a view to increase its share capital. The expenditure incurred by Brooke Bond to increase its capital, was claimed to be Revenue in nature and, therefore, deductable. The Apex Court upheld the order of the High Court and held that the amount spent to increase the share capital is not revenue but capital expenditure. Thus, it is to be disallowed. The aforesaid decision was rendered in a completely different fact situation from the one here. In this case, there is no increase of share capital but the Company has been forced to pay off one of the warring group of share holders by buying its shares for its own well-being and carrying on business. It was the expenditure which was forced upon the Respondent-Assessee so as to carry on its business and not an expenditure of choice. Therefore, the Supreme Court in Brooke Bond India Ltd. (supra) is inapplicable to the present facts…

In Bramha Bazar, the question of law sought to be raised by the Revenue before the High Court was in respect of the premium paid vis-a-vis the face value of the shares. The ITAT had recorded that "the extra amount paid over and above the face value... was claimed as a revenue business expenditure...In Chemosyn, the question was in relation to ‘amount spent in acquiring the shareholding’: presumably the entire amount, and not just the excess over market value. Therefore, the position appears to be that the entire amount representing the excess over the face value will be available as deduction if there is evidence that the payment was made for smooth running of the business. 

[Disclaimer: I appeared for the taxpayer to oppose the appeal before the High Court in Bramha Bazar. My views cannot be regarded as independent. The issue is, however, of some significance; and I would welcome any comments on the correctness or otherwise of the stand taken.]


vswami said...

“In an earlier post on this blog....”
Refer posted comment on that ‘earlier post’. For added comment on the present write-up, may look up , the specially shared thoughts on Facebook @ Swaminathan Venkataraman >

vswami said...

In one’s independent view (for sharing own sporadic thoughts):

Such points of dispute are required to be, according to case law, examined and settled broadly on following grounds:

Whether or not the impugned expenditure, -

a)has been incurred or laid out wholly and exclusively for the purpose of the business;

b)is it to be regarded as in ‘capital’ field.

For the said purpose,a close application of mind and logical reasoning, in an unbiased manner, to each and every word /concept as has been employed by the legislature in framing the enactment has to be construed in the light of largely accepted and finally settled position in law; that is, being guided by the case law in which the two above said basic propositions have been gone into and thrashed out, mainly on the ground of , and by ideally applying the most fundamental principle of all namely, “COMMERCIAL EXPEDIENCY”.

Further, for deciding whether or not it is of the nature referred to in b) above, the fact that it has relation to assessee’s share capital,- going by widely known judicial reasoning / conceded wisdom as is to be gathered from case law,- ought not to be the deciding criterion.

Should the matter be so viewed, on the foregoing premises, strictly speaking, the issues taken up to courts in the cited cases do not really partake the nature of a question of law, or a substantial question of law. If so, most such points of dispute are capable of being , and might have been, finally settled at the ITAT level itself; and not taken or allowed to travel beyond that stage. To put it differently, most such issues could have been resolved at that level itself, had all concerned – not barring the members of the Bar – made it a point, as a matter of righteous / virtuous principle, to address their arguments manly using the plank of “first principles”- i.e. what the enactment, according to a simple reading and straightforward understanding , says ; instead of dubiously resorting to long winding and confusing pleas, through the gimmick of blindly citing case law , unless absolutely called for, inevitable, but having ensured that case law is 'on all fours' wrt the case on hand. Besides, instead of relying on case law, mindfully choosing and employing /invoking anyone or more of the rules /principles of interpretation as enunciated by courts , as appropriate, to serve as ‘aids’ , to directly help the case on hand, should go a long way in accomplishing the best outcome in its altruistic sense, not beyond the stage of ITAT.>>>>

Anonymous said...

Thanks for this update. For AYs after introduction of distribution tax on buyback, how would this work? Would it mean that cos can claim a revenue expenditure, while at the same time having to pay tax under 115Qa?

Mihir Naniwadekar said...

@vswami: I agree that whether something is a matter of commercial expediency or not is essentially a question of fact. However, whether an expenditure is capital or revenue in nature is a mixed question of fact and law; and would be subject to challenge if it can be shown that an incorrect legal test has been applied. In these cases, what the HC seems to be suggesting is that the ITAT has not applied a wrong legal test; and the view taken by the ITAT on an application of the correct test is a possible view. I agree that it is for the ITAT to be satisfied in each case, on the facts, that the payment was one of commercial expendiency. To put the issue slightly differently: say a capital asset is written off completely: can the assessee argue that this write-off was on account of commercial expediency, and hence allowable u/s 28 r.w.s 37? If the ITAT accepted this argument, it would possibly be open to the High Court to at least examine whether such a conclusion was, in law, at all open to the ITAT?

@Anonymous: Insofar as 115QA is concerned, there would still be some doubt. It seems that 115QA applies only to buybacks under s 77A of the 1956 Act. Even under the 1956 Act, buybacks pursuant to orders of the Court/CLB could be treated differently from s. 77A buybacks. It would be a far harder argument to make, that s. 77A buybacks were also revenue expenditures.