QUESTION: During the financial year 2002-03, a closely held public company had issued one per cent non-cumulative redeemable convertible preference shares. These preference shares could be redeemed or converted into equity shares compulsorily at the end of seven years or earlier at the option of the company.
The company during 2010-11 had converted the said preference shares into equity shares. The conversion has been made at par at Rs.10 each and accordingly the preference shareholders have been allotted shares, the fair market value of which is Rs.32 per share.
In this connection my query is
(1) whether the said conversion of preference shares into equity shares attracts the provisions of long-term capital gains tax,
(2) whether the allottees who got equity shares on conversion of preference shares is liable to pay long-term capital gains tax for the difference in the fair market value and the face value of shares, that is, 32-10=22 per share and
(3) also kindly advise whether indexation benefits are available for the allottees for such transaction.
ANSWER: Conversion of one kind of shares for another, from preference shares to equity shares, was understood as exchange by the AP High Court in Addl. CIT v Trustees of H.E.H. Nizam's Second Supplementary Family Trust (1976) 102 ITR 248 (AP) following the reasoning of the Supreme Court in understanding the word “exchange” in CIT v Motors and General Stores (P) Ltd. (1967) 66 ITR 692 (SC).
In a similar situation, where the original equity shares were exchanged in a scheme or reorganisation for a new type of equity shares and irredeemable preference shares, it was held that the loss occasioned on such conversion with reference to the market value of the substituted asset has to be allowed as capital loss following the above decision of the AP High Court in CIT v Santosh L. Chowgule (1998) 234 ITR 787 (Bom).
The decision in Trustees of H.E.H. Nizam's Second Supplementary Family Trust's case (supra) was on the short question, whether conversion of preference shares into ordinary shares at the option of the shareholders would constitute “exchange”.
The option of the shareholder in this case was available to the shareholders five years after the issue of preference shares.
As regards the decision in Santosh L. Chowgule's case (supra), the short point for consideration related to the period of holding for the inference whether it was long-term or short-term capital asset. Since the sale was within a period of 60 months after conversion, which was the prescribed period of holding for inference of short-term capital asset at the relevant time, it was held to be short-term capital asset.
Though the above two decisions of the court would infer transfer by exchange, the interpretation of Sec. 55(2)(b)(v) was not at issue, though this provision was inserted by the Finance Act, 1964, with effect from April 1, 1964.
It follows from this provision that it may be an exchange but the very fact that Sec. 55(2)(b)(v) requires that the cost has to be taken as that of the original “shares or stock from which such asset is derived”, clearly implies that there can be no liability at the time of conversion, since imposition of such liability at the time of conversion would amount to double taxation in the light of the requirement of adoption of cost of original shares at the time of sale of converted shares. Conversion of one kind of share to another falls under sub-clause (e) of the provision referred to.
It is in this context that there should be no liability for the reader on the date of such conversion but revenue will catch up at the time of sale of converted assets by allowing only the cost of the original asset.
It may also be probably argued that where the exchange is of shares for shares, transfer cannot possibly be implied where such conversion is under the terms of issue of original shares and where the conversion is not at the option of the shareholder but of the company because conversion to constitute transfer should be act of both parties at the time of conversion.
Though the conversion of one type of share for another is not referred for exemption under Sec. 47, the specific provisions under Sec. 55(2)(b)(iv)(e) should cover such conversion, requiring cost of original shares to be adopted as cost in computation of capital gains on sale of converted shares, the answer to the question raised by the reader is that there is no liability at the stage of conversion.
In the view taken in the answer that there is no liability as on date of conversion, the question of indexation does not arise.
As and when the converted shares are sold, the period of holding will include the period for which original shares were held for purposes of indexation.
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