The Income Tax Appellate Tribunal recently ruled that compensation received for a waiver of the right to acquire shares against capital advances is taxable.(1)

Natco Pharma Ltd, the assessee, was a company engaged in the manufacture and sale of bulk drugs. The assessee had advanced money to Krishnapatnam Port Co Ltd (KPCL), whereby the assessee acquired the right to an allotment of shares in its favour. The assessing officer held that Rs100 million received as compensation for forgoing the right to acquire shares in KPCL should be taxed as short-term capital gains.

The right to convert the advance given to KPCL into an allotment of shares is 'property', as contemplated under Section 2(14) of the Income Tax Act. Furthermore, there was a relinquishment of an asset, which falls within the definition of the term 'transfer' under Section 2(47) of the act.

The tribunal did not agree with the assessee's contention that there was no acquisition cost incurred for the right to acquire the shares. Rather, it held that as the assessee had advanced money to KPCL, it had acquired the right to the allotment of shares. Thus, the tribunal held that the entire amount of Rs100 million received by the assessee as compensation for waiving the right to receive KPCL shares should be brought to tax as a capital gain. This capital gain should be computed as long term or short term, on a pro rata basis, depending on the investments or advances made by the assessee.

Relinquishment of an asset is a 'transfer' under Section 2(47) of the act and gains earned on such transfer would be capital gains taxable under the act.

The capital gains computation mechanism fails if the cost of acquisition is indeterminable.(2) The tribunal concluded that the compensation was taxable, as there was cost of acquisition in the form of advance money; thus, the capital gains computation mechanism did not fail. It is unclear from this decision whether compensation received for relinquishment of assets will always be taxable or will be taxable only if the cost of acquisition can be determined, as in this case.

The most common rights that generally prevail in a shareholders' agreement are call options and put options. It is important to determine whether capital gains tax could be applied to the transfer or relinquishment of such rights, as it is difficult to determine the cost of acquiring such assets.

For further information on this topic please contact Ranjeet Mahtani at Economic Laws Practice by telephone (+91 22 6636 7000), fax (+91 22 6636 7172) or email ([email protected]).

Endnotes

(1) DCIT v Natco Pharma Ltd, ITA 765/Hyd/2011.

(2) As was held by the Supreme Court in BC Srinivasa Shetty (128 ITR 294).