Premium on Redemption of Preference Shares Is Not Accruable Interest

Nikhil Mogha

28 May, 2024

The Bangalore Income tax appellate tribunal, while allowing the appeal of the appellant in the case Enzen Global Solutions (P.) Ltd. v. Income Tax Officer held that the assessing officer should consider the additional evidence adduced by the assessee before the CIT (A) and other evidence to which the assessee relies on its claim. The tribunal further disallows the revenue authorities’ action to tax the assessee’s income. The premium received at the time of redemption of preference shares will be taxed in the year of redemption. Further, only the returns on such shares are liable to be taxed on an accrual basis.

Facts of the case

The Assesse has invested a total amount of Rs.130,00,00,000 in 13,00,00,000 preference shares with a face value of Rs 1000 per share of M/s. Resource Consulting Private Limited. These shares shall be redeemed at the end of 20 years at an interest rate of 16.5 % on the face value. It means both the principal and the premium amount shall be payable to assesse at the time of redemption. The assessee in the original return of income has mistakenly declared an amount of Rs.17, 09, 02,857 as the premium payable on redemption of preference shares under the head “Income from other sources”. However, the assessee has realised the mistake and filed a revised return wherein the amount of Rs.17, 09, 02,857 is subsequently reduced from the net profit.

It was claimed by the assessee that the premium received was to be taxed under the capital gain only at the time of redemption. Therefore, an amount of Rs.17, 09, 02,857 shall stand withdrawn. The assessee’s contention is rejected by the assessing officer (AO). The AO states that preference shares contain features of equity and debt instrument. Hence the payment to the preference shareholder is started from the beginning. Henceforth, the taxability of the premium does not depend upon the redemption of preference shares.

Further, the AO states that the interest on the dividend is on a cumulative basis. Hence, it becomes a cumulative preference share, and even though its payment is uncertain, its accrual is definite. Therefore, according to AO, the dividend is the income received on the preference shares.

The assessing officer also made an additional case by observing that the cumulative preference shares can be termed as an equity instrument, and the dividend will be received by the assessee irrespective of whether the company has declared a dividend or not. The AO presumes that the dividend distribution tax is already deducted, which can be claimed as an exemption by the investor. Henceforth the dividend is accrued on an accrual basis, and the interest expenses cannot be allowed for that specific investment as it is an expenditure incurred on earning exempt income. Therefore expenses incurred in the process of claiming preference shares shall not be allowed under Section 14A.

Therefore, an amount of Rs 17, 09, 02,857 has to be either taxed as interest income or regarded as an expenditure. In both cases, the accrued premium must be taxed, and dividend interest shall be disallowed.

Being aggrieved by order of the Assessing officer, the assessee filed an appeal before CIT (A). The CIT (A) also upheld the views of the assessing officer by treating the non-convertible preference shares as a debt instrument and taxing the premium on an accrual basis under “Income from other sources”. Being aggrieved by order of CIT (A), the assessee filed an appeal before the tribunal.

Issues of the case

• Whether the assessing officer is right in treating the share premium on redemption of preference shares on an accrual basis?
• Whether the share premium on redemption of preference shares can be treated as income or revenue and be assessed under “Income from other sources”?

Submissions from the side of the appellant

The submissions made from the side of the appellant are:

• Section 55 of the Companies act 2013 clearly states that the company cannot issue irredeemable preference shares, and the maximum redemption period cannot exceed 20 years from the issuance date. Moreover, the redemption of preference shares can be made out of the profits earned by the company.
• It is further contended by the appellant’s counsel that the dividend can be made only out of the profits or free reserves of the company under Section 123 of the Companies act 2013^[1].
• The appellant’s counsel relied on Sections 55 & 123 of the Companies Act 2013 and stated that preference shares could not be termed as debt instruments because preference shareholders have priority over equity shareholders. Based on this difference, the preference shareholder cannot be regarded as a debtor of the company, and the preference shares cannot be termed as debt.
• The counsel relied on the case of Aditya Prakash Entertainment Pvt. Ltd. Vs Magic wand Media Pvt. Ltd. and state that the action of the revenue department in treating the preference shares as debt is wrong. Also, subsequently holding that the dividend incomes generated on the assessee could not be supported.

Submission from the side of Respondent

The submissions made from the side of the Respondent are:

• The revenue department took note of the share subscription agreement and stated that the agreement specifically state that the preference shares are redeemable at a premium of 16.5% P. A will be accrued on a year-to-year basis and payable at the date of redemption.
• It is also contended by the revenue department that at the time of liquidation, the preference shareholders shall be given preference over the equity shareholders.
• The revenue department, based on the above contentions, states that the assessee is entitled to dividends on an accrual basis, and therefore according to the mercantile accounting system, it can be said that the income assessed by the assessee is directly attributable to the previous year.

Observations of the tribunal

The observations made by the tribunal are:

• The tribunal did a plain reading of the share subscription agreement and observed that the agreement clearly states that only the premium was to be paid at the time of redemption of preference shares, not the returns. Therefore, the assessee is only a preference shareholder and not a debtor to the company and hence entitled to receive a premium.
• On the question of treating the preference shares as equity, it is observed by the tribunal that even if the premium is regarded as a dividend, it is not a matter of right. It is declared by the directors of the company and approved by the shareholders under AGM (Annual General Meeting). Henceforth the preference shares cannot be treated as equity. Further, the income can be accrued only when the assessee is entitled to receive periodic payments.
• The tribunal observed that the revenue department could not address whether the premium on redemption of preference shares is taxable on the year when it is redeemed. The tribunal, while answering the issue, relied on the case of Anarkali Sarabia and Karthikeya Sarabia andstated that the premium on redemption of preference shares is liable to be taxed under “Income from capital gains”. Moreover, any investment made in the preference shares is termed as unlisted and unquoted security and hence is eligible for tax.

Decision of the tribunal

The tribunal, while allowing the assessee’s appeal, held that the revenue department was not justified in putting an amount of Rs 17, 09, 02,887 as premium receivable at the time of redemption of preference shares as the income of the assessee. The tribunal further holds that the revenue department’s action to tax the assessee’s income is disallowed.

Conclusion

The preference shares are exclusive shares that are allocated to preference shareholders. The preference shareholder is given priority over the equity shareholders in terms of dividend payment. In the present case, it is stated by the tribunal that the share subscription agreement clearly specifies that only the premium is to be paid to the assessee at the time of redemption of preference shares. Moreover, even if the premium is regarded as a dividend, the assessee cannot claim it as a matter of right as the directors of the company declare the dividend. Therefore, the premium is taxable in the year when the redemption is made.

Read Our Article: Rights of Preference Shareholders under the Insolvency and Bankruptcy Code, 2016