Commissioner of Income Tax (Central)-III, New Delhi vs. M/s. J.S. Electronics Pvt. Ltd. – Deletion of Additions on Share Purchase Price under Section 40A(2) and Principles of Closing Stock Valuation at Cost or Market Price under Section 49(2).

Facts of the Case

The Assessee is a private limited company dealing in shares. The Assessee came to know that the erstwhile HCL had entered into a joint venture agreement with Hewlett Packard, USA and that in terms thereof, shares of the erstwhile HCL would effectively be transferred to HCL Ltd. and HCL HP Ltd. In fact, a scheme of arrangement to this end was prepared and sanctioned under Sections 391 and 394 of the Companies Act, 1956 by this Court. One of the terms of the scheme of arrangement, with which we are concerned, provided that the shareholders of the erstwhile HCL would receive, for 100 shares held by each shareholder, 68 shares of HCL HP Ltd. and 32 shares of HCL Ltd. The Assessee also came to know that Hewlett Packard, USA would buy the shares of HCL HP Ltd. at a predetermined price of Rs.168.80 per share.

Based on this information, the Assessee purchased 7,77,100 shares of the erstwhile HCL. Out of these, the Assessee sold 1,29,600 shares on various dates leaving behind a balance of 6,47,500 shares of the erstwhile HCL. In terms of the joint venture agreement, for these 6,47,500 shares the Assessee was allotted 4,40,300 shares of HCL HP Ltd. and 2,07,200 shares of HCL Ltd. Out of the 4,40,300 shares of HCL HP Ltd. held by the Assessee, it sold to Hewlett Packard, USA 1,14,486 shares at the predetermined price of Rs.168.80 per share. On these broad facts, two issues arose before the Assessing Officer on the return of income filed by the Assessee.

Issues Involved

1. Whether the addition of Rs.89,29,635/- made by the Assessing Officer to the income of the Assessee on account of the high price paid by the Assessee for the purchase of shares of the erstwhile HCL was sustainable under Section 40A(2) of the Act or on the ground of the transactions being sham/bogus.
2. Whether the addition of Rs.1,40,94,839/- (or Rs.1,43,29,635/-) made by the Assessing Officer to the closing stock of shares by valuing the shares of HCL HP Ltd. at an estimated market price of Rs.100/- per share, instead of the average cost price of Rs.55.82 per share as worked out by the Assessee, was sustainable.

Petitioner’s Arguments (The Revenue)

The Revenue contended that the Assessee paid an unjustifiably high price for the purchase of the shares of the erstwhile HCL, relying on the prices prevalent in the Bombay Stock Exchange, and thereby sought to sustain the addition of Rs.89,29,635/-. Regarding the second issue, the Revenue argued that the closing stock of the shares of HCL HP Ltd. should be valued at the market price of Rs.100/- per share rather than the average cost price of Rs.55.82 per share. The Departmental Representative also contended before the Tribunal that Section 49(2) of the Act was not applicable to the valuation of the closing stock in this case.

Respondent’s Arguments (The Assessee)

The Assessee submitted that the explanation for purchasing shares of the erstwhile HCL at a high price was that it had purchased a large number of shares in large blocks from the Delhi Stock Exchange. The Assessee submitted that necessary brokers' notes were available and the payment made to the brokers was by account payee cheques, proving the transactions were above board. The Assessee had special knowledge about the joint venture and the scheme of arrangement and was, therefore, willing to pay a higher price to corner the shares. No part of the consideration had come back to the Assessee.

As regards the second issue, the Assessee argued that it had worked out the average cost of the shares of HCL HP Ltd. at Rs.55.82 per share following the scheme of arrangement which required splitting up of the shares. The Assessee maintained that it was entitled to value the closing stock of shares at the cost price, which was lower than the market value, in accordance with established accounting principles.

Court Order / Findings

The High Court observed that the CIT (A) correctly understood and fully implemented the earlier remand directions of the Tribunal. On the first issue, the Court confirmed that Section 40A(2) of the Act was inapplicable as the expenditure was neither excessive nor unreasonable, nor was the transaction a sham. The transactions were confirmed by brokers, payments were made via account payee cheques, and no evidence showed that any consideration returned to the Assessee. The explanation of the Assessee was plausible and essentially a question of fact.

On the second issue regarding valuation of closing stock, the High Court held that the Assessee was well within its rights to value the closing stock at the cost price which was lower than the market price. The Court ruled that the action of the Assessee is fully backed by the decision of the Supreme Court in Sakthi Trading Co. v. Commissioner of Income-tax, [2001] 250 ITR 871, which established that where there is no discontinuation of business, the closing stock is to be valued at cost or market price, whichever is lower. No substantial question of law arose, and the appeal of the Revenue was dismissed.

Important Clarification

• Genuine Higher Purchase Price: A mere difference in the purchase price compared to another stock exchange is not enough to sustain an addition if the transaction is verified by brokers, paid via account payee cheques, and driven by commercial commercial rationality (such as strategic cornering of shares based on special knowledge of a corporate restructuring scheme).
• Valuation of Closing Stock: It is an established rule of commercial practice and accountancy that unless a business is discontinued, an assessee has the absolute right to value its closing stock at cost or market price, whichever is lower.

Section Involved

• Section 40A(2) of the Income Tax Act, 1961 (Expenses or payments not deductible in certain circumstances / payments to related parties/unreasonable expenses)
• Section 49(2) of the Income Tax Act, 1961 (Cost with reference to certain modes of acquisition / cost of shares in an amalgamated company)

Link to download the order –https://delhihighcourt.nic.in/app/case_number_pdf/2007:DHC:1162-DB/MBL21092007ITA13152006.pdf

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