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p. 564

includes all income, profits and gains from whatever sources derived which are received or are deemed to be received in the taxable territories in such year by or on behalf of such person, or accrue or arise or are deemed to accrue or arise to him in the taxable territories during such year, or accrue or arise to him without the taxable territories during such year, or having accrued or arisen to him without the taxable territories before the beginning of such year and after the 1st day of April, 1933, are brought into or received in the taxable territories by him during such year. The Act does not contain much guidance as to cases in which tax is to be levied on income received, and cases in which tax is to be levied on income accrued or arisen. Section 13 however requires that income, profits and gains for the purposes of Sections 10 and 12 shall be computed in accordance with the method of accounting regularly employed by the assessee. If accounts are maintained according to the mercantile system, whenever the right to receive money in the course of a trading transaction accrues or arises, even though income is not realised, income embedded in the receipt is deemed to arise or accrue. Where the accounts are maintained on cash basis receipt of money or money’s worth and not the accrual of the right to receive is the determining factor. Therefore, if commercial assets are received by a trade maintaining accounts on cash basis in satisfaction of an obligation, income which is embedded in the value of the assets is deemed to be received : the receipt of income is not deferred till the asset is realized in terms of cash or money. It makes no difference whether the receipt of assets is in pursuance of an agreement or that the trader is compelled by law to accept the assets from the debtor. Once title of the trader to an asset received is complete, whether by a consensual arrangement or by operation of law, he receives the income embedded in the value of the asset. In Californian Copper Syndicate (Limited and Reduced) v. Harris (Surveyor of Taxes) [5 TC 159] Lord Trayner in dealing with a case of assessment to income tax of a Company formed for the purpose, inter alia, of

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M/s Jindal Equipment Leasing Consultancy Services Ltd. v. Commissioner of Income Tax Delhi – II, New Delhi

acquiring and reselling mining property resold the whole of its assets to a second Company and received payment in fully paid shares of the purchasing Company, observed: “A profit is realised when the seller gets the price he has bargained for. No doubt here the price took the form of fully paid shares in another company, but, if there can be no realised profit, except when that is paid in cash, the shares were realisable and could have been turned into cash, if the appellants had been pleased to do so. I cannot think that Income tax is due or not according to the manner in which the person making the profit pleases to deal with it.” Counsel for the appellant contended that the bonds were intended to renew the promise to pay the amount due by the debtor through his agent, and by the renewal of the promise even if the original liability was extinguished and a fresh liability was substituted, no income was received by the appellant.

5. We are unable to agree with that contention. The Government of the State undertook to pay the amount of the bonds in satisfaction of the liability of the debtor. The liability of the original debtor was extinguished and a fresh obligation was undertaken by the State Government in substitution of the original liability. The Government had the right to recover the amount due under the bonds from the landholder, but on that account the Government did not become the agent of the landholder for payment of his debts. Even if the Government was unable to recover the money from the landholder, the liability undertaken by the Government under the bond remained unimpaired. The bond was a security for payment of the debt which completely replaced the original liability of the debtor.”

22. This Court in Commissioner of Income Tax v. Ashokbhai Chimanbhai33, reiterated that profits do not accrue from day to day

p. 566

but are ascertained by a comparison of assets at two points in time. Further, the test of accrual is whether the person entitled thereto has a right to claim the profits. The following paragraphs are relevant in this regard: “6. Under the Income Tax Act, income is taxable when it accrues, arises or is received, or when it is by fixation deemed to accrue, arise or is deemed to be received. Receipt is not the only test of chargeability to tax; if income accrues or arises it may become liable to tax. For the purpose of this case it is unnecessary to dilate upon the distinction between income “accruing” and “arising”. But there is no doubt that the two words are used to contradistinguish the word “receive”. Income is said to be received when it reaches the assessee : when the right to receive the income becomes vested in the assessee, it is said to accrue or arise. Fletcher Moulton, L.J., in In re The Spanish Prospecting Co. Ltd. [(1911) 1 Ch 92] observed at p. 98: “The word ‘profit’ has * * * a well-defined legal meaning and this meaning coincides with the fundamental conception of profits in general parlance; although in mercantile phraseology the word may at times bear meanings indicated by the special context which deviate in some respects from this fundamental signification. ‘Profit’ implies a comparison between the state of a business at two specific dates usually separated by an interval of a year. The fundamental meaning is the amount of gain made by the business during the year. This can only be ascertained by a comparison of the assets at the two dates.” In the gross receipts of a business day after day or from transaction to transaction lie embedded or dormant profit or loss: on such dormant profit or loss undoubtedly taxable profits, if any, of the business will be computed. But dormant profits cannot be equated with profits charged to tax under Sections 3 & 4 of the Income Tax Act. The concept of accrual of profits of a business involves the

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M/s Jindal Equipment Leasing Consultancy Services Ltd. v. Commissioner of Income Tax Delhi – II, New Delhi

determination by the method of accounting at the end of the accounting year or any shorter period determined by law. If profits accrue to the assessee directly from the business the question whether they accrue de die, in diem or at the close of the year of account has at best an academic significance, but when upon ascertainment of profits the right of a person to a share therein is determined, the question assumes practical importance, for it is only on the right to receive profits or income, profits accrue to that person. If there is no right, no profits will be deemed to have accrued. This principle was applied by this Court in E.D. Sassoon & Co. Ltd. v. CIT [26 ITR 27]. The material facts bearing on that principle were these: E.D. Sassoon & Co. Ltd, — called “Sassoons” — were the managing agents of a Company which may be called ‘the United Mills’ and were entitled to receive a percentage of annual net profits of the Company as their remuneration. On December 1, 1943 Sassoons assigned to Messrs Agarwal & Co. their office as managing agents and all their rights and benefits under the managing agency agreement. Accounts of the managing agency commission payable to the managing agents for the calendar year 1943 were made up in 1944 and commission for the whole year was paid to Messrs Agarwal & Co. thereafter. In the course of assessment proceeding of Sassoons it was debated whether in respect of commission earned by the managing agency, tax was payable on the entirety of the commission by Messrs Agarwal & Co. or by Sassoons or it was liable to be apportioned between Messrs Agarwal & Co. and Sassoons. This Court held (Jagannadhadas, J. dissenting) that Messrs Agarwal & Co. alone were liable to pay tax on the whole of the remuneration received under the contract of service between the United Mills, because the managing agency was entire and indivisible, and the remuneration or commission fell due to the managing agents, only on completion of a definite period of service and at stated periods it being a condition of recovery of wages or salary that the service or duty should be completely performed. Remuneration as managing agents constituted according to the Court “a debt” only at the end of each such period of

p. 568

service and no remuneration or commission was payable to the managing agents for broken periods. After referring to the observations of Fletcher Moulton, L.J. in the Spanish Prospecting Co. Ltd. case [(1911) 1 Ch 92] (already set out), Bhagwati, J., observed that “it would be absurd to suggest that the profits of the company could accrue from day to day or even from month to month”. The working of the company from day to day could certainly not indicate any profit or loss, even the working of the company from month to month could not be taken as a reliable guide for this purpose. If the profit or loss has to be ascertained by a comparison of the assets at two stated points, the most businesslike way would be to do so at stated intervals of one year and that would be a reasonable period to be adopted for the purpose. In the case of large business concerns the working of the company during a particular month may show profits and the working in another month may show loss. The business during the earlier part of the year may show profit or loss and in the later part of the year may show loss or profit which would go to counterbalance the profit or loss as the case may be in the earlier part of the year. It would therefore be reasonable to determine the profit or loss as the case may be at the end of every year so that on such calculation of net profits the managing agents may be paid their remuneration or commission at the percentage stipulated in the managing agency agreement and the shareholders also be paid dividends out of the net profits of the Company.

7. Counsel for the Commissioner submitted that the judgment in E.D. Sassoon Co. Ltd. case [26 ITR 27] proceeded upon the special character of a managing agency agreement and did not purport to lay down a general rule that accrual of income depends on quantification, or that right to payment of an ascertainable amount does not arise till accounts are made. Counsel also submitted that in sale transactions of a trading venture profits accrue to the trader from transaction to transaction and are embedded in each transaction carried on by the trader, and the charge imposed by Section 4(1)(a) is not deferred till settlement

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of accounts. On that premise, counsel said, that profits dormant or embedded in the transactions carried on by Messrs Amrit Chemicals accrued from transaction to transaction till November 12, 1955 and properly belonged to the assessee and were liable to be taxed in the hands of the assessee notwithstanding any subsequent disposition of those profits by the assessee. In support of his contention counsel relied upon Turner Morrison & Co. Ltd. v. CIT [23 ITR 152] — a case decided by this Court. In that case an Indian Company received commission on sales effected in India of goods received from a foreign company. The Indian Company handled the cargo arriving at Calcutta and made disbursements in connection therewith, collected and after deducting expenses including their commission remitted the balance to the foreign principal. It was held by this Court that the income, profits and gains derived from sale of goods by the Indian Company in British India were assessable to tax under Section 4(1)(a) as income, profits and gains received in the taxable territories by the Company on behalf of the foreign principal. The Court in that case observed at p. 160: “There can therefore, be no question that when the gross sale proceeds were received by the Agents in India they necessarily received whatever income, profits and gains were lying dormant or hidden or otherwise embedded in them. Of course, if on the taking of accounts it be found that there was no profit during the year then the question of receipt of income, profits and gains would not arise but if there were income, profits and gains, then the proportionate part thereof attributable to the sale proceeds received by the Agents in India were income, profits and gains received by them at the moment the gross sale proceeds were received by them in India and that being the position the provisions of Section 4(1)(a) were immediately attracted and the income profits and gains so received became chargeable to tax under Section 3 of the Act.”

p. 570

8. These observations were, it may be noticed, made in rejecting the contention raised by counsel for the taxpayer that in the gross sale proceeds received by him in India, there was no income at all. Counsel for the Indian Company said that the gross sale proceeds were merely credit items in the account and that several amounts were to be debited in the same account and if there remained any credit balance, such balance alone could be regarded as stamped with the formal impress of income capable of being dealt with as such : income could therefore be said to have been received only at that stage. The Court did propound that when gross sale proceeds are received in which is embedded income, that income will enter the ultimate computation of the total profits assessable to tax. But that is not to say that the profits accrue or arise to a trader from day to day or from transaction to transaction. The observation that to the income, profits and gains embedded in the gross receipts Section 4(1) was immediately attracted also does not warrant the inference that the Court intended to lay down that profits accrue to a taxpayer before the right thereto has come into existence. “Profits” as pointed out in E.D. Sassoon Co. Ltd. case [26 ITR 27] do not accrue from day to day or even from month to month and have to be ascertained by a comparison of assets at two stated points. The Court also pointed out in that case that the test for ascertaining whether profits have accrued or arisen is whether the person who is entitled thereto has a right to claim the profits.”

23. Accordingly, where under a scheme of amalgamation the shareholder merely receives, in substitution, shares of the amalgamated company in lieu of the shares held in the amalgamating company, there is no real or completed profit capable of being taxed under Section 28, unless it is shown that the shares are held as stock-in-trade and are readily available for realisation. In the absence thereof, what takes place is only a statutory vesting and substitution of one form of holding for another. Unless and until the substituted shares are commercially realisable – whether saleable, tradeable, or by whatever other mode of disposition so described – so as to yield real income, no taxable event can be said to arise.

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Definite valuation

24. The next test, which is well settled, is that profit must be capable of definite valuation, so that the real gain or loss stands crystallized. Judicial decisions have consistently underscored that “profits”, in the commercial sense, are ascertainable only when the old position is closed and the new position is determined in terms of money’s worth – whether by sale, transfer, exchange, or statutory substitution. This principle is an application of the doctrine of real income and applies with equal force to stock-in-trade as it does to other forms of commercial receipts. Therefore, the test is not satisfied merely by the receipt of realisable shares in substitution of earlier holdings; such shares must also be capable of quantification. 24.1. In Commissioner of Income Tax v. Woodward Governor India (P) Ltd.34, this Court reaffirmed the settled principles of commercial accounting, particularly that profits can be ascertained only by a comparison of assets at two defined points in time, and that unrealised gains embedded in stock- in-trade are not brought to charge unless and until they are crystallised in terms of money’s worth. The following paragraphs are apposite: “28. One more aspect needs to be highlighted. Under Section 28(i), one needs to decide the profits and gains of any business which is carried on by the assessee during the previous year. Therefore, one has to take into account stock-in-trade for determination of profits. The 1961 Act makes no provision with regard to valuation of stock. But the ordinary principle of commercial accounting requires that in the P&L account the value of the stock-in-trade at the beginning and at the end of the year should be entered at cost or market price, whichever is the lower. This is how business profits arising during the year need to be computed. This is one more reason for reading Section 37(1) with Section 145.

34 (2009) 13 SCC 1

p. 572

29. For valuing the closing stock at the end of a particular year, the value prevailing on the last date is relevant. This is because profits/loss is embedded in the closing stock. While anticipated loss is taken into account, anticipated profit in the shape of appreciated value of the closing stock is not brought into account, as no prudent trader would care to show increased profits before actual realisation. This is the theory underlying the rule that closing stock is to be valued at cost or market price, whichever is the lower. As profits for income tax purposes are to be computed in accordance with ordinary principles of commercial accounting, unless, such principles stand superseded or modified by legislative enactments, unrealised profits in the shape of appreciated value of goods remaining unsold at the end of the accounting year and carried over to the following year’s account in a continuing business are not brought to the charge as a matter of practice, though, as stated above, loss due to fall in the price below cost is allowed even though such loss has not been realised actually.

30. At this stage, we need to emphasise once again that the above system of commercial accounting can be superseded or modified by legislative enactment. This is where Section 145(2) comes into play. Under that section, the Central Government is empowered to notify from time to time the accounting standards to be followed by any class of assessees or in respect of any class of income. Accordingly, under Section 209 of the Companies Act, mercantile system of accounting is made mandatory for companies. In other words, accounting standard which is continuously adopted by an assessee can be superseded or modified by legislative intervention. However, but for such intervention or in cases falling under Section 145(3), the method of accounting undertaken by the assessee continuously is supreme. …….

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33. It is well established, that, on general principles of commercial accounting, in the P&L account, the values of the stock-in-trade at the beginning and at the end of the accounting year should be entered at cost or market value, whichever is lower—the market value being ascertained as on the last date of the accounting year and not as on any intermediate date between the commencement and the closing of the year, failing which it would not be possible to ascertain the true and correct state of affairs. No gain or profit can arise until a balance is struck between the cost of acquisition and the proceeds of sale. The word “profit” implies a comparison between the state of business at two specific dates, usually separated by an interval of twelve months. Stock-in-trade is an asset. It is a trading asset. Therefore, the concept of profits and gains made by business during the year can only materialise when a comparison of the assets of the business at two different dates is taken into account.” 24.2. Accordingly, in the context of amalgamation, the issue does not turn on the accrual of income in the abstract sense, but on whether the assessee has received a commercially realisable consideration in kind. Upon sanction of the scheme, there is only a statutory substitution of rights; no asset then exists in the hands of the assessee that is capable of commercial realisation. The charge under Section 28 crystallises only upon allotment of the new shares, when the assessee actually receives realisable instruments capable of valuation in money’s worth. At that point, the old stock-in-trade ceases to exist and stands replaced by new shares having a definite market value. Since these shares are received in the course of business and in substitution of trading assets, their receipt represents a commercial profit or gain arising from business activity. What attracts Section 28 is, therefore, the receipt of shares coupled with their present realisability and their nexus with business. These three conditions—actual receipt, present realisability, and ascertainability of value—together determine the timing of taxability in cases of amalgamation. Consequently, the profit

p. 574

arising on receipt of the amalgamated company’s shares may be taxed under Section 28 where the shares allotted are tradable and possess a definite market value, thereby conferring a presently realisable commercial advantage. This conclusion flows from the real income principle and not from any judicially created fiction. Equally, it must be emphasised that where such attributes are absent, the Court cannot, by analogy, extend Section 28 to tax hypothetical accretions in the absence of an express statutory mandate. 24.3. It is further clarified that the principles enunciated herein lay down a fact-sensitive test. The enquiry whether, consequent upon an amalgamation, the allotment of new shares has resulted in a real and presently realisable commercial benefit must be determined on the facts of each case. The burden lies on the Revenue to establish the same. It is thereafter for the Tribunal, as the final fact-finding authority, to apply these principles to the evidence on record.

Timing of Taxability

25. Having established that the charge under Section 28 may be attracted if the shares are saleable, tradable, etc., and of definite market value, thereby conferring a presently realisable commercial advantage, it becomes necessary to clarify the general principle. In the context of amalgamation, three points in time require to be distinguished. First, the appointed date specified in the scheme, which determines corporate succession and continuity between the transferor and transferee companies. Secondly, the sanction of the scheme by the Court, which gives statutory force to the amalgamation. At these stages, however, there is only a substitution of rights by legal fiction, without any asset in the hands of the shareholder capable of commercial exploitation. Thirdly, the allotment of new shares in the amalgamated company, which alone crystallises the benefit in the shareholder’s hands, for it is only then that the old stock- in-trade ceases to exist and is replaced by new shares of definite market value capable of immediate realisation. Even if the scheme contemplates the issue of shares in a certain ratio from the appointed date, until allotment there is no identifiable scrip or tradable asset in existence in the hands of the assessee. Thus, the charge under Section 28 is not attracted on the mere sanction of the scheme or

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on the appointed date, but only upon the receipt of the new shares, when the statutory substitution translates into a concrete, realisable commercial advantage.

26. Without prejudice to the broader question of chargeability under Section 28, it was contended on behalf of the appellants that even if the fair market value of the shares allotted in the amalgamated company exceeded the book value of the shares held in the amalgamating company, such excess would be merely hypothetical and illusory until the shares were sold, given that market value is inherently fluctuating. As discussed, the test under Section 28 is not postponed until an actual sale, but is satisfied once the assessee comes into possession of an asset of determinable and presently realisable value in substitution of its trading stock. The fact that such value may fluctuate subsequently does not render the benefit unreal; valuation for tax purposes is always carried out at a particular point in time, notwithstanding subsequent volatility. What matters is that, on the date of allotment, the assessee must have received realisable instruments capable of being valued in money’s worth, and such receipt constitutes a real, and not a notional, commercial gain.

Distinction between Capital and Business assets

27. Notably, Section 47 of the I.T. Act expressly carves out an exemption in respect of certain transfers in the context of amalgamation, but that exemption is confined to capital assets. The rationale is plain. Where a shareholder holds shares as an investment, the underlying object is to remain invested in the corporate venture, and a mere amalgamation ordinarily does not alter that position. While the possibility of tax avoidance in the investment field cannot be ruled out altogether, the legislative judgment reflects that the risk is relatively low. The exemption under Section 47 is thus founded on the recognition that amalgamation, in the capital field, is essentially a corporate restructuring and not a true realisation of profit. It is also common in business parlance for entities to hold shares either as investments or as stock-in-trade. 27.1. By contrast, Section 28, which governs profits of business, contains no such carve-out, nor could it be otherwise. The nature of stock-in-trade is wholly different from that of an

p. 576

investment. Stock-in-trade represents circulating capital: it is held not for preservation or appreciation, but for conversion into money in the ordinary course of business. In Commissioner of Income Tax v. Express Newspapers Ltd.35 it was observed as follows: “... The profits and gains of business and capital gains are two distinct concepts in the Income Tax Act: the former arises from the activity which is called business and the latter accrues because capital assets are disposed of at a value higher than what they cost the Assessee. They are placed under different heads; they are derived from different sources; and the income is computed under different methods…..” 27.2. In this context, the substitution of one trading asset by another, such as the receipt of shares in an amalgamated company in lieu of shares held as stock-in-trade in the amalgamating company, cannot be equated with a mere continuation of an investment. It represents a commercial realisation in kind, for the new shares are distinct assets with a definite and presently realisable market value. 27.3. If amalgamations involving trading stock were insulated from tax by judicial interpretation, it would open a ready avenue for tax evasion. Enterprises could create shell entities, warehouse trading stock or unrealised profits therein, and then amalgamate so as to convert them into new shares without ever subjecting the commercial gain to tax. Equally, losses could be engineered and shifted across entities to depress taxable income. Unlike genuine investors who merely restructure their holdings, traders deal with stock-in-trade as part of their profit-making apparatus; to exempt them from charge at the point of substitution would undermine the integrity of the tax base. 27.4. Accordingly, while the Act makes an express exception for amalgamation of capital assets, no such exception is contemplated in the case of business assets. Section 28 is deliberately cast in wide terms to bring to tax real and presently

35 1964 INSC 152 : MANU/SC/0126/1964

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realisable profits arising in the course of business, and in the context of stock-in-trade, the allotment of shares upon amalgamation constitutes precisely such a taxable realisation.

Application to the present case

28. In the present case, the Tribunal, relying on Rasiklal Maneklal, held that no “transfer” occurs in a scheme of amalgamation. The High Court, however, found this view unsustainable, observing that under the 1961 Act, as clarified in Grace Collis, the extinguishment of rights in the shares of the amalgamating company constitutes a “transfer” within the meaning of Section 2(47). Since such transfer is exempt under Section 47(vii) only in respect of capital assets, the High Court proceeded to examine whether shares held as stock-in-trade would nonetheless give rise to taxable business income under section 28. 28.1. The High Court reasoned that once the shares of the amalgamating company ceased to exist and were substituted by shares of the amalgamated company, there was a cession of the old trading stock and its replacement by a new commodity of ascertainable market value. On this footing, it held that a realisation of business profit had occurred, taxable under Section 28. Relying upon Orient Trading and Hindustan Lever, the Court observed that shares received on amalgamation are fundamentally new assets, and the process results in realisation of value irrespective of shareholder status. The taxable event, therefore, depends on the substance of the transaction and not merely accounting entries. On this reasoning, the Tribunal’s findings were set aside, the question of law was answered in favour of the Revenue, and the matter was remitted to the Tribunal.

29. As already noticed, the correctness of this reasoning constitutes the core issue in the present appeals. In view of the foregoing discussions, we reiterate that Section 28 of the I.T. Act is of wide import and encompasses all profits and gains arising in the course of business, even when such profit is realised in kind. The statutory substitution of shares of the amalgamating company by shares of the amalgamated company is not a mere neutral replacement; where the new shares are freely marketable and possess a definite commercial value, the event constitutes a commercial realisation giving rise to

p. 578

taxable business income. The principle laid down in Orient Trading and similar authorities makes it clear that such profit need not await actual sale if the benefit received is real and presently realisable.

30. We thus hold that where the shares of an amalgamating company, held as stock-in-trade, are substituted by shares of the amalgamated company pursuant to a scheme of amalgamation, and such shares are realisable in money and capable of definite valuation, the substitution gives rise to taxable business income within the meaning of Section 28 of the I.T. Act. The charge under Section 28 is, however, attracted only upon the allotment of new shares. At earlier stages namely, the appointed date or the date of court sanction, no such benefit accrues or is received.

31. Accordingly, the main issue is answered in favour of the Revenue, in principle holding that the receipt of shares of the amalgamated company in substitution of stock-in-trade can give rise to taxable business profits under Section 28. However, the actual application of this principle to the facts of the present case, including whether the shares received are freely realisable or otherwise subject to restrictions, or whether the shares are held only as investment, is a matter requiring factual determination. In these circumstances, the proper course is to remit the matter to the Tribunal for fresh adjudication in accordance with law.

32. Before parting, we may observe that business, by its very nature, admits of profits arising in diverse forms, whether in money or in kind, yet the common denominator is that the benefit must be concrete, capable of commercial realisation, and not a mere paper re-arrangement. Amalgamation, as a statutory substitution, ensures continuity of enterprise but also extinguishes one form of holding and replaces it with another. As we have held, where such substitution confers on the assessee realisable assets of definite market value, a commercial realisation takes place, and Section 28 is attracted. At the same time, courts must remain alive to the distinction between genuine commercial gain and hypothetical accretion. The touchstone is, therefore, the doctrine of real income, applied with due regard to the facts of each case, ensuring that the tax charge operates neither oppressively nor evasively, but in harmony with the legislative design, to tax true profits of business, however manifested, while eschewing illusory gains.

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33. In fine, the judgment of the High Court is affirmed, and all these appeals stand disposed of in the aforesaid terms. There is no order as to costs.

34. Pending application(s), if any, shall stand disposed of.

Result of the case: Appeals disposed of.