Shell-shocked: Companies cutting deals to launder money face Supreme Court heat

MUMBAI: The Supreme Court has dealt a blow to companies which cut dubious deals with shell firms to launder money and escape tax.

Over decades, businesses have perfected the art of transferring cash to paper firms which invest or lend the funds back into the companies to legitimise the latter’s ‘black’, or undisclosed, money.

According to a recent ruling by SC, if the taxman can back up its claim with sufficient investigation and the company receiving funds as share capital fails to prove the genuineness of the deal and creditworthiness of the investor, the company will have to pay tax on the amount.


The ruling, issued on Tuesday, relates to a dispute between the income tax (I-T) department and NRA Iron & Steel Pvt Ltd, a Delhi-based company that had issued shares to 19 entities which either gave incorrect address, or failed to justify their investments, or did not respond to the tax department’s queries.

“The verdict may open the floodgates to litigations on the issue of testing creditworthiness for share capital,” said senior chartered accountant Dilip Lakhani.

TAX TRIBUNAL, HIGH COURT RULED IN FAVOUR OF TAXPAYER
“It would apply to other cases with similar facts. Significantly, the amendment to Section 68 dealing with share capital became effective from assessment year (AY) 2013 -14 while the present case pertains to AY 2008-09,” said Lakhani. According to Rajesh H Gandhi, partner at Deloitte, “The fact that all appellate authorities up to high court ruled in favour of the taxpayer makes the ruling more interesting… It could be used by tax authorities to probe deeper into share issue deals — more so, with wider powers now available under the amended Section 68 of the I-T Act.”

The upshot of the verdict is that PAN of investors, proof of address, tax returns, and routing investment through a bank may not be sufficient to authenticate a transaction and demonstrate investors’ creditworthiness. Indeed, in this case, the assessee, NRA Iron, had produced such information that satisfied the tax tribunal and even the HC which dismissed the tax department’s appeal. However, the Supreme Court upheld the taxman’s appeal as extensive probe carried out by the I-T department put several question marks on the investor firms (based in Kolkata, Guwahati and Mumbai) which subscribed to NRA Iron shares.

In her ruling, Justice Indu Malhotra said, “The lower appellate authorities appear to have ignored the detailed findings of the AO (tax assessing officer) from the field enquiry and investigations carried out by his office.”

“The practice of conversion of unaccounted money through the cloak of share capital/ premium must be subjected to careful scrutiny. This would be particularly so in the case of private placement of shares, where a higher onus is required to be placed on the assessee since the information is within the personal knowledge of the assessee,” said the apex court.

The ruling, however, would not directly influence the ongoing disputes between many startup companies and the tax department which has invoked another section of the I-T Act to question the disparity between stock subscription price and the fair value of startups. “For startups, the main issue relates to whether the share premium is ‘excessive’, which is taxable under Section 56(2)(viib). While there is some overlap between these two sections, this judgment by the Supreme Court should not per se have an adverse effect on startups receiving genuine angel investments,” said Sanjay Sanghvi, partner at the law firm Khaitan & Co.

Here, the taxman won the day as the investee company could neither prove the creditworthiness of its investors and genuineness of share premium nor counter the findings of the tax department. Earlier, the burden on proof was largely on the company issuing shares. Since AY 2013-14, Section 68 was amended and investors are required to convince the assessing officer. “In this particular case, no one represented the assessee in the SC. Also, no one pointed out before the court that the investors’ responsibility to prove to the satisfaction of the AO became effective only in 2013-14,” said Lakhani.