Conversion of Share Warrants into Equity Shares Held Not to Constitute a Taxable Transfer

1. The Core Dispute: Conversion vs. Sale

The assessee held share warrants and eventually converted them into equity shares by paying the remaining balance of the exercise price. The Assessing Officer (AO) viewed this event as a taxable “transfer” of rights.

AO’s Contention: The AO treated the difference between the Market Value of the shares on the date of conversion and the Exercise Price as a Long-Term Capital Gain (LTCG). The AO further invoked Proviso (iv) to Section 48, attempting to tax the “profit” supposedly realized upon the exercise of the warrant.
Assessee’s Stand: The assessee argued that conversion is merely the fulfillment of a pre-existing right to acquire shares and does not involve any third-party transfer or “realization” of income.

2. Legal Analysis: The Definition of “Transfer”

The court examined whether the conversion of warrants fits the definition of “transfer” under Section 2(47), which includes sale, exchange, relinquishment, or extinguishment of rights.

I. Exercise of Option is Not a Relinquishment

The court held that when a warrant holder pays the balance amount to get shares, they are simply exercising an option.

This does not involve the “extinguishment” of a right in the sense of losing an asset; rather, it is a transformation of a right (to acquire shares) into the asset itself (the shares).
The payment made for the warrants is treated as an advance towards the total cost of acquisition of the shares.

II. Erroneous Invocation of Section 48

The AO’s attempt to use the market value on the date of conversion was found to be legally flawed.

Capital Gains Principle: Under Indian tax law, capital gains are generally triggered only when an asset is alienated (sold or transferred to someone else) for consideration.
No Notional Gains: Taxing the difference between market value and cost at the stage of conversion would amount to taxing “notional” or “unrealized” gains.
Cost Base: The total cost of the shares will be the sum of the amount paid for the warrants + the exercise price paid at conversion. This total cost will be deducted from the sale price only when the shares are eventually sold.

3. Final Ruling: No Chargeable Gains

The court upheld the decision of the Commissioner (Appeals), ruling that no capital gains could be charged at the point of conversion.

Verdict: The conversion of warrants into shares is not a transfer under Section 2(47).
Outcome: The adoption of market value as a “sale price” was erroneous. The addition made by the AO was deleted.

Key Takeaways for Investors

Tax Deferral: You are not liable to pay capital gains tax when you convert warrants, convertible debentures, or preference shares into equity. The tax liability is deferred until the final sale of the equity shares.
Holding Period: For the purpose of determining if the eventual gain is Short-Term or Long-Term, the holding period typically starts from the date of allotment of the original warrants (depending on specific instrument rules and Section 2(42A)).
Cost of Acquisition: Ensure you keep records of both the initial warrant application money and the final conversion price paid, as the total of both constitutes your cost of acquisition.

IN THE ITAT MUMBAI BENCH ‘A’

Deputy Commissioner of Income-tax

Kemper Holding (P.) Ltd.^*

Sanjay Garg, Judicial Member
and SANJAY ARORA, Accountant Member

IT Appeal No. 6426 (M) of 2011
[Assessment year 2008-09]

APRIL 26, 2013

Surinder Jit Singh for the Appellant. Pradeep Sagar for the Respondent.

ORDER

Sanjay Garg, Judicial Member.- The present appeal has been filed by the revenue against the order of the learned CIT(A) dated 13.06.2011 relating to A.Y. 2008-09, deleting the addition of Rs. 9,45,00,000 made by the AO. The grounds of appeal read as under:

“1. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) erred in deleting the addition of Rs.9,45,00,000/-made by way of treating as Long Term Capital Gain, the difference between value of share on the date of its allotment by the company and the price of warrant paid as per letter of allotment of warrant issued by the company, Garware Offshore Services Ltd.

2. On the facts and in the circumstances of the case and in law, the Ld. CIT(A) erred in deleting the addition of Rs.9,45,00,000/-without appreciating the fact that relinquishment /exchange of warrant into equity is a transfer within the meaning of Section 2(47)(i) and income earned on such transfer is covered as per the provisions of Section 48 of the I.T.Act.”

2. The brief facts of the case are that the assessee filed its return of income declaring total income at Rs. 59,98,660. During the assessment proceedings u/s. 143(3) of the I.T.Act the AO noticed that during the F.Y. 2006-07 the assessee company was allotted 7,00,000 warrants of Rs.100 each. The warrant holder in terms of the said allotment was asked to pay 10% of the cost of the said warrant i.e. Rs.70 lacs. During the year under consideration, the said warrants were converted into equity shares on the total payment of the remaining cost price of Rs.6,30,00,000. The AO found that the assessee had not considered this transaction as transfer within the meaning of provisions of I.T.Act, 1961. The AO citing section 2(47) of the I.T. Act held that the conversion of warrants into shares amounts to transfer. The AO observed that the assessee while exercising his option for conversion of warrants into equity shares had extinguished his rights in warrants and simultaneously gained rights in equity shares. The AO further held that the said shares were purchased by the assessee at the past price of Rs.100 only whereas the actual closing price as on the date of transaction was Rs.231.35 per warrant. Therefore, the assessee had gained a benefit of Rs.135.35 per warrant. She therefore calculated the total benefit that had accrued to the assessee at Rs.9,45,00,000 and treated the same as long term capital gain in the hands of the assessee. The AO further noticed that even in the alternative the assessee was in the business of dealing in shares and securities. The assessee had acquired 7 lac warrant of Rs. 100 by paying 10% of the cost price and then converted those warrants into equity shares on a particular date when the price was Rs.231.35. Thus, the assessee derived a benefit of Rs.9.45 crores. However, the AO computed the said income under the head “Capital gains”. In appeal, the learned CIT(A) deleted the addition observing as under:

“3.10 I have considered the A.O’s order as well as appellant AR’s submissions. Having considered both, I am of the considered view that there is complete force in the appellant’s submission. The appellant company did not extinguish its any right over the warrant. The said warrant was allotted on application to the appellant company. There was an option available with the appellant company which embedded in the warrant itself for the appellant company to make an application for allotment of share after making necessary compliance as stipulated in the Conditions and Covenants of Warrants specified in the said warrant. Thus the appellant company had an option for making application for allotment of equity share as per terms and conditions laid down specifically stated in the Covenants as placed in the offer of the issuing company. I find that the A.O. has wrongly used the deeming provisions which was not meant for such transaction at all as the Jurisdictional High Court very clearly held in the aforesaid decision that deeming provisions should be used very strictly for which and in the situation wherein it is meant for. Besides this also, I find that there was no consideration of any kind received to the appellant company either in the form of money or any kind. The A.O. merely took the market value as a full consideration value for working out the capital gain which was actually not at all realized to the appellant company. In view of the same and also taking note of the aforesaid decision illustrated above, I am of the considered view that there was no transfer at all in the case of such transaction as the appellant company has merely exercised its option. The said exercise of option was available in the said warrant, which was allotted to the appellant company under the said resolution of the issuing company and which was approved by the shareholders of the said company as specifically mentioned by the appellant’s AR in his submissions. In view of the aforesaid discussion and also taking note of the decision of the Apex Court, I am of the considered view that the AO was not justified in her action while making the aforesaid addition in the case of the appellant company as capital gain. I thereby hold that the addition so made by the AO is not justified and it was contrary to the provisions of law in the Income-tax Act. Accordingly, the addition so made by the A.O. of Rs.9,45,00,000 is deleted. Thus, the appellant this ground of appeal is allowed.

3.11 Besides this, even I find that the alternative argument of the A.O. of taxability of the said benefit in the hands of the appellant company u/s. 28(iv) of the Act is misplaced and it is held in the preceding para that the appellant company was not at all benefited of any kind of receipt either convertible in the form of money or any kind then the question of taxability of such non-existing thing u/s. 28(iv) of the Act does not arise. Accordingly, I consider it proper an appropriate to hold that the A.O. was not justified even while proposing to tax the appellant company u/s. 28(iv) of the Act alternatively. Then this proposition of the A.O. is also held to be not justified.”

Aggrieved, the revenue is thus in appeal before us.

3. We have heard the learned representatives of the parties and have also gone through the record. In our view, the AO while adding back the amount of Rs.9.45 crores into the income of the assessee, calculating the same as per the market rate of the shares, has totally mistaken herself. She has not only wrongly interpreted the provisions of the I.T.Act, but also over extended the meaning of the same, so as to bring the amount in dispute into the taxable income of the assessee without any legal basis. The conversion of warrant into shares by paying the remaining 90% amount was neither any extinguishment nor relinquishment of any rights in the assets. It may be observed that the assessee had purchased the warrants by paying 10% of the pre-determined price of the shares. There was an option for the assessee to get the said warrants converted into shares by paying 90% of the amount within the stipulated period, the non-payment of which would have resulted in forfeiture of the money. So the money paid for the warrants was just an advance payment for the purchase of shares and the assessee exercised his rights within the stipulated time and got the shares allotted by paying the remaining 90% amount at the predetermined value of the shares. It can be said to be an investment in shares. The capital gain would have arisen if the assessee would have sold the said shares in the market at a higher price. The shares have been retained by the assessee and the gain or fall in the market value of the said shares does not itself constitute any transfer under the Act. The purchase of shares at a specified rate, which were booked by paying 10% amount in advance neither amounts to any transfer of shares or warrant by the assessee nor does it invite any tax liability under the Act. While computing the income of the assessee, the AO has wrongly and illegally interpreted proviso (iv) to section 48 of the I.T. Act. A bare perusal of the said proviso reveals that the same is attracted in case the shares, debentures or warrants are transferred by the assessee to some other person without receiving any consideration in terms of money and in that event market value of the asset on the date of such transfer is deemed to be the value of consideration received as a result of transfer. In the case in hand, the assessee has not transferred any warrant or share to any other person rather he has just exercised his option to purchase the shares at a stipulated rate by paying the remaining 90% amount, which in clear term falls in the definition of investment and not in the definition of sale or transfer on his part. There is no merit in the appeal of the revenue.

4. In the result, the appeal filed by the revenue is dismissed.