By Hook or By Crook - When IT dept. sought to tax rights issue as unexplained cash credit but Tribunal refused


In general, tax can only be levied on an amount, which falls within the meaning of the term ‘income’ or ‘deemed income’. Capital receipts are not taxable except where they are characterised as ‘income’ through specific provisions in the Income-tax Act, 1961 (“IT Act”). Thus, amounts received by way of share capital, whether the amount representing face value or premium, being capital receipt are not characterised as ‘income’ of a company, and therefore not taxed. However, it has been seen that this exemption under the law can be misused. A time-tested strategy aimed at laundering an individual’s unaccounted funds involves incorporation of sham entities with huge capital at premium, which in turn invests these funds in the individual’s legitimate businesses by way of subscription to shares at a premium. Section 68 (‘Cash Credits’) of the IT Act attempts to deter such practices by bringing to tax any sum found credited in the books of an assessee if the assessee offers no or unsatisfactory explanations on the nature and source of the credit.

Section 68 is often resorted to by the Income Tax Department (“ITD”), when large amounts of funds at significant premium are invested in companies, and the source of such funds is unexplained. Instead of going after the person who has provided these funds to the assessee company, the law has put the onus on the assessee, i.e., the investee company, to ensure that it is able to provide satisfactory explanation as regards the source of those funds. The ITD has used this provision extensively and demonstrated its predilection towards holding the issuing company responsible for producing details to evidence the identity, genuineness and creditworthiness of the shareholders, as well as the source of the shareholders’ funds. However, in deserving cases, the Courts have also intervened and eased the burden of proof under Section 68 in favour of the assessee. Recently, the Mumbai Income Tax Appellate Tribunal (“ITAT”) staved off an attempt of the ITD to levy tax on Vodafone India for subscription by its non-resident shareholders to its rights issue.[1] We briefly discuss this ruling in this blog and comment on the experience of the ITD in invoking this provision to trace unaccounted money.

ITAT Ruling in Vodafone

In this case, when the ITD invoked Section 68, Vodafone produced some documents which the ITD found unsatisfactory. However, the ITD failed to give any reason behind the dissatisfaction. However, the Mumbai ITAT relied on these documents to satisfy itself of the identity, genuineness and creditworthiness of Vodafone’s Mauritius-based investors. The ITAT was primarily convinced by the fact that the transaction in question was a rights issue (shares allotted to existing shareholders). The ITAT was of the view that since the ITD had accepted the investors as genuine in the year they acquired initial stake in the assessee, a subsequent rights issue could not be flagged under Section 68. Moreover, the investment was made through appropriate banking channels and with the approval of the Foreign Investment Promotion Board, which itself was taken as proof of the identity and genuineness of the shareholders. This fact is relevant here since the Assessee operates in the telecom sector, in which foreign direct investment is highly regulated. The ITAT also found that financial statements and other documents produced by the assessee, including letters from the Mauritius Revenue authorities were sufficient to establish creditworthiness of the investors. In the ITAT’s view, the back-to-back financing arrangements executed by each of the nine Mauritian investors with their holding companies was customary practice for investor entities, acceptable as sufficient proof of their ability to fund the capital infusion into Vodafone.

It appears that in arriving at this conclusion, the ITAT placed heavy reliance on the observations of the Supreme Court in the infamous Vodafone judgment,[2] where the Court had analysed and validated Vodafone’s investment structure. The ITAT therefore opined that any finding contrary to the Supreme Court’s conclusion would result in ‘judicial indiscipline’. The ITAT also made another notable observation on the intendment of the first proviso to Section 68, inserted with effect from Assessment Year 2013-14. This proviso reads as follows:

Provided that where the assessee is a company (not being a company in which the public are substantially interested), and the sum so credited consists of share application money, share capital, share premium or any such amount by whatever name called, any explanation offered by such assessee-company shall be deemed to be not satisfactory, unless—

  • the person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited; and
  • such explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory.

As can be seen, the proviso creates a deeming fiction whereby any explanation offered by an assessee on share premium is deemed to be insufficient and enough to trigger taxation under Section 68, unless the resident investor, in addition to the company which has received cash credit, also offers explanation as to the nature and source of the amount paid to the company. Though the Vodafone rights issue in question took place in Assessment Year 2006-07, much before the insertion of the above proviso, the ITAT drew upon the language of the proviso which only required establishment of source of funds where the investor is a resident. The ITAT, thus found that since Vodafone’s investors were Mauritius residents, there was no need for Vodafone to prove the source of funds beyond the immediate investor level.

This Vodafone decision seems to validate taxpayers’ long pressed contention that financing arrangements made for the purpose of securing investments are not emblematic of tax avoidance. The judgment recognises that not all investments acquired by companies are necessarily made through their internal accruals or cash readily available with them. Investor companies often evaluate the commercial benefit of making the investments and may use leverage to make such investments.


The very large number of adverse assessments made under Section 68 evince the need to factor in coexisting local anti-abuse laws, in addition to treaty-based rules and General Anti-Avoidance Rules (“GAAR”), for successful global tax planning. Section 68 and the GAAR provisions operate in different spheres. GAAR is much wider in scope than Section 68. When GAAR is successfully invoked on the basis of an ‘impermissible avoidance arrangement’, the tax officer can completely recharacterise the entire transaction, thereby impacting the tax treatment of all parties to the transaction and not just the taxability of unexplained cash credits in the hands of the entity being examined. However, it is possible that GAAR may not be successfully invoked in every case. Where the GAAR sword fails to bear fruit, the ITD may still be able to invoke Section 68 and successfully levy the penal tax.

Upon review of a plethora of rulings dealing with invocation of Section 68, it is indeed reassuring to note that Courts are in favour of expecting from genuine companies only what the law expects of them, i.e., establishing the identity and creditworthiness of the immediate investors and the genuineness of the transaction. In the recent past, the Courts and ITATs have reversed additions made by the ITD under Section 68 even where the assessee’s investors had filed meagre tax returns,[3] or the assessee was unable to produce details of the investor’s directors,[4] and where it appeared that the investors would not earn immediate returns from their investments[5]. In these situations, the Courts have insisted that the only onus of the assessee is to establish the source of its own funds and not of its investors. It would therefore appear that receiving a notice from the ITD under Section 68 is indeed defendable, especially where the investor is a non-resident. However, in today’s environment where the focus is on finding hidden assets and unearthing black money with several ammunitions available to the ITD, companies, especially startups would be well advised to have appropriate due diligence in place in respect of their investors to defend the invocation of Section 68, even for assessment years prior to the insertion of the abovementioned proviso in Section 68.

As India moves to Faceless Assessment Scheme recently introduced, the thrust of the government on improving tax administration and mapping the mountain of data received against the tax returns filed by taxpayers with substantial investments and acquisitions, seems to herald the next phase of action that can be expected from the ITD. Along with the Taxpayer Charter, it seems that the ITD is inching towards facilitating India’s ambitious growth targets and making India an attractive investment destination globally. For achievement of this goal, it is most climacteric for the ITD to acknowledge that ‘Mauritius’ is not a taboo (the ITD in Vodafone relied heavily on Mauritius being a tax haven to support its adverse assessment under Section 68). Besides the obvious tax advantages, Mauritius is a favoured intermediary jurisdiction for making Indian investments, owing to low administrative costs and familiarity of officials with Indian administrative and tax system. The Faceless Assessment Scheme may also bring respite to taxpayers being stranded in a ‘docket deluge’ and allegedly regressive tax litigation during their genuine business activities.

[1] Vodafone India Ltd. v. DCIT, ITA No. 1835/Mum/2018, order dated August 28, 2020 (Mumbai ITAT).

[2] Vodafone International Holdings B.V. v. Union of India, (2012) 341 ITR 1 (Supreme Court).

[3] PCIT v. Ami Industries (India) (P.) Ltd., ITA No. 1231/2017, order dated January 29, 2020 (Bombay High Court).

[4] ITO v. Commitment Financial Services (P.) Ltd., ITA No. 107/Del/2017, order dated January 23, 2020 (Delhi ITAT).

[5] PCIT v. Aditya Birla Telecom Ltd., ITA No. 1502/2016, order dated March 26, 2019 (Bombay High Court).