The Income Tax Act, 1961 (“IT Act”) confers various powers on the Income Tax Department (“ITD”) to curb the menace of laundering of unaccounted money. One such power-bestowing provision is Section 68 of the IT Act, which is often resorted to by the ITD when large amounts of unaccounted funds are invested in companies at a significant premium. This provision puts the onus on the taxpayer, i.e., the investee company, to satisfactorily explain the source of those funds and produce details to evidence the identity, genuineness and creditworthiness of the shareholders as well as the source of the shareholders’ fund.
With the ITD tightening the noose around notorious taxpayers, the provisions of Section 68 are being invoked frequently, even in cases where the transactions conform to compliance and applicable regulations and have been taken through proper banking channels. This was apparent in the recent case of Azure Retreat, where the ITD sought to determine the source of funds in the hands of a shareholder of the taxpayer.
ITAT decision in Azure Retreat
In the said case, the taxpayer was an Indian company which issued shares to certain resident shareholders and a non-resident shareholder, during the relevant financial year. While the shares were issued to the resident shareholders at a face value, they were issued at a significant premium to the non-resident shareholder, a company situated in Mauritius (“Mauritius Co.”). The tax officer noted that Mauritius Co. was a loss-making entity without any active business operations and asked the taxpayer to justify this difference in the valuation of its shares. After considering the submissions made by the taxpayer, the tax officer pointed out certain defects with the evidence presented before it and made an addition under Section 68 of the IT Act. An appeal was successfully made before the CIT(A), which deleted the addition. Aggrieved of the CIT(A) order, the ITD appealed before the ITAT.
The Delhi ITAT upheld the decision of the CIT(A) and noted that the valuation of shares had been done in accordance with the RBI guidelines on allotment of shares to foreign investors, which in this case was Mauritian Co. Further, the entire transaction took place through proper banking channels and had been confirmed by the Mauritius Revenue Authority pursuant to the information sought by the ITD under Section 90/90A (exchange of information) of the IT Act. The ITAT also noted that Mauritius Co. had received the funds in the form of an unsecured loan from an individual in Dubai, who was the beneficial owner of Mauritius Co. The identity of the individual in Dubai had also been confirmed by the Mauritius Revenue Authority.
It was accordingly held that the “source of the source” of the investment had been conclusively explained by the taxpayer and the same had also been confirmed by the Mauritius Revenue Authority. The evidence presented by the taxpayer in this case was conclusive and it had discharged its burden of proof as required under Section 68 of the IT Act.
It is pertinent to note that in the instant case, inter alia, the difference in valuation of the shares issued to two different set of investors invited the ITD’s scrutiny. While such difference in valuation of shares may arise for multitude of reasons (as demonstrated in this case as well), such as internal restructuring within the taxpayer company or issue of shares under an ESOP scheme or any other previously executed agreement(s), etc., it becomes even more pertinent for taxpayers to maintain sufficient material on record to discharge their burden of proof under Section 68, in such situations.
Interestingly, the Finance Bill, 2022 proposes to amend Section 68 to place a similar burden of proof on the taxpayer, i.e., to provide an explanation regarding the source of source of funds in cases where a credit is made in the books of accounts of a taxpayer pursuant to loan or borrowing or any other liability. Thus, taxpayers would need to ensure that they have sufficient supplementary evidence for any such future transactions as well.
In the Azure Retreat decision, the ITAT placed high reliance on the fact that the impugned transaction was compliant with the RBI regulations (and the evidence submitted had been approved by the Mauritian Revenue Authority). However, it would be relevant to note the Madras High Court’s recent observations that a taxpayer’s compliance with all the applicable rules and regulations and securing of statutory approvals from the RBI and the Foreign Investment Promotion Board (FIPB) are not sufficient to sanctify a transaction, which the ITD believes amounts to an unexplained cash credit.
Thus, the Madras High Court judgment leaves the Delhi ITAT decision susceptible to further appeal and emphasises on the importance of vetting all such share transactions from a tax perspective.
Interestingly, the decision in Azure Retreat pertained to FY 2011-12, while the amendment to Section 68, with respect to determining the source of source of share application money, share capital, share premium, etc., was only notified with effect from FY 2012-13. However, this argument was not raised by the taxpayer before the ITAT.
 The ITO Ward – 3(4), New Delhi v. M/s. Azure Retreat P. Ltd., ITA No. 949/DEL/2017.
 Vishwatej Developers (P.) Ltd. v. Assistant Commissioner of Income-tax, Company Circle V(2), Chennai,  130 taxmann.com 9 (Madras).