Commissioner Of Income-Tax, Bihar vs Dalmia Investment Co. Ltd

Rewritten Version Notice: This is a rewritten version of the original judgment.

Court: supreme-court

Case Number: Civil Appeal No. 780 of 1962

Decision Date: 13 March 1964

Coram: A.K. Sarkar, M. Hidayatullah, J.C. Shah

In the matter Commissioner of Income‑Tax, Bihar versus Dalmia Investment Co. Ltd, the Supreme Court of India delivered its judgment on 13 March 1964. The decision was authored by Justice A.K. Sarkar, who was joined by Justices M. Hidayatullah and J.C. Shah. The case is reported in 1964 AIR 1464 and 1964 SCR (7) 210, with subsequent citations in later reports. The issue concerned the valuation of bonus shares held by an investment company for purposes of the Income‑Tax Act.

The respondent company, Dalmia Investment Co. Ltd, engaged in the purchase and sale of shares and, as at 1 January 1948, held a total of 1,10,747 shares of Rohtas Industries. The book value of these shares was recorded as Rs 15,57,902. Among the shares, 31,909 were bonus shares that Rohtas Industries had issued in 1945 at a face value of Rs 1 each. The company had entered a debit of Rs 3,19,090 to its investment account for these bonus shares and a corresponding credit of the same amount to its capital‑reserve account. The cost of acquiring the bonus shares in 1944 had been Rs 5,84,283. On 29 January 1948, the company sold the entire holding of 1,10,747 shares for Rs 15,50,458. It deducted the sale proceeds from the book value, thereby claiming a loss of Rs 7,444 on the transaction.

The appellate Tribunal, however, valued the bonus shares at nil and concluded that the company had earned a profit of Rs 3,11,646. This assessment was challenged, and the matter was referred to the High Court, which held that the Tribunal’s conclusion was erroneous because it incorrectly treated the sale as yielding a profit of Rs 3,11,646.

The Supreme Court, speaking through Justices Hidayatullah and Shah, clarified the legal position. It observed that the Income‑Tax Act defines “dividend” and extends the definition in certain respects, but the definition does not encompass the issue of bonus shares as a release of reserves that would be treated as profits. Consequently, the face value of the bonus shares cannot be regarded as a dividend under the statute. The Court explained that a bonus‑share certificate confers upon the holder a right to a proportionate share in the company’s assets and to partake in future profits, not a fixed amount equal to its face value. When a bonus share is sold, its market price may be higher or lower than the face value, demonstrating that the certificate is not a voucher for the face‑value amount. Market price is influenced by many factors, including expected yield, and any detriment to the shareholder must be assessed on a reasonable principle. The Court rejected the method of assigning the cost of bonus shares solely at their face value, finding it inconsistent with factual reality and sound business accounting. The Court disapproved of the authority cited in Swan Brewery Co. Ltd. v. Rex (1914) A.C. 231, approved the approach in Commissioner of Inland Revenue v. John Blott, 8 Tax Cases 101, and referred to Bouch v. Sproule (1887) 12 A.C. 385. The judgment therefore set out a proper framework for valuing bonus shares in tax assessments.

In addressing the issue of how bonus shares should be valued, the Court cited the decisions in Income‑tax, Bengal v. Mercantile Bank of India Ltd., 1936 A.C. 478 and Nicholas v. Commissioner of Taxes of the State of Victoria, 1940 A.C. 744. The Court observed that bonus shares could not be regarded as having cost the shareholder nothing, because the issuance of bonus shares creates an immediate reduction in the value of the shareholder’s original holding. The Court explained that the earning capacity of the capital employed remains unchanged even after a reserve is transformed into bonus shares, but the issuance of those shares causes a corresponding decline in actual or expected dividends and consequently the market price adjusts in response. The Court therefore rejected any method of calculation that assigned a nil value to bonus shares, holding that such an approach was inconsistent with the economic realities of the transaction. The Court further held that when bonus shares rank pari passu with the existing shares, their value may be determined by spreading the original cost of the old shares over both the old and the newly issued shares taken together. In situations where the shares do not rank pari passu, the Court indicated that the price might need to be adjusted in proportion to the face values of the different classes, provided no other distinguishing circumstances exist, or on equitable grounds using the market price before and after the issue, taking a middle price that excludes any abnormal fluctuations. Applying this principle to the facts before it, the Court found that the bonus shares in the present case were pari passu with the old shares, and therefore it was straightforward to allocate the original cost between the old and the new shares. The Court noted that the earlier decision in Commissioner of Income‑tax v. Maneklal Chunilal and Sons, Income‑tax Reference No. 16/1948, dated 23‑3‑1949, was disapproved, while Emerald and Co. Ltd. v. Commissioner of Income‑tax, Bombay City, (1956) 29 I.T.R. 814, was distinguished, and Eisner v. Macomber, 252 U.S. 189‑64 L.Ed. 521, was referred to for comparative purposes. In a dissenting opinion, Justice Sarkar argued that the majority view reflected in the Blott case was correct; he explained that when a company’s articles authorize the issue of bonus shares and the transfer of a sufficient amount from accumulated profits to the share capital account, the result is a capitalization of profits and the bonus shares are not income‑liable in the hands of the shareholder. Justice Sarkar maintained that the High Court erred in treating the bonus shares as having been acquired by the assessee at face value, and therefore the profits could not be computed on that basis. He relied on Commissioner of Inland Revenue v. Blott (1921) 2 A.C. 171, and disapproved Swan Brewery Co. Ltd. v. King (1914) A.C. 231, while finding Osborne (H.M. Inspector of Taxes) v. Steel Barrel Co. Ltd., 24 T.C. 293, inapplicable, and also referring to Commissioner of Inland Revenue v. Fisher’s Executors, (1926) A.C. 395, and Commissioner of Income‑tax, Bengal v. Mercantile Bank of India Ltd., (1936) A.C. 478.

The Court noted that certain authorities were cited for their relevance to the question of how to treat bonus shares for tax purposes. It referred to a decision of the House of Lords reported in 1936 A.C. 478, and also mentioned the case of Commissioner of Income‑tax v. Maneklal Chunilal and Sons Ltd., I.T. Ref. No. 16 of 1948, together with Emerald and Co. Ltd. v. Commissioner of Income‑tax, Bombay City, 29 I.T.R. 814. The Court then explained that the decision in the case of Bai Shirinbai Kooka constitutes the authority for the proposition that when the purchase price of a trading asset cannot be shown, the asset must, for tax purposes, be deemed to have been acquired at its market value on the date of acquisition. Applying that principle, the Court held that the bonus shares in the present matter must be deemed to have been acquired at their market value on the date they were issued. The Court further observed that, on the same basis, it would be incorrect to say that the bonus shares were acquired for nothing. Accordingly, the view adopted by the Appellate Commissioner and by the Tribunal could not be sustained. The Court relied on Commissioner of Income‑tax v. Bai Shirinbai K. Kooka, [1962] Supp. 3 S.C.R. 391 to support this conclusion.

The judgment was delivered in the civil appellate jurisdiction in Civil Appeal No. 780 of 1962. The appeal arose by special leave from a judgment and decree dated 28 November 1960 of the Patna High Court, rendered in Miscellaneous Judicial Case No. 724 of 1958. Counsel for the appellant were engaged to present the case, while counsel for the respondent represented the opposing side. The judgment dated 13 March 1964 recorded that a majority opinion was delivered by Justices Hidayatullah and Shah, and that Justice SARKAR filed a dissenting opinion.

Justice SARKAR explained that the matter was before the Court on a case stated by the Income‑tax Appellate Tribunal. The central issue was the method for determining the cost of acquisition of bonus shares in order to compute the profit or loss arising from their subsequent sale. The assessment year in question was 1949‑50, which corresponded to the accounting year calendar 1948. The assessee was a share dealer who held shares both as an investment and as stock in trade. The Court limited its consideration to the assessee’s holdings of ordinary shares in Rohtas Industries Ltd. The factual matrix disclosed that in 1944 the assessee purchased 31,909 shares of Rohtas Industries Ltd. at a total cost of Rs 5,84,283 and continued to hold those shares into January 1945. In that month the company distributed bonus shares at a ratio of one bonus share for each original share, resulting in the issue of an additional 31,909 bonus shares to the assessee. Between that time and 31 December 1947 the assessee sold 14,650 of the original shares. Consequently, on 1 January 1948 the assessee’s shareholdings comprised 17,259 original shares acquired in 1944, 31,909 bonus shares issued in January 1945, 59,079 newly issued shares purchased during 1945 after the bonus issue, and 2,500 further shares acquired in 1947, giving a total of 1,10,747 shares. In the assessee’s books these shares were valued at Rs 15,57,902. In arriving at this figure the assessee had valued

The assessee had valued the bonus shares at their face value of ten rupees each while valuing the remaining shares at their actual purchase cost. On 29 January 1948 the assessee sold the entire holding for a total of fifteen million five hundred thousand four hundred fifty‑eight rupees, which amounted to fourteen rupees per share, and in the return for the financial year 1949‑50 claimed a loss of seven thousand four hundred forty‑four rupees on that sale. The Income‑Tax Officer rejected the claim, holding that the assessee could not assign a cost equal to the face value to the bonus shares because no consideration had actually been paid for them. The officer therefore computed the cost of each bonus share at six rupees eight paise by applying an averaging method, specifically multiplying the total original purchase price of five lakh eighty‑four thousand two hundred eighty‑three rupees by the ratio of the face value of the bonus shares to the number of original shares, that is, three hundred nineteen thousand ninety multiplied by one divided by thirty‑one thousand nine hundred nine. In applying this approach the officer said he was following the Bombay High Court’s decision in Commissioner of Income‑Tax v. Maneklal Chunilal and Sons Ltd. (1), a decision later affirmed in Emerald and Co. Ltd. v. Commissioner of Income‑Tax, Bombay City, Bombay (2). On that basis the officer concluded that the assessee had earned a capital gain of two lakh thirty‑nine thousand three hundred seventeen rupees and accordingly levied tax on that amount. On appeal, the Appellate Assistant Commissioner held that the shares did not constitute investment shares but formed the assessee’s stock in trade, making any profit taxable as ordinary income rather than as capital gains. He further observed that because the assessee had valued its stock at cost and no amount had been paid for the bonus shares, there was an apparent inflation of the opening stock by three lakh nineteen thousand ninety rupees, the amount representing the face‑value cost of the bonus shares. Consequently, the Appellate Assistant Commissioner determined that the assessee was liable to tax on a trading profit of three lakh eleven thousand six hundred forty‑six rupees arising from the sale of the shares. This assessment was affirmed by the Appellate Tribunal, although it is unclear from the record whether the Tribunal characterized the profit as trading income or as capital gains. The question was not raised again after the Appellate Commissioner’s order and does not affect the principal issue for determination. Following the Tribunal’s judgment, the High Court issued an order directing the Tribunal to refer to it the question: whether, on the facts and circumstances of the case, the profit of three lakh eleven thousand six hundred forty‑six rupees computed on the sale of Rohtas Industries Ltd. shares was lawful. The answer to this question hinged on the appropriate cost that should be assigned to the bonus shares. If the Appellate Commissioner’s method of assigning a nil cost to the bonus shares was erroneous, the answer would be negative. The High Court, relying on Lord Sumner’s judgment in Swan Brewery Company Limited v. The King (1) and his later elaboration in Commissioner of Inland Revenue v. Blott (2), concluded that the true cost of the bonus shares to the assessee was their face value and therefore answered the question in the negative.

In this case, the Court noted that the High Court, following Lord Sumner’s judgment in Swan Brewery Company Limited v. The King (1), held that the real cost of the bonus shares to the assessee was their face value and therefore answered the question in the negative because treating them as nil was wrong. The Court further observed that Lord Sumner’s later, more fully expressed comments in Commissioner of Inland Revenue v. Blott (2) certainly supported the High Court’s view. The Court then stated that it would consider the view expressed by Lord Sumner at a later stage. The Court proceeded to mention another case on which the High Court relied, namely Osborne (H.M. Inspector of Taxes) v. Steel Barrel Co. Ltd (3). It expressed the view that the observations of Lord Greene, M.R., in that case, to which the High Court referred, were of no assistance to the matter at hand. The Court explained that the passage cited in Osborne merely stated that when fully paid shares were properly issued for a consideration other than cash, the consideration must be at least equal in value to the par value of the shares and must be based on an honest estimate by the directors of the value of the assets acquired. The Court noted that in Osborne the fully paid shares had been issued in lieu of stocks and that the issue concerned how the stocks were to be valued; consequently, that case had nothing to do with the issue of bonus shares or the ascertainment of the cost of their acquisition. The Court reiterated that, although Lord Sumner’s observation in Blott (2) supported the High Court’s approach, Lord Sumner was in the minority in that decision. The other learned Judges, excepting Lord Dunedin, whose separate view was not relied upon, held that when the articles of a company authorise the issue of bonus shares and the transfer of a sufficient amount out of the accumulated profits in its hands representing their face value to the share‑capital account, the operation amounts to a capitalisation of the profits and the bonus shares issued are not in the hands of the shareholder as income liable to tax. In Blott the articles gave the power which had been exercised. Lord Sumner, however, held that since a company could not issue shares for nothing nor pay for them out of its profits, the transaction should be treated as if the company had issued a cash dividend to the shareholder and had set it off against the liability of the shareholder to pay for the bonus shares issued to him. The Court expressed the opinion that the view taken by the majority of the Judges was the preferable one. When the articles permit the issue of bonus shares and the transfer of undivided profits directly to the share‑capital account, it cannot

In this case the Court observed that it could not be said that a cash dividend had to be deemed to have been declared and then set off against any liability to pay for the bonus shares. The actual transaction, as recorded, involved a resolution passed by the majority of the shareholders that transferred the profits directly into the share‑capital account. By this transfer the shareholders never acquired any right to any portion of those profits. The Court noted that the view adopted by the majority of judges in earlier authorities has since been followed without dissent, and even if that view were open to doubt, the Court would not now be prepared to depart from it. The Court cited two earlier decisions, Commissioners of Inland Revenue v. Fisher’s Executors and Commissioner of Income‑tax, Bengal v. Mercantile Bank of India Limited, the latter being an Indian case, to support this position. The record in the present matter did not contain any reference to the specific resolutions that resulted in the issue of the bonus shares, nor to the exact provisions of the articles of association. Nevertheless, the proceedings before the Court were based on the premise that the bonus shares had been lawfully issued under the powers contained in the articles and that the profits had been lawfully transferred to the share‑capital account without the shareholders acquiring any right in those profits. Relying on the majority opinion expressed in Blott’s case, the Court concluded that the High Court had erred in its view in the present matter. There was no basis for treating the bonus shares as having been acquired by the assessee at their face value, and consequently the profits could not be computed on that basis. The Court examined two alternative methods that had been suggested for ascertaining the cost of acquisition of the bonus shares for the purpose of computing profit on their sale. The first method, employed by the Bombay High Court in earlier cases, involved averaging. The second method attempted to determine the fall in the price of the original shares at the time of the bonus issue and to attribute that decline to the newly issued shares. Both methods, the Court observed, were intended to discover what the bonus shares actually cost the assessee. However, the Court held that this exercise was impossible because the assessee paid nothing for the bonus shares. The suggestion that the assessee might be deemed to have paid the face value of the bonus shares was also rejected, on the ground that no actual amount was paid by the assessee for those shares. For the same reasons, the Court rejected the two proposed methods for ascertaining the actual cost of the shares.

In the present case the Court noted that the authorities cited as (1) (1926) A.C. 395, (2) (1936) A.C. 478 and (3) (1921) 2 A.C. 171, which deal with the cost of shares, must also be rejected. If one were to suggest that those methods are intended to determine the market value of the bonus shares, the Court observed that the relevance of such a market value will become apparent shortly. The Court explained that the only reliable source for market value is the market itself. Consequently the question arose how to determine the cost of the bonus shares. The Court began by stating that no amount was actually paid for the bonus shares; therefore the cost of acquisition is zero. If the acquisition cost were treated as nil, the entire proceeds from any subsequent sale would be regarded as taxable profit. The Court referred to Commissioner of Income‑tax v. Bai Shirinbai K. Kooka (1), where it had endorsed the Bombay High Court’s observation that “obviously, the whole of the sale proceeds or receipts could not be treated as profits and made liable to tax, for that would make no sense” (p. 397). Accordingly, profit cannot be measured on the premise that the bonus shares were acquired for nothing. The view adopted by the Appellate Commissioner and the Tribunal was therefore untenable.

The Court then held that the cost price of the bonus shares must be fixed in accordance with the principle articulated in Bai Shirinbai Kooka’s case (1). In that precedent the assessee had bought shares many years earlier as an investment at a price lower than their later market price and had begun trading them from 1 April 1945. The issue before the High Court was how to compute the profit on the sale of those shares. While the sale price was known, the cost price was in dispute. The High Court resolved that, to obtain real profit, one must examine the business accounts on commercial principles and interpret profit in its ordinary commercial sense, a meaning that no businessman would misinterpret. The High Court concluded that the shares cost the assessee the amount actually paid for them, but for the business the shares cost nothing more or less than their market value on 1 April 1945, the date the business commenced. The Supreme Court fully approved those observations. Hence, Bai Shirinbai Kooka’s case (1) stands for the proposition that where the amount paid for a trading asset cannot be demonstrated, the asset shall, for tax purposes, be deemed to have been acquired at its market value on the date of acquisition.

Applying that authority, the Court held that the bonus shares in the present matter must be deemed to have been acquired at their market value on the date of issue. Accordingly the Court answered the question posed in the negative. (1) [1962] Supp. 3 S.C.R. 391. Hidayatullah.

In this appeal, the Commissioner of Income‑tax for Bombay posed the significant issue of how an assessee who carries on a business of dealing in shares must value bonus shares. The assessee was Dalmia Investment Co. Ltd., which is now known as Shri Rishab Investment Co. Ltd., a public limited company. In the calendar year 1945, Rohtas Industries Ltd. issued bonus shares to its existing shareholders at a ratio of one bonus share for each ordinary share already held. Consequently, the assessee received thirty‑one thousand nine hundred nine bonus shares, each having a face value of ten rupees, which demonstrated that its earlier holding comprised thirty‑one thousand nine hundred nine ordinary shares. The ordinary shares that the assessee had previously purchased were acquired for a total consideration of five lakh eighty‑five thousand two hundred eighty‑three rupees.

The assessment year in question was 1949‑50, which corresponded to the assessee’s accounting period of the calendar year 1948. During that period, the company held shares both as investments and as part of its trading activities. For the shares classified as stock‑in‑trade, the company valued them at the beginning of the year and again at the end of the year, using the cost method for book valuation. Between 31 December 1945 and 1 January 1948, the company sold some of its Rohtas Industries Ltd. shares and purchased others. On 1 January 1948, its holding stood at one hundred ten thousand seven hundred forty‑seven shares, which were recorded in the books at a total cost of fifteen lakh fifty‑seven thousand nine hundred two rupees. On 29 January 1948, the company sold these shares to Dalmia Cement and Paper Marketing Company Limited for fifteen lakh fifty thousand four hundred fifty‑eight rupees. That date fell within the period during which capital gains were taxable, and the transaction resulted in a loss of seven thousand four hundred forty‑four rupees. The company’s books broke down the valuation of the one hundred ten thousand seven hundred forty‑seven shares as follows: the original thirty‑one thousand nine hundred nine ordinary shares were shown with a book value of seventeen thousand two hundred fifty‑nine rupees, representing a proportionate cost of thirteen lakh ten thousand nine hundred fifty‑one rupees; the same number of bonus shares were recorded at a nominal value of three lakh nineteen thousand ninety rupees, calculated at ten rupees per share; newly issued shares amounted to eight lakh eighty‑eight thousand five hundred sixty‑one rupees at cost; and newly purchased shares added two thousand five hundred rupees, representing a cost of thirty‑nine thousand three hundred rupees. The aggregate of these entries yielded the total of fifteen lakh fifty‑seven thousand nine hundred two rupees for all one hundred ten thousand seven hundred forty‑seven shares.

The amount of three lakh nineteen thousand ninety rupees, which represented the cost attributed to the bonus shares in the above schedule, was debited to the investment account and an identical amount was credited to a capital reserve account. The loss of seven thousand four hundred forty‑four rupees was computed as the difference between the claimed cost price of fifteen lakh fifty‑seven thousand nine hundred two rupees for the one hundred ten thousand seven hundred forty‑seven shares and their actual sale price of fifteen lakh fifty thousand four hundred fifty‑eight rupees. The Income‑tax Officer of the Special Investigation Circle in Patna rejected the company’s claim. In his assessment order, the Officer held that the market value of the existing shares at the time the bonus shares were issued was eighteen rupees per share, making the value of the thirty‑one thousand nine hundred nine shares equal to five lakh seventy‑four thousand three hundred sixty‑two rupees (computed as thirty‑one thousand nine hundred nine multiplied by eighteen rupees). He further determined that the shares were sold at a price of fourteen rupees per share. Applying these figures, the Officer referenced a decision of the Bombay High Court in Commissioner of Income‑tax v. Maneklal Chunnilal and Sons and concluded that there was a profit of seven rupees eight paise per bonus share, amounting to a total profit of two lakh thirty‑nine thousand three hundred seventeen rupees, which he classified as a capital gain and accordingly brought to tax.

In the matter involving Maneklal Chunnilal and Sons, the assessment officer concluded that each bonus share yielded a profit of Rs 7/8/0 and that, in aggregate, this resulted in a total profit of Rs 2,39,317/‑, which was characterized as a capital gain. Accordingly, the amount of Rs 2,39,317/‑ was taxed as capital gains. During the proceedings before the Appellate Assistant Commissioner in Patna, reliance was placed on the decision of the Bombay High Court in Emerald and Co. Ltd. v. Commissioner of Income‑tax, Bombay City (2). It was submitted that, by applying the principle laid down in that precedent, the average cost of the shares should be taken as Rs 9/10/0 per share, thereby producing a total profit of Rs 1,49,355/‑. The Appellate Assistant Commissioner rejected this computation. He held that the bonus shares had incurred no cost to the assessee company and consequently omitted Rs 3,19,090/‑ from the book valuation. He then determined that the actual cost of the 1,10,747 shares stood at Rs 12,38,812/‑ and that, contrary to the claimant’s contention of a loss of Rs 7,444/‑ on the sale, the company had actually realised a profit of Rs 3,11,646/‑. Acting on this finding, he issued a notice to the assessee company and enhanced the tax assessment.

The assessee company subsequently appealed to the Tribunal, again invoking the Emerald and Co. Ltd. ruling and asserting that the true profit amounted to Rs 1,57,326/‑. This figure was derived by spreading the cost of the 31,909 ordinary shares across both the ordinary and the bonus shares, adding to half of the cost attributable to the old ordinary shares the cost of new purchases made in the same year, and then determining the average cost of the shares other than the bonus shares. The Tribunal did not accept this methodology. It observed that it was impossible to assign a valuation to shares for which no consideration had been paid and that the old shares and the bonus shares could not be “clubbed together.” Consequently, the Tribunal affirmed the decision of the Appellate Assistant Commissioner. Nevertheless, the Tribunal instituted a reference under section 66(1) of the Income‑tax Act, at the behest of the assessee company, to obtain the High Court’s opinion on the question: “Whether, on the facts and circumstances of the case, the profit computed at Rs 3,11,646/‑ on the sale of shares in Rohtas Industries Ltd. was in accordance with law?” The reference, Income‑tax Reference No. 16 of 1948 dated 23‑3‑1949, was heard by Vice‑President V. Ramaswamy, C.J., and Justice Kanhaiya Singh, J. Both judges held that the Income‑tax authorities were erroneous in fixing the profit at Rs 3,11,646/‑ or any other amount, concluding that there was no profit on the sale of the 31,909 shares and answering the reference in favour of the assessee. Before the High Court, the assessee contended that the bonus shares should be valued at their face value of Rs 10/‑ per share, while the Department maintained that they should be valued at nil. At that stage, the alternative methods of calculating the cost price of the bonus shares were abandoned.

The Court noted that the approach of treating the cost price of bonus shares as nil had been abandoned during the earlier proceedings. The learned Chief Justice Ramaswami and Justice Kanhaiya Singh had held that the issuance of bonus shares amounted merely to a capitalisation of the company’s reserve account or of its profits, and therefore the bonus shares could not be regarded as having been issued free of consideration. They explained that the consideration for the bonus shares derived from the undistributed profits that had been declared as a bonus, and that the face value of the bonus shares represented the loss to the assessee company of those undistributed reserves. Consequently, the present appeal was filed against the High Court’s decision, after special leave had been granted by this Court. The Court observed that, on the facts, four distinct methods could be employed to determine the cost of bonus shares. The first method assigned to the bonus shares a cost equal to their face value, which was the approach adopted by the assessee company in its accounting records. The second method, advanced by the Department, treated the cost as nil on the ground that the shareholder paid no cash for the shares. The third method spread the original cost of the existing shares over the total of original and bonus shares taken together. The fourth method attempted to calculate the decline in market price of the original shares on the stock exchange and to attribute that decline to the bonus shares. Before the Court, the assessee company advocated acceptance of the first method, while the Department pressed the third method. The Court then set out to determine which method properly valued the bonus shares.

The Court found it necessary to examine in detail the contention that the cost of bonus shares should be taken as their face value. This argument required careful analysis because it was supported by certain pronouncements of Lord Sumner, which the Court would consider. Counsel for the assessee, identified as Mr. Kapur, argued that a company could not ordinarily issue shares at a discount, and consequently could not issue shares for nothing. He maintained that the issue of bonus shares involved a dual operation: first, the creation of new shares by the company, and second, the declaration of a dividend or bonus that must be deemed to have been paid to the shareholder, who then returned it in order to acquire the new shares. Since the amount recorded in the company’s books as the shareholder’s contribution of capital corresponded to the face value of the bonus shares, Mr. Kapur asserted that the shareholder’s cost equaled that face value. He relied upon the Privy Council decision in Swan Brewery Company Ltd. v. Rex, wherein Lord Sumner observed that, although the transaction could be described as a single event, it was in reality two separate transactions—the creation and issue of new shares by the company, and the corresponding action by the allottee. The Court therefore proceeded to evaluate whether this reasoning provided the appropriate basis for valuing the bonus shares.

The Court explained that the shareholders satisfied the liability to pay for the bonus shares by consenting to a transfer from the company’s reserves to its share capital. That transfer terminated any claim to the amount of £101,450 that had been attached to the old shares and, in its place, created a general right for the shareholders to partake in the company’s profits and assets in respect of the new shares, without any additional cash contribution being required. The Court further noted that Lord Sumner had maintained the same view later when he sat in the House of Lords in Commissioner of Inland Revenue v. John Blott (2). However, Lord Dunedin and Lord Sumner formed a minority on that issue, and their view was not adopted by the majority of the House.

Given this disagreement, the Court found it necessary to describe precisely what occurs when a company issues bonus shares. A limited‑liability company is required, in its memorandum of association, to state the amount of capital it intends to employ for its business and the number of shares into which that capital will be divided. The company is not obliged to issue the entire authorised capital at one time; it may initially issue only a portion of the capital and later issue further shares from the unissued portion. After the company commences its business and generates profits, it may either distribute those profits to shareholders or retain them as reserves. When the profits are retained, the money is not simply kept in a cash drawer; it is employed in the business and effectively increases the capital that is being used. If the reserves grow to a substantial size, the issued share capital may no longer correspond accurately to the capital actually employed in the business.

At that point, the company may decide to increase its issued capital by declaring a bonus issue. The bonus issue involves giving the shareholders, in place of a cash dividend, certificates that entitle them to additional shares in the enlarged capital. From an accounting perspective, if the company were wound up before the increase in issued capital, the original shares would have yielded to the shareholder the same return as the combination of the old and the new shares after the bonus issue. Thus, what the shareholder previously owned by virtue of the original certificates becomes, after the bonus issue, a larger number of shares documented by more certificates (see (1) (1914) A.C. 231; (2) 8 Tax Cases 101). In real terms, however, the shareholder does not receive cash; instead, he receives a property interest from which future income, in the form of money, may be derived. Consequently, there is no payment to the shareholder in cash; rather, there is an increase in issued capital, and the shareholder’s right to that capital is now evidenced by the greater number of certificates he holds, not by any cash outlay. The Court emphasized that this situation does not constitute a dividend. A dividend, in the strict sense, is a share of the profits that is paid to the shareholder in cash, and only when a portion of the profits is actually released to the shareholder in cash can it be described as a dividend.

In this case the Court explained that when a company converts its reserves into share capital, no profit is actually released to the shareholder; the money stays where it was, namely employed in the business. After the conversion the company treats that money as proper capital that has been issued to and contributed by the shareholders, rather than as a profit reserve. The Court noted that if a shareholder decides to sell his bonus shares, which shareholders often do, he relinquishes his right to participate in the company’s capital, and the cash he receives is the price of that right, not a dividend. The Court pointed out that a bonus share may be sold for more than its face value or for less, which demonstrates that the share certificate is not a voucher for the amount printed on its face. To treat the certificate as cash or as representing cash paid by the shareholder would ignore the internal process that creates the certificate. The Court then referred to the decision in the Swan Brewery case. In that case the company had never distributed all of its profits and therefore possessed a large reserve fund. The company increased its capital and, from the reserve fund, issued shares on a pro‑rata basis. Lord Sumner held that those shares constituted a dividend. The opposing argument claimed that no dividend had been distributed because no cash had been paid out. The Court rejected that argument, observing that after the bonus issue the number of shares doubled while the right of participation remained the same, and therefore the face value of the new shares was treated as a dividend. Section 2 of the Western Australian Act defined dividend to include “every profit, advantage or gain intended to be paid or credited to or distributed among the members of any company.” The Court found it impossible to exclude the bonus shares from that extended definition. Consequently, the Swan Brewery decision was accepted as correctly decided on the special terms of the statutory definition.

The Court then turned to the authority in Blott’s case. Rowlatt, J. observed that the bonus shares fell within the expression “advantage” that formed part of the highly artificial definition of the word “dividend.” The Court of Appeal, through Lord Sterndale, M. R. and Warrington and Scrutton, LJJ, distinguished the case on the same ground. However, the Master of the Rolls pointed out that, in Bouch v. Sproule, Lord Herschell had noted that in such circumstances the company does not intend to pay any sum as a dividend but instead appropriates the undivided profits and treats them as an increase in the capital stock of the concern. The matter proceeded to the House of Lords in Blott’s case. At that stage the Court highlighted that the principal issue was whether a super‑tax was payable on the amount represented by the face value of the bonus share. The Court therefore examined the nature of the bonus share and its treatment for tax purposes in light of the earlier authorities.

In this case the Court explained that the value of a bonus share was represented by its face value. For the purpose of assessing super‑tax, which in India is a tax imposed on the income of an individual, the assessment required adding together income from every source. The super‑tax became payable only when the total income exceeded a prescribed threshold, and the Court described this additional levy as essentially an extra income‑tax, commonly referred to as super‑tax. The Court then set out the positions of earlier authorities. Viscounts Haldane, Finlay and Cave had held that an amount equal to the face value of the bonus shares could not be treated as an amount actually received by the taxpayer. According to their view the issue of bonus shares represented merely the capitalisation of the company’s profits; the certificates issued to shareholders gave them a right to participate in the reserve as part of the capital, not a receipt of income. By contrast Lords Dunedin and Sumner expressed a different view. They described the term “capitalisation” as somewhat hazy and said that the issuance of bonus shares involved a dual operation: on the one hand an amount was released to the shareholder, and on the other hand that amount was retained by the company and applied to the payment for the new shares. The Court then stated that, with due respect, it found the majority opinion expressed by Viscounts Haldane, Finlay and Cave to be the more persuasive, and that its earlier conclusions were substantially in line with that majority view. It reasoned that although profits remain profits while they are held by the company, once those profits are converted into capital instead of being distributed as cash, no income accrues to the shareholder. The new shares merely give the shareholder a larger proportionate title to the surplus assets of the company upon a general distribution. The floating capital that formerly consisted of subscribed capital together with reserves therefore becomes part of the subscribed capital. Consequently the amount that might be described as payable to shareholders as income actually serves only to increase the company’s capital, and the shareholders’ certificates represent a property interest from which future income may be derived. The Court noted that Lord Dunedin did not rely upon Swan Brewery’s case (1914) A.C. 231. He held that because the company could not make a payment for another, the shareholder must be deemed to have paid for the bonus shares out of the accumulated profits, citing the authority (1887) 12 A.C. 385 and 8 Tax Cases 101. Lord Sumner, by contrast, observed that in Swan Brewery’s case he did not depend on the extended definition of dividend in the Australian statute but on the underlying principle. He explained that, as a matter of mechanism, the money released to the shareholder was retained and applied towards the increased capital. Lord Sumner had previously expressed the same view in an earlier Privy Council decision, and the Court mentioned that Swan Brewery’s case together with Blott’s case had been considered by the Privy Council in Commissioner of Income‑tax, Bengal v. Mercantile Bank of India Ltd. and others. Finally the Court recorded that Lord Thankerton distinguished the earlier authorities.

Swan Brewery’s(1) case was applied and Blott’s(2) case was followed, although in Nicholas v. Commissioner of Taxes of the State of Victoria(4) the Court distinguished Blott’s(2) case. The distinction was based on the wording of the Unemployment Relief Tax (Assessment) Act, 1933, which stated that a person’s assessable income includes “any dividend, interest, profit or bonus credited, paid or distributed to him by the company from any profit derived in or from Victoria or elsewhere by it.” Under that statutory definition, bonus shares were to be treated as a dividend.

The Indian Income‑Tax Act also contains a definition of “dividend” and extends that definition in certain respects. However, the Act does not extend so far as to treat the issue of bonus shares as a release of reserves that are profits, which would bring those shares within the meaning of dividend. Consequently, the face value of bonus shares cannot be regarded as a dividend merely by reference to the definition contained in the Act.

A share certificate issued as a bonus confers upon the holder a right to a portion of the company’s assets and an entitlement to participate in future profits. As noted earlier, if such a bonus share is sold, the proceeds may be higher or lower than the face value. The market price of a share is influenced by many uncertain factors, one of which is the expected yield. Any detriment suffered by a shareholder, if any, must therefore be measured on an appropriate principle. Computing the cost of bonus shares simply at their face value does not correspond with the factual situation nor with commercial accounting practice.

The Court considered whether bonus shares could be described as a gift acquired at no cost. At first glance they appear to be so, but the effect of issuing bonus shares must be examined. The issuance immediately creates a detriment to the shareholder in relation to his original holding. The Income‑Tax Officer, relying on the facts of this case, showed that in 1945, when the share price had settled, the market price was nine rupees per share, whereas before the bonus issue the price had been eighteen rupees per share. Thus, the pro‑rata issue of bonus shares, which were issued pari passu with the existing shares, halved the market price, dividing it equally between the old shares and the bonus shares.

This halving is the usual result when the shares rank pari passu. It does not occur when the shares are not pari passu, a situation that will be considered separately. When the shares are pari passu, the situation can be illustrated by saying that a shareholder who formerly possessed a single rupee coin now possesses two fifty‑paisa coins after the bonus issue. The aggregate value remains unchanged, but the representation of that value is now in two certificates rather than one.

The Court quoted the decision of the Supreme Court of the United States in Eisner v. Macomber(1), which expressed the principle that “A stock dividend really takes nothing from the property of the.”

In describing a stock dividend, the Court explained that the issuance of bonus shares does not take anything away from the corporation’s property, nor does it add anything to the shareholders’ interests. The corporation’s assets are not reduced and the shareholders’ interests are not increased. Consequently, each shareholder’s proportional interest remains exactly the same after the bonus issue. The only alteration is the form of the evidence that represents that interest; the new shares together with the original shares together constitute the same proportional interest that the original shares alone represented before the issue of the new ones. In effect, the corporation is no poorer and the stock‑holder is no richer than they were prior to the bonus issue. If the plaintiff derived any slight advantage from the change, it was certainly not an advantage of the $417,450 on which he was taxed. What actually occurred was that the plaintiff’s old share certificates were, in effect, split, and their value was reduced by the amount represented by the new shares. This split necessarily disposes of a portion of his capital interest, just as if he had sold part of his old stock, either before or after the dividend. The portion that he continues to hold no longer entitles him to the same proportion of future dividends as before the sale, and his share of control in the company is likewise diminished. The Court noted that the decision in Swan Brewery’s case was distinguished on the basis of an extended definition, and consequently held that bonus shares cannot be said to have cost the shareholder nothing, because on issuance there is an immediate loss in the value of his original holding.

The Court observed that the earning capacity of the capital employed remains unchanged even after a reserve is converted into bonus shares, but the issue of the bonus shares brings about a corresponding fall in actual or expected dividends and the market price adjusts accordingly. Therefore, a method of calculation that assigns a zero value to the bonus shares cannot be correct. The Court referenced United States Supreme Court precedent (252 U.S. 189‑64, L.Ed. 521) and the case reported in (1914) A.C. 231. It then considered two alternative methods of valuation. First, it noted that the new shares may rank pari passu with the old shares or they may be of a different class, which may require different cost‑accounting approaches, though in principle there is no substantive difference. One method involves determining the exact decline in the market price of the shares already held and attributing that decline to the price of the bonus shares, using a mid‑point price that is not distorted by unusual fluctuations. The second method, suggested by the Department, involves taking the amount the shareholder originally spent to acquire his shares and spreading that amount over both the old and the new shares, treating the new shares as accretions to the old and considering the cost price of the original shares as the combined cost price of the old and bonus shares. Since, in the present case, the bonus shares rank pari passu with the old shares, the Court found that there is no difficulty in spreading the original cost over the combined holdings.

The Court observed that allocating the original purchase cost between the pre‑existing shares and the newly issued bonus shares can be difficult, and it accepted that the Department’s contention in the present case was correct. However, the Court stressed that this observation did not conclude the discussion. It explained that the simple method of cost allocation may encounter problems when the bonus shares do not rank pari passu with the old shares or when the two classes of shares are of a different nature. In such situations, the Court said it may be necessary to compare the market price of the two kinds of shares in order to arrive at an appropriate valuation of cost. In other words, where the shares are not on an equal footing, other evidence may have to be considered to fix the cost price of the bonus shares, and the market result may need to be examined to determine an equitable cost. The Court mentioned that in England, paragraph 10 of Schedule Tax to the Finance Act 1962 provides for similar matters and for valuing rights issues, but it clarified that the present case did not require a discussion of those provisions and that no opinion would be expressed on them. The Court then turned to three authorities that had been referred to earlier and on which reliance had been placed. The first authority was The Commissioner of Income‑tax (Central), Bombay v. M/s Maneklal Chunnilal and Sons Ltd., Bombay (1). In that case the assessee held certain ordinary shares of face value Rs 100 each in Ambica Mills Ltd. and Arvind Mills Ltd. Both companies declared a bonus and issued preference shares in the ratio of two to one, each preference share also bearing a face value of Rs 100. The assessee sold the preference shares and, if the face value were taken as cost, a small profit would have resulted. The Department argued that the entire consideration received on the sale should be taxed because the assessee had paid nothing for the bonus shares and therefore the whole amount represented profit. The assessee contended that the cost of the bonus shares should be taken as their face value. The High Court rejected both submissions and held that the cost of the original shares must be apportioned between the original and the bonus shares in the same proportion as their face values, after which profit or loss should be determined by comparing this apportioned cost with the sale price. The Court expressed a view that the High Court’s decision was difficult to accept, because the preference shares and the ordinary shares could hardly be valued in proportion to their face values, noting that the two classes of shares did not rank pari passu. The second authority cited was Emerald Co. Ltd. v. C.I.T., Bombay City (1). In that case the assessee possessed, at the beginning of the year, 350 shares of which 50 were bonus shares, all having a face value of Rs 250 each. The assessee sold 300 shares and claimed a loss of Rs 35,801 by valuing the bonus shares at face value. The Department, using a different method, arrived at a loss figure of

In the earlier case the Department had calculated the loss by using the averaging method that the Bombay High Court had previously approved, arriving at a loss of Rs 27,766. The Tribunal then proposed a third approach, which ignored the fifty bonus shares altogether and derived the loss by comparing the cost of only the three hundred ordinary shares that were sold with the actual sale price; this calculation produced a loss of Rs 27,748. Although the Tribunal’s figure differed by only eight rupees, it chose not to overturn the order of the Appellate Assistant Commissioner because the difference was considered immaterial. The High Court subsequently held that the Department’s averaging method was appropriate, but on appeal this Court reversed that view and held that, in the circumstances, the Tribunal’s method was the correct one. The Court did not pronounce which of the four possible methods of accounting for bonus shares was the definitive rule, thereby leaving the precise method open for future determination. The factual background involved the assessee originally possessing fifty shares in 1950, receiving an additional fifty bonus shares in 1951, disposing of the original holding three days later, and then acquiring another one hundred shares after a two‑month interval.

During the financial year 1950‑51 (assessment year 1951‑52) the Income‑Tax Officer averaged the cost of one hundred and fifty shares and consequently recorded a profit of Rs 1,060 on the sale of fifty shares, whereas the assessee had claimed a loss of Rs 1,365; the assessee did not pursue an appeal against that assessment. In the following year, 1951‑52 (assessment year 1952‑53), the assessee began with one hundred and fifty shares—comprising one hundred purchased shares and fifty bonus shares—subsequently bought two hundred shares in two separate lots and sold three hundred shares, retaining fifty shares at year‑end. The assessee claimed a loss of Rs 35,801. The Income‑Tax Officer computed the loss as Rs 27,766, while the Tribunal, applying its own method, arrived at a loss of Rs 27,748 but again refrained from altering the Officer’s figure because the difference was merely eighteen rupees. This Court set aside the High Court’s decision, noting that the High Court had disregarded all intermediate transactions and improperly averaged the three hundred shares with the fifty bonus shares, even though those original shares had already been averaged with the bonus issue in an earlier year. The case did not involve bonus shares issued in the year of account; rather, it involved purchases and sales of shares after the bonus issue. The earlier average cost of the original and bonus shares, fixed by the Department in a preceding year, should have been taken into account. Although Chief Justice Chagla observed that it was uncertain which specific shares were sold in the year of account, the Statement of the Case clearly indicated that the bonus shares remained untouched. The precedent set by Emerald Co. Ltd. supports the view expressed herein, namely that bonus shares may be valued by proportionally spreading the cost of the original shares over both the original and bonus issues when the shares rank pari passu; where they do not rank equally, the cost must be adjusted either in proportion to their face values, provided no other distinguishing circumstance exists, or on equitable grounds based on market price movements before and after the issue.

In this case the Court explained that where shares are indistinguishable, their value may be determined either by the nominal value they bear, provided no other circumstance differentiates them, or by equitable considerations that examine the market price before and after the issue. Applying those principles to the facts before it, the Court held that the cost of thirty‑one thousand nine hundred nine shares, amounting to Rs 5,84,283, had to be allocated across both the original thirty‑one thousand nine hundred nine shares and the thirty‑one thousand nine hundred nine bonus shares. Consequently the cost price attributable to the bonus shares was Rs 2,92,141, because the bonus shares were required to rank pari passu with the original shares. The resulting statement of accounts for the Rohtas Industries Ltd share therefore read as follows: the old issue comprised seventeen thousand two hundred fifty‑nine shares carried forward from 1945 with a proportionate cost of Rs 1,58,035; the bonus issue comprised thirty‑one thousand nine hundred nine shares received in 1945 with a proportionately spread cost of Rs 2,92,141; a new issue of fifty‑nine thousand seventy‑nine shares was also carried forward from 1945 bearing a cost of Rs 8,88,561; and new purchases of two thousand five hundred shares brought forward from 1947 carried a cost of Rs 39,300. In total the holding amounted to one hundred ten thousand seven hundred forty‑seven shares with an aggregate cost of Rs 13,78,037. All of these shares were sold in 1948 for a total consideration of Rs 15,50,458, thereby generating a profit of Rs 7,444. The profit to be added to the income returned consequently amounted to Rs 1,79,865. The Court found that the answer previously given by the High Court to the questioned computation was erroneous, and that the profit figure of Rs 3,11,646 had been computed in a manner inconsistent with law. Accordingly the appeal was allowed and costs were awarded both in this Court and in the High Court. The final order recorded the appeal as allowed, citing the reported decision (1956) 29 I.T.R. 814 and the reference UP (D)SCI‑8(a).