Capital Appreciation On Conversion Of OCRPS Into Equity Shares Not Taxable Under Section 56(2)(x)

Facts of the case

• The assessee¹ , a private limited company incorporated in Mauritius, acts as an investment holding company by investing in securities of Indian companies and does not conduct any business in India or elsewhere.
• For the Assessment Year ('AY') 2022-23, the assessee was a non-resident under the Income-tax Act, 1961 ('Act') and a tax resident of Mauritius as per the India – Mauritius Double taxation avoidance agreement ('DTAA').
• For the year under consideration, the assessee was allotted 43,56,57,000 Optionally Convertible Cumulative Redeemable Preference Shares ('OCRPS') of Thomas Cook (India) Limited ('TCIL'), a listed entity, on private placement basis at a per share price of INR 10.
• The OCRPS were convertible at a predetermined price of INR 47.30 per share, which represented the fair market value of equity shares of TCIL on the date of issuance and allotment of the said OCRPS.
• Upon conversion of 30,27,20,000 OCRPS during the year under consideration, the assessee received 6,40,00,000 equity shares of TCIL at a pre-agreed conversion price, resulting in increase of its holding in TCIL from 65.60% to 70.58%. The assessee earned capital gains from sale of such equity shares.
• The assessee's case was selected for scrutiny and notices were issued by the Assessing Officer ('AO'), wherein the AO computed the fair market value of equity shares as per Rule 11UA of the Income-tax Rules,1962 ('the Rules') at INR 66.15 per share and issued a draft assessment order proposing to tax the difference between INR 66.15 per share and INR 47.30 per share, on the premise that the conversion price of INR 47.30 per share represents the "consideration" under 56(2)(x) of the Act.
• The Ld. Dispute Resolution Panel ('DRP'), confirmed the addition made by AO. Pursuant to which, the AO issued a final assessment order against which the assessee filed an appeal before the Tribunal.
• Among other issues raised before the Tribunal, the core issue was - whether the conversion of OCCRPS into equity shares of TCIL gives rise to a taxable receipt under section 56(2)(x) of the Act.

Observations of the Tribunal

• Section 56(2)(x) is a deeming provision, introduced with an anti-abuse object to tax cases of gratuitous enrichment or colourable value shifting, and cannot be stretched to tax genuine commercial transactions.
• The core enquiry under section 56(2)(x) is identification of "consideration", which must be understood in its ordinary commercial sense. In a conversion transaction, the consideration for receipt of equity shares is the value of the preference shares surrendered at the point of conversion, which is treated as cost of acquisition under section 49(2AE).
• Treating the predetermined conversion price (INR 47.30) as "consideration" amounts to conflating "cost of acquisition" with "consideration", which is impermissible in law.
• The approach adopted by the AO and later affirmed by the DRP, freezes the value of OCRPS at the point of issuance and ignores the natural appreciation, thereby seeking to tax capital appreciation as income from other sources.
• Acceptance of the AO's interpretation would result in layered taxation, first under 56(2)(x) at the time of conversion and again as capital gains on transfer, which is alien to the scheme of the Act and contrary to legislative intent.
• Section 56(2)(x) mandates an "aggregate" comparison between the fair market value of property received and the consideration paid, requiring the transaction to be seen as a whole, not a fragmented per-share comparison.
• Rule 11UA is only a machinery provision which provides a method for determining fair market value once the conditions of 56(2)(x) are satisfied and cannot be used to create a charge by itself.
• The AO effectively sought to tax a legitimate and natural increase in the value of a capital asset, which the Act does not tax at the stage of conversion.
• The Tribunal also noted that conversion of preference shares into equity shares is specifically treated as a tax-neutral transaction under section 47(xb), reinforcing that such appreciation is intended to be taxed, if at all, only at the stage of actual transfer.
• Accordingly, the Tribunal held that the essential condition of "inadequate consideration" was not satisfied, and the addition under section 56(2)(x) was unsustainable and liable to be deleted.

Aurtus Comments

• This ruling clarifies the scope of section 56(2)(x) of the Act in the context of conversion of convertible instruments. The Tribunal has affirmed that section 56(2)(x) is an anti-abuse provision and cannot be invoked to tax normal capital appreciation arising from genuine commercial transactions or used as a substitute for capital gains taxation. The decision draws a clear boundary between anti-abuse taxation and genuine transactions and holds that increase in value of underlying assets at the time of conversion do not by themselves give rise to a taxable receipt under section 56(2)(x).

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