Convertible preference shares (CPS)/Cumulative Convertible Preference Shares (CCPS) are issued with the specific terms and conditions that after a certain period the CPS/CCPS shall be converted into equity shares (or other asset) at a pre-determined price or the price to be determined as per the prescribed formula.
On conversion of a CPS/CCPS, preference shares are redeemed, and equity shares is issued. The issue arose before the courts as to whether conversion of preference shares into equity shares results in capital gains. This is dealt by Tribunal in the following case.
Periar Trading Company Private Limited vs. ITO [2018] 100 taxmann.com 263 (Mumbai – Trib.) – During AY 2012-13, the assessee company converted 51,634 number of cumulative and compulsory convertible preference shares (CCPS) held by it in Trent Ltd., into equity shares. According to AO, the conversion of CCPS into equity shares was transfer within the meaning of the definition provided in section 2(47)(i) of the IT Act. Accordingly, AO taxed difference of market value of 51,634 number of equity shares of Trent Ltd. as on date of conversion and the cost of the acquisition of CCPS as capital gains. The CIT(A) confirmed the order of the AO.
The Tribunal noted that the CBDT vide its Circular F. No. 12/1/84-IT(AI) dated 12.05.1964 has clarified that where one type of share is converted into another type of share, there is no transfer of capital asset within the meaning of section 2(47). The ITAT further observed that the contrary interpretation would lead to double taxation in as much as, having taxed the capital gain upon such conversion, at the time of computing capital gain upon sale of such converted shares, the assessee would still be taxed again, as the cost of acquisition would still be adopted as the issue price of the CCPS and not the consideration adopted while levying capital gain upon such conversion. Accordingly, it was held that conversion of CCPS into equity shares cannot be treated as ‘transfer’ within the meaning of section 2(47) of the Act.
Subsequently the Income Tax Act was amended to provide for following:
Finance Act, 2017 w.e.f. AY 2018-10 inserted clause (xb) in section 47 (transactions not regarded as transfer). Section 47(xb) now provides that any transfer by way of conversion of preference shares of a company into equity shares of that company shall not be regarded as transfer.
Finance Act, 2017 also inserted Section 49(2AE), which provides for cost of acquisition in case of conversion preference shares of a company into equity shares of that company. It provides that in cases referred in 47(xb), the cost of acquisition of the asset shall be deemed to be that part of the cost of the preference share in relation to which such asset is acquired by the assessee.
Other Relevant Provisions
One can also draw reference to clause f to Explanation 1(i) to section 2(42A) which provides for inclusion of period from allotment of preference share to its conversion, for reckoning period of holding. Its provides that “in the case of a capital asset, being a financial asset, allotted without any payment and on the basis of holding of any other financial asset, the period shall be reckoned from the date of the allotment of such financial asset”. Accordingly, holding period of preference shares before conversion will be considered for determining nature of asset (short term v long term) on sale of equity shares post conversion.