Capital generation capability not profit generation ability to be seen for investment – ITAT

Capital generation capability not profit generation ability to be seen for investment – ITAT deleted addition u/s 68 

In a recent judgment, ITAT Delhi deleted addition u/s 68 and held that tax authorities erred in believing that new investment can be made only on the basis of profit generation ability instead of capital generation capability of the entity. 

ABCAUS Case Law Citation:
4302 (2024) (10) abcaus.in ITAT

In the instant case, the assessee had challenged the order passed by the CIT(A) / National Faceless Appeal Centre (NFAC) in confirming addition made u/s 68 of the Income Tax Act, 1961 (the Act)  towards share subscription money received by the appellant for issuing Compulsory Convertible Preference Shares (CCPS) to a Limited Liability Partnership (LLP).

The appellant assessee was a limited company and was engaged in the business of providing car rental services. During the year under consideration, the assessee company filed its return of income declaring a loss.

The assessee company had a long-term objective of giving form and structure to the un-organized transportation industry in India. It wanted to create a similar business model as adopted by “Ola” and “Uber” to book cabs with the help of a mobile app. In order to raise funds to execute its business idea and to bring in the required expertise, the assessee, during the year under consideration had issued and allotted equity shares as well as Compulsory Convertible Preference Shares (“CCPS”).

The case of the assessee was selected for scrutiny through CASS for the reason of large share premium received during the year. The AO, during the entire assessment proceedings, primarily verified the valuation of shares done by the assessee, correctness of DCF method adopted for the valuation, and the applicability of the provisions of Section 56(2)(viib) of the Act specifically for the allotment of SEED Compulsory Convertible Preference Shares (CCPS).

However, the Assessing Officer (AO) AO treated the investment by the LLP as unexplained cash credits under Section 68 of the Act mainly on the ground that the said LLP lacked the creditworthiness to make such a big investment on the ground that its statement of income & expenditure and ITR showed Nil Income. Further, the AO observed that the main funds of LLP had come from two managing partners of LLP as unsecured loans which had been diverted to the assessee company for subscribing the CCPS.

Before the Tribunal the assessee filed an application under Rule 29 of the ITAT Rules for admitting the additional evidences to substantiate its case. The Tribunal observed that the documents were relevant for adjudication of the issue raised in the appellate order which substantiated the allotment of shares, the relevant approval by the board and relevant documents submitted before the ROC towards compliance. The Tribunal opined that the said documents were relevant for reaching the decision and accordingly admitted them.

The Tribunal observed that the investment was made by a LLP, the affairs of which were controlled and managed by the managing partners, technically the financials of the company belonged to the partners. The two partners brought capital to the LLP-company initially introduced as unsecured loan in the LLP and the same was utilized to make the investment in the assessee company.

The Tribunal noted that the assessee had already brought on record various documents to prove the source of source and genuineness of the investment. What tax authorities raised doubt was that the LLP had no capital on its own, since it did not have enough profit and capital on its own.

The Tribunal observed that the tax authorities totally ignored the fact that the LLP was mainly formed on the basis and strength of the managing partners. They had already introduced the capital inside the LLP company. With the loan and capital together forms the capital, it was otherwise called quasi capital.

The Tribunal further observed that the lower authorities expected that the new investment can be made only on the basis of profit generation ability of the investors instead of capital generation capability of the entity. Whereas in the instant case, the capital generation of the LLP had to be seen not on the basis of profit generation of the LLP. The existence of the LLP was totally on the basis of its partners. Therefore, there was no reason to doubt the credit worthiness of the LLP. Documents in support of additional evidences did substantiate the availability of source of introduction of capital and source of funds in the hands of the managing partners.

Accordingly, the Tribunal allowed the appeal in allowed the appeal in favour of the assessee.

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