FIFO vs Specific Identification for Physical Shares: Mumbai ITAT’s Clear Stand Against Colourable Tax Devices

1. Background of the Dispute

The decision in Megasolis Renewable Private Limited Vs ACIT (ITAT Mumbai) concerns the manner of computing capital gains on sale of a large block of equity shares of a subsidiary company, where the shares were held in physical form.

The assessee, engaged in the business of power generation and distribution, held equity shares of its subsidiary Brightsolar Renewable Energy Private Ltd. (BREPL). During the A.Y. 2016-17, it sold a substantial portion of those shares and a controversy arose regarding:

  • The correct method of determining cost of acquisition for the sold shares, and
  • The appropriate disallowance under Section 14A of the Income Tax Act 1961.

The Mumbai ITAT ultimately:

  • Confirmed a huge addition of Rs. 10,76,48,000 towards short-term capital gains (STCG) by applying the FIFO method, and
  • Granted partial relief on disallowance computed under Section 14A read with Rule 8D.

The order also contains extensive discussion on colourable devices, substance over form, and reliance on judicial precedents including McDowell & Co. Ltd. v. CTO and Nawal Kishore Kejriwal vs Commissioner Of Income Tax.

2. Facts Relevant to Capital Gains Computation

2.1 Shareholding and Sale Transaction

The assessee held 95,24,000 equity shares of its wholly owned subsidiary BREPL. During the year, it entered into a Share Purchase Agreement dated 17.12.2015 with Trina Solar (Singapore) Third Pte Limited, under which it transferred 46,66,760 shares at Rs. 34 per share, aggregating to Rs. 15,86,69,840.

2.2 Acquisition of Shares – Different Lots at Different Prices

The relevant purchase history, as noted by the Assessing Officer (AO), was:

  • 14.03.2014 – 10,000 shares @ Rs. 10 (Rs. 1,00,000)
  • 26.11.2014 – 61,50,000 shares @ Rs. 10 (Rs. 6,15,00,000)
  • 27.06.2015 – 33,64,000 shares @ Rs. 42 (Rs. 14,12,88,000)

The sale during the year was:

  • 29.01.2016 – 46,66,760 shares @ Rs. 34 (Rs. 15,86,69,840)

2.3 Treatment in Books vs Treatment in Return

  1. Books of account

    • The assessee credited Rs. 5,92,54,720 as “Profit on sale of equity shares” under “Other Income”.
    • This profit was computed using the average cost method in line with Accounting Standard-13 (AS-13), particularly para 22 which requires average carrying amount when part of an investment holding is sold.

  2. Income-tax computation

    • In the computation of income, this profit of Rs. 5,92,54,720 was reduced from business income and
    • Under the head “Capital Gains”, the assessee offered Short Term Capital Gain (STCG) of only Rs. 43,54,240.

Thus, there was a major mismatch between book profit (Rs. 5.92 crore) and capital gain offered (Rs. 43.54 lakh).

3. Assessee’s Method: Selective Specific Identification of Physical Shares

3.1 Assessee’s Computation of Capital Gains

For tax purposes, the assessee did not apply FIFO or average cost. Instead, it claimed to have specifically identified which shares were sold, as under:

  • 33,64,000 shares sold @ Rs. 34 each, claimed as part of lot acquired @ Rs. 42 each

    • Sale value: Rs. 11,43,76,000
    • Cost: Rs. 14,12,88,000
    • Loss: Rs. 2,69,12,000

  • 13,02,760 shares sold @ Rs. 34 each, claimed as part of lot acquired @ Rs. 10 each

    • Sale value: Rs. 4,42,93,840
    • Cost: Rs. 1,30,27,600
    • Gain: Rs. 3,12,66,240

Net result: STCG of Rs. 43,54,240.

The assessee contended that:

  • The physical share certificates carried distinctive numbers and certificate numbers.
  • Thus, each lot was clearly identifiable, and
  • It was legally permissible to select specific certificates to be transferred, thereby using the “Specific Identification Method” for computing capital gains.

3.2 Core Arguments of the Assessee

The assessee advanced several legal and factual positions:

  1. Section 45(2A) applies only to dematerialised securities, not to physical share certificates.
  2. CBDT Circular No. 768 dated 24.06.1998 and Section 45(2A) were introduced due to the fungible nature of demat holdings, where individual identification is impossible.
  3. For physical shares, where distinctive numbers are available, the default rule under Section 45 and Section 48 is to compute capital gains using actual identifiable cost, not FIFO.
  4. AS-13 is relevant for financial reporting, not for tax computation. Thus, the use of average cost in books cannot bind the assessee for income-tax purposes.
  5. Reliance was placed on:
    • Decision of Savyasachi Constructions P Ltd (Hyderabad ITAT), and
    • Bright Star Investment (P.) Ltd ((2009) 120 TTJ 498),
      to argue that where the law does not prescribe a specific method, a method beneficial to the assessee may be adopted if it is otherwise permissible.

The assessee also furnished: