Reopening Blocked Where No Evidence of Assessee’s Knowing Role in Sham Transactions: Gujarat High Court

Background and Context

In Mukundbhai Manubhai Patel Vs ACIT, the Gujarat High Court examined whether reassessment proceedings under Section 148 could be sustained when the assessee had merely invested in a mutual fund scheme later alleged to be involved in sham dividend and loss-generating transactions, without any material showing that the assessee knowingly participated in such alleged tax avoidance arrangement.

The decision directly engages with:

  • The scope of reassessment jurisdiction post Section 148A,
  • The legal treatment of dividend stripping and short-term capital loss claims, and
  • The requirement of a clear nexus between material on record and the belief of income escapement.

The Court’s ruling is grounded heavily in the Supreme Court’s landmark judgment in Commissioner of Income-Tax v. Walfort Share and Stock Brokers P. Ltd. and follows the Bombay High Court’s view in Karan Maheshwari v. Assistant Commissioner of Income-Tax & Ors.

Core Facts of the Case

Filing of Return and Initial Proceedings

  • The assessee filed the Return of Income for Assessment Year 2018-19 on 18.09.2018 declaring total income of Rs.1,67,40,840/-.
  • On 23.03.2022, the Assessing Officer (AO) issued a show cause notice under Section 148A(b) of the Income Tax Act, 1961, enclosing information which allegedly indicated escapement of income for AY 2018-19.
  • The assessee submitted a detailed reply on 28.03.2022 (uploaded on 30.03.2022), asserting that no income had escaped assessment and seeking dropping of the proposed reassessment.
  • On 08.04.2022, the AO passed an order under Section 148A(d) holding it to be a fit case for issuing notice under Section 148, and simultaneously issued the reassessment notice dated 08.04.2022.

These actions were challenged under Articles 226/227 of the Constitution of India by way of a writ petition before the Gujarat High Court.

Basis of Reopening: Alleged Sham Mutual Fund Transactions

Survey on JM Financial and SEBI Guidelines

The AO’s reasons for initiating reassessment traced back to:

  1. A survey under Section 133A conducted on 15.02.2021 in the case of “M/s. J.M. Financial Asset Management Limited” (JM Financial) by DDIT, Unit 3(1), Mumbai.
  2. During the survey, it was allegedly detected that JM Balanced Fund – Annual Dividend Option Regular scheme (“the Plan”) had:
    • Manipulated accounting methodology,
    • Artificially enhanced distributable surplus, and
    • Violated SEBI circular No. SEBI/IMD/CIR No. 18/198647/2010 dated March 15, 2010 regarding “Unit Premium Reserve” and dividend distribution.

The reasons recorded summarised SEBI’s position that “Unit Premium Reserve” must be treated on par with unit capital and cannot be used to declare dividends, and that only realized gains or dividend income generated from investments can form the basis for dividend distribution.

Chronology of the Alleged Scheme

The AO reproduced a chronology for the Plan, including:

  • The Plan initially had a very small AUM of Rs.5,000/- as on 23.09.2014.
  • As on 15.03.2018, AUM was around Rs.6,388/-.
  • Between 16.03.2018 and 22.03.2018, the Plan received massive inflows aggregating Rs.2673.96 crores.
  • As on 22.03.2018, closing AUM was Rs.2,660.95 crores.
  • On 22.03.2018, dividend of Rs.13.00 per unit was declared, resulting in a total dividend payout of Rs.1081.14 crores (about 40% of inflows).
  • Post dividend payout, NAV fell from Rs.32.5 to Rs.22.34.

The AO inferred that the distributable surplus was engineered by misclassifying part of the capital as distributable, in disregard of SEBI’s framework.

Allegations Against the Assessee

Findings Recorded in Section 148A(b) Notice

For AY 2018-19, the specific allegation against the assessee in the notice was:

  • The assessee had shown:
    • A so-called fictitious short-term capital loss of Rs.20,56,835/-, and
    • Dividend of Rs.1,36,79,785/- claimed as exempt under Section 10(35).
  • It was further stated that the assessee had set off this short-term capital loss against other capital gains in the return.
  • According to the AO, since the dividend was alleged to arise from sham transactions in JM Financial’s scheme, it could not qualify as “dividend” nor be exempt under Section 10(35), and the corresponding short-term capital loss also could not be treated as genuine.