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Advocate Arjun Gupta has discussed the taxability of penny profits in light of the recent changes to Section 68 of the Income Tax Act and the decisions of various courts. He also argued that the law places an unfair burden on taxpayers and is not workable.

A study of Section 68 of the Income Tax Act, 1961 w.r.t Penny Stocks


Until now, the term 'Penny Stock' has not been specified under any new Indian legislation but has often been subject to substantial tax litigation in progress. The term could be represented as ' a stock sold at an unusually low price, ' which derives its meaning.

As normal, the tax authorities are responsible for taxation the Long Term Capital Gain ("LTCG") or Short Term Capital Gain ("STCG") arising from the selling of these securities at abusively high prices in compliance with Section 68 of the Income Tax Act of 1961(the "Act"). According to the assessing officer, in such situations, the modus operandi followed by the taxpayer is first to send uncompiled money by operators/enterprises/associates, which exponentially inflate the stock price and then sell the same penis stock at that inflated price.

Not only is it a single buyer who drives the price but a host of others, who make up a racket. The parties involved in such a scam are performing a series of transactions to increase the price of a single penny stock. These vendors receive a fee for their illegal activities. Exit sellers are stock owners, while so-called ' beneficiaries ' are stockholders who discharge their stocks and profit unlawfully.

The increase in stock from these sales is immense and, for those securities kept for more than a year, the capital gain under Section 10(38) of the Act would be excluded, given that the sale has taken place before April 1, 2018. As a result, once the penny stock price crashes due to the equity disbursement, the other creditors on the market are left high and dry, while the assessee receives tax-free earnings and is paid for, laundered or charged for, the unearned capital.

This process not only led to the economy being flooded with deep black capital but also had the double effect of allowing taxpayers, under LTCG, to avoid large-scale taxation. What an unrecounted income distribution system via the capital market process by buying and selling shares is thus clearly unlawful and must be properly handled.



Section 68 of the Act reads as follows:

Cash credits.

Where any sum is considered attributed to an assessee's accounts kept for any preceding year and no detail on the existence and source of that amount is provided by the assessee, or if, in the judge's opinion, the explanatory explanation proposed by that assessee is not sufficient, the amount so credited may be paid to the income tax of the assessee in the preceding year:

Where a company (not a company in which the public is significantly interested) is an assessee and the sum credited in such a manner consists of the share request money, share capital, share premium or any other sum, by whatever name it is named, any explanation provided by that assessee company shall be deemed not satisfactory unless otherwise specified.

(a) the person, being a resident in whose name such credit is recorded in the books of such company also offers an explanation about the nature and source of such sum so credited; and

(b) such an explanation in the opinion of the Assessing Officer aforesaid has been found to be satisfactory:

However, if the person on whose behalf the sum referred to herein is reported is a venture capital fund or a venture capital company under clause (23FB)of Section 10, then nothing found in the first proviso is applicable. 

Section 68 burdens the assessor with proving the source of any amount found credited to his account books. To attract Section 68 of the Act, tests set down in the recent judgment of the Superior Commissioner of Income Tax (Central) – 1 Vs. NRA Iron & Steel Pvt by different courts including the Hon'ble Supreme Court. Ltd. [ 2019 ] 412 ITR 161(SC) is the proof of the investor/creditor identity and creditworthiness and the genuineness of the transaction. Once the evaluating officer has satisfactorily explained all three elements, the client is responsible for disproving the genuineness of the deal.

The financial act, 2012 w.e.f. 1-4-2013 introduced the two provisions of section 68 of the Act. The Memorandum of Objects and Reasons states that the reason for introducing these provisions should be that they place additional burdens upon close owners since they generally receive money from private individuals known to them, the share application, share capital, share premiums or any such similar amount received by such companies and thus those persons investing in those companies. It was also made clear that nothing in those provisions will apply to a well-regulated entity, such as a risk capital fund or a risk capital firm registered in the Indian Securities and Exchange Board (SEBI).

The amendment was made with a view to overcoming the ruling in the case of the Income Tax Committee vs. Lovely Exports (P) Ltd.[2008 ] 299 ITR 268 (SC), which ruled that if money from the alleged bogus shareholders had been received by the Supreme Court, its assessments could be re-opened in compliance with the law. This resulted in the assessee's deduction from funds in the form of the equity offer money/share premium is earned.

The section requires that the investor must determine further the source of the funds obtained by the Assessee company in addition to the fundamental requirement of the Assessee company that defines the nature and source of the funds that the investor receives. The source of the funds up to two points thus needs to be proven. In the past, the assessee just needed to establish the identity and creditworthiness of the lender and the genuineness of the contract, which meant that it was immaterial to show how the funds were being obtained.

Thus, the proviso has placed an additional burden upon the assessee investor by requiring the assessee investee company to understand the source when that is not practical and to make matters worse by subjecting the assessee to taxation, by taxing such income as cash credits in accordance with section 68 of the Act, instead of taxing investors bringing into illegal funds.

The written complaint pursuant to Article 226 of the Indian Constitution must be submitted in unconstitutional protest against the provision and in gross violation of Article 14. It is entirely impractical that the assessee creditor company knows the origins and conducts due diligence with respect to investments. While the proviso may apply to only closely held companies, people other than families, friends, and relatives that are investing in the company can be misinterpreted, because it would be extremely difficult to define what is called "family," what are "relatives" and, especially, what kind of "friends" that invest in the assessee, and to what extent a company can be described as "close holding."

There are a number of other problems arising from the interpretation of this rule, what if investors are known as friends, relatives or family to the assessee company but are not closely owned, will the proviso apply? Therefore, can the assessee party be held to account if there is no conspiracy between the parties if the funds are not paid for? Can the assessee be taxed only on the grounds that it failed to exercise due diligence on non-compliance funds invested in the form of shares or securities, for which it considered the investors? The proviso is impracticable and in direct violation of Article 14. It will only trigger the assessor's unreasonable problems and raise lawsuits.

In the case of the Income Tax Commissioner Vs. NR Portfolio Pvt. Ltd. (2014) 264 CTR (Del) 258 An amendment was discussed in Section 68. Speaking for the Division Bench of the high court in Delhi, Justice Sanjiv Khanna observed that it is indeed difficult for such companies to explain the source or origin, but that the proviso will be applicable depending on the facts and circumstances of the case. Therefore, if the assessee is unwilling or unaware of the source of the investor's funds, the proviso may not apply. If the contract is not an arms-length deal or if the assessee is interested in the trade, the proviso applies.

With regards to the extent to which "involvement" exists between the parties, it is impossible to really ascertain whether there is no involvement or whether the income can say there is participation. Whether or not this involvement is sufficient to tax funds in the hands of the assessee company or permit an investigation into the source of the funds invested, and what is the true nature of the involvement between the parties, that is, how they are involved or known to each other, would be impossible to establish and unfair to that assessee, since the funds should be taxed in h Furthermore, this trivial factual consideration can not be based on the law as it is not only harsh and oppressive but vague and not capable of precise determination.

To sum up:

(i) Taxing unaccounted funds in the hands of the assessee company by requiring it to have knowledge of the source is not practical.

(ii) An act of collusion needs to be proved to show that the assessee company received unaccounted money in the form of investment and is liable to pay tax on the same. This is very difficult to prove and in most cases, the result would be that the assessee had no knowledge of the funds invested.

(iii) Even if the proviso is to be applied based on the facts and circumstances of each case, to prove involvement/knowledge between parties inter se cannot be fastened upon the assessee or the investor, at the most, it can be an onus upon the Revenue to establish the same.

(iv) The provision is arbitrary and one sided inasmuch as if funds are received from friends, family or relatives and the company is not closely held, that portion of investment would in all probability escape income tax.

(v) In cases where no collusion is established between the parties, can the assessee company be made liable on the ground that it failed to conduct due diligence of the funds invested? The answer is obviously No. However, then can the assessee company escape payment of tax altogether even if the case falls squarely within the proviso? The proviso would definitely require reconsideration.

(vi) The law cannot be premised on considerations such as proximity of the relationship between two persons or their knowledge into each others’ business affairs.

(vii) The proviso, in other words, is unworkable and impractical and causes undue hardship to the assessee. At the same time, it leaves scope for mass litigation and the opportunity to exploit its various loopholes.

In view of the above discussion, the provision ought to be struck down as unconstitutional.


In a recent decision in the case of Vijayrattan Balkrishan Mittal and Ors of the Tax Appeal Tribunal ("ITAT"). Vs. Dy. Vs. Dy. On 01 November 2019, the following authorities held that the LTCG had been deemed to be unexplained cash credits under Section 68 of the Act. Commissioner of Income Tax, Central Circle-8(1)ITA Numbers 3429, 3428, 3427, 3311, 3312, 3313, 3314, 3426, 3256, 3247, 3265 and 3244/Mum/2019 The year of assessment was: 2012-13; 2013-14; 2014-15; 2015-16. The facts are this: the acquired 1,50,000 shares of Rs. 10/- each of the companies listed on the Bombay Stock Exchange(BSE) Pine Animation Limited (PAL). The payment was made to PAL through an Rs. 15,00,000/-cheque. The Assessee filed before the Assessing Officer and the Commissioner and before the ITAT, copies of the share application form and the relevant bank statements. The company allocated Rs. 10 1,50,000 shares to the assessee, crediting the shares to the Demat account of the assessee. The sale of shares was fully disclosed in the financial statements for the year ended 31 March 2013. The shares were subsequently divided into Re. 1/-per PAL shares on 21.05.2013. The assessee sold the above shares of PAL on the BSE Platform via its regular broker, M / s, in the fiscal year 2014-15 (FY 2015-16). Geojit, registered with BSE and SEBI, the regulator of the market. For the last 10 years, the assessee had held shares through his broker Geojit. The assessee received the proceeds of selling the shares directly from his broker Geojit and on the date of the settlement, he was credited to his bank account. Copies were provided of the contract notes together with the summary and corresponding bank statements showing the amounts credited. There were also copies of the broker's ledger and 10DB Form. The sales transaction for the shares involved costs such as brokerage, service tax, STT, stamp duty, exchange, and SEBI turnover fees, etc., which was specifically shown in the contractual notes issued by the broker. The assessee earned long-term capital gains (LTCG) in the year under consideration amounting to Rs. 14,00,76,815/- on the sale of PAL shares.

The assessee had 15 lacs equity shares of PAL in previous year, and sold those shares during the year of consideration for a sum of Rs. 14,16,80,449/- after holding them for more than a year. Such acts were sold to BSE and billed STT, Service Tax, Calendar Duty, etc. According to Article 10(38) of the Act, the assessee claimed that LTCG was exempt.

The ITAT noted that it is not necessary to explain the source of the funds. It was also noted that if documents such as contract notes, bank statement and stamp duty, brokerage, STT, etc. were all recorded and established, there appears to be no reason to maintain the orders of the following authorities.

It also found that no addition can be based on mere assumptions and conjectures and without giving an opportunity for cross-examination to the auditor. It further noted that since the assessee was disqualified by SEBI and no adverse judgments against the assessee could not be imposed. It observed further that if there was no collusion in the assessee investing money in the stock market, it can not be concluded that the transaction is not genuine. The extension was therefore omitted.

When reading Section 68 of the Act in plain language, it becomes abundantly clear that the addition must be based on credit entries in the accounts. It must be noted that no indication/reference has been given to any examination of the account books, nor to the scope of the section in the judgment. But as ITAT correctly states, it has been demonstrated, once the required documents are recorded, that there is no collusion between the parties, and the SEBI's order clearly has exonerated the assessee and the exit providers, there is little room for addition under section 68 of the Act.

The situation would have been entirely different if the assessee had shown that the prices were rigged or that the exchange in question caused any kind of fraud. In such situations, the fairness of the contract would thus invoke Section 68 of the Act. Then, if there seemed to be anomalies in terms of selling the shares, the date at which the securities were sold or the actively involved racket of operators jackpotting the share prices, or even the declarations from these operators that they were submitting the assessor accommodation entries, the real nature of the contract would certainly be a concern.

If the assessee himself has invested in shares using unexplained assets, then under section 69 of the Act, the assessing officer may have rendered unexplained investments. The unaccounted money buying in shares would, therefore, be a separate practice that differed from the argument that stock prices were being regulated. The first would be covered by Section 69 of the Act and the latter would be covered by Section 68 of the Act. The assessee will explain why the extension should not be made of accordance with Section 69 at the time of the transaction. Nonetheless, the extension made in accordance with Section 68 of the Act by the appraisal officer has been removed.

Thank you!


Published by

Veronika Desai
Category Income Tax   Report

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