Madras High Court: Suspicion Cannot Replace Proof In LTCG Exemption Cases

In a significant ruling on tax treatment of capital gains from allegedly manipulated penny stocks, the Madras High Court has firmly held that suspicion, however grave, cannot substitute for concrete evidence when disallowing exemptions under the Income Tax Act.

A Division Bench comprising Chief Justice Sushrut Arvind Dharmadhikari and Justice G. Arul Murugan dismissed a batch of appeals filed by the Revenue challenging the deletion of additions totaling ₹70.95 crore made under Section 68 of the Income Tax Act, 1961. The Court upheld the Income Tax Appellate Tribunal's orders that had allowed long-term capital gain (LTCG) exemptions claimed by two assessees—Sohanraj Uttamchand and Sohanraj Praveen Kumar—on sale of shares of PFL Infotech Limited and Risa International Limited.

Suspicion vs Proof: The Core Issue

The case arose from assessments for the year 2014-15. The Assessing Officer had treated gains from sale of shares as unexplained cash credits, alleging that the share prices had been artificially inflated through "pump and dump" operations and that the transactions were accommodation entries aimed at converting unaccounted money into exempt LTCG. The officer cited the meteoric rise in share prices—from ₹22.38 to ₹760 in PFL Infotech, and from ₹10 to ₹600 in Risa International—despite negligible business fundamentals.

However, the Tribunal had deleted the additions, observing that the Revenue's case rested on suspicion without direct evidence linking the assessees to any manipulation. The High Court agreed, holding that the Tribunal's findings were not perverse and warranted no interference under Section 260-A of the Act.

The Revenue's Case: Human Probabilities

Senior Standing Counsel T. Ravi Kumar argued that the transactions defied human probabilities. The assessees had no prior experience in share trading, invested crores in illiquid companies based on an oral "tip" from an unidentified source, and the price movements were scientifically inexplicable. The Revenue relied on statements from intermediaries like Prasanta Bose, who allegedly admitted to providing accommodation entries, and on the Supreme Court decisions in Sumathi Dayal v. CIT and CIT v. Durga Prasad More , which enunciated the "test of human probabilities" for evaluating genuineness of transactions.

Assessees' Stand: Documentary Trail Unbroken

Senior Counsel Srinath Sridevan countered that every transaction was carried out through recognised stock exchanges, Securities Transaction Tax was paid, and sale proceeds were received through banking channels. The allotment of Risa International shares was pursuant to a scheme sanctioned by the Bombay High Court. No regulatory agency—SEBI, stock exchanges, or investigating authorities—had taken any adverse action against the assessees. The buyers were anonymous third parties, and the Revenue failed to complete its investigation into them.

Court's Verdict: No Perversity Found

The High Court rejected the Revenue's reliance on the human probabilities test, distinguishing the cited precedents. The Court observed that Sumathi Dayal dealt with horse race winnings (pure chance) and Durga Prasad More with cash credits lacking documentary trail—both inapplicable to listed securities transactions with full documentation.

The Bench noted that the Tribunal had correctly applied the settled principle from Dhakeshwari Cotton Mills Ltd v. CIT and Umacharan Shaw and Bros v. CIT that suspicion cannot form the basis of an assessment . "The ' test of human probabilities ' ... is undoubtedly a valid and useful tool of appreciation of evidence, but it does not dispense with the requirement that the Revenue must, at the very least, bring on record some positive material connecting the assessee with the alleged design," the Court stated.

Key Observations

The judgment emphasised that mere steep appreciation in share price does not justify treating capital gains as bogus when shares are traded on a recognised stock exchange, STT is paid, and consideration flows through banking channels. The Court noted that the Revenue had not carried its investigation to completion—summonses to purchasers returned unserved without follow-up, and alleged operators were never examined.

" Findings of fact rendered by the Tribunal, being the final fact-finding authority under the Act, are ordinarily binding upon this Court in its appellate jurisdiction under Section 260-A of the Act , unless such findings are shown to be perverse ," the Bench observed.

Final Decision and Implications

The High Court dismissed T.C.A. Nos. 714 and 721 of 2018, confirming the deletion of additions. It also dismissed the connected penalty appeals (T.C.A. Nos. 8 and 9 of 2023) and allowed the writ petitions challenging reassessment proceedings, holding that those proceedings were based on the now-set-aside assessment orders.

The ruling reinforces the principle that tax authorities cannot rely on mere suspicion to deny exemptions when assessees produce credible documentary evidence of transactions through regulated channels. It serves as a reminder that the "human probabilities" test cannot override the requirement of positive evidence directly implicating the taxpayer.