ITAT Upholds Addition for Bogus LTCG from Penny Stocks

ITAT Ahmedabad Upholds Addition of Bogus LTCG from Penny Stocks: A Critical Analysis

Introduction to Bogus LTCG and Section 68

Long Term Capital Gains (LTCG) arising from the sale of shares typically enjoy certain tax exemptions under the Income Tax Act. However, the tax authorities have often scrutinized such gains when linked with penny stocks, suspecting these as conduits for bogus or fabricated LTCG claims to evade tax. Under Section 68 of the Income Tax Act, unexplained cash credits or credits representing unexplained investments can be added back to an assessee’s income if found to be bogus.

The recent decision by the Income Tax Appellate Tribunal (ITAT) Ahmedabad bench upholding an addition of ₹93.92 lakh under Section 68 for bogus LTCG from Kushal Tradelink penny stock shares brings this issue into sharp focus[7]. This blog examines the case, the rationale of the tribunal, and broader implications for investors and tax practitioners.

Understanding the ITAT Ahmedabad Decision on Bogus LTCG

The case involved an assessee who claimed long-term capital gains on shares of Kushal Tradelink, a penny stock company. The Assessing Officer (AO) suspected the LTCG to be bogus, added the amount as unexplained income under Section 68, and disallowed the claim. The assessee challenged this addition before ITAT.

The ITAT upheld the addition based on the “human probability test,” rejecting the assessee’s appeal. This test evaluates the likelihood of genuine transactions by considering the surrounding facts and circumstances. The tribunal found that:

• The transactions did not realistically demonstrate market behavior expected from genuine share transfers.
• The peculiarity of penny stock pricing and rapid unjustified gains suggested manipulation rather than real investment profits.
• The assessee failed to provide sufficient evidence to substantiate the LTCG claim.

Consequently, the tribunal ruled that the amounts credited as LTCG were unexplained and rightly added to income under Section 68[7]. This aligns with the tax department’s broader approach to curb misuse of penny stocks for bogus LTCG claims.

Contextualizing Bogus LTCG from Penny Stocks and Tax Jurisprudence

Cases involving penny stocks and bogus LTCG have proliferated due to the ease of manipulating prices in illiquid penny stock scripts. The Income Tax Department and courts have been vigilant about this issue, frequently relying on investigative reports and deposit trails revealing accommodation entries[3]. The modus operandi often involves:

• Routing unaccounted cash through penny stocks.
• Generating artificial LTCG to convert black money into apparent tax-exempt capital gains.
• Using shell companies with nominal genuine business operations.

While some cases have seen the deletions of such additions when the assessee successfully disproves collusion or the bogus nature of the gains[2], others like the Kushal Tradelink case reaffirm the tax authorities’ stance.

It is important to note that the courts have also ruled that not all penny stock investments are bogus by default. Genuine investments, supported by adequate documentation and lacking suspicious features, may not attract adverse inference or Section 68 additions[6]. However, where human probability and objective analysis denote suspicion, additions are likely to be sustained.

Implications for Taxpayers and Professionals

The ITAT ruling sends a clear message to taxpayers and their advisors dealing with penny stocks and LTCG claims:

• Due diligence and documentation are critical: Maintain detailed records to substantiate the genuineness of every transaction, especially in penny stocks.
• Risk of additions under Section 68: Unexplained LTCG claimed on penny stock sales may attract heavy scrutiny, and taxpayers need to be prepared for rigorous questioning and possible additions.
• Human probability test application: This assessment standard evaluates the realistic nature of transactions based on facts, making subjective claims or mere explanations insufficient.
• Professional prudence: Chartered Accountants and tax consultants must advise clients judiciously regarding the risks of claiming LTCG from illiquid, low-priced stocks.

In summary, the ITAT Ahmedabad decision underscores the importance of genuine market behavior and robust evidentiary support in claims involving capital gains from penny stocks. Taxpayers should be cautious about indulging in or structuring transactions that could be perceived as accommodation entries, lest they face unwelcome additions and litigation.