Can a Short-Term Capital Loss from sale of Compulsorily Convertible Debentures be set off against Long-Term Capital Gain under the Income Tax Act?

Yes, provided the loss arises from a genuine transaction supported by documentary evidence and economic compulsion, as confirmed by ITAT Delhi in this case. The law permits such set-off regardless of timing, as long as the loss is real and not artificial.

Does the fact that a company has negative net worth invalidate the subscription price of CCDs for tax purposes?

No. The subscription price at par does not become invalid merely because the company’s net worth is negative. The Tribunal held that subsequent decline in value due to business distress is not evidence of manipulation, especially when the subscription was made to meet genuine guarantee obligations.

Can the timing of capital gain and capital loss in the same assessment year be used to infer tax avoidance?

No. The ITAT explicitly held that coincidence in timing does not equate to design. The law allows set-off of capital losses against capital gains, and the mere neutralization of tax liability does not render the underlying transaction colourable without concrete evidence of sham.

Capital loss set-off from CCDs in financial distress ITAT

The Income Tax Appellate Tribunal, Delhi, has affirmed that a genuine financial distress scenario, backed by documented transactions and economic compulsion, cannot be dismissed as a colourable device merely because it results in tax-neutralizing capital loss set-offs. This ruling reinforces the principle that tax authorities must distinguish between legitimate commercial restructuring and sham arrangements.

Background & Facts

The Dispute

The Revenue appealed against the order of the Learned First Appellate Authority (CIT(A)) which deleted the disallowance of a Short-Term Capital Loss (STCL) of Rs. 12,48,75,000 arising from the sale of Compulsorily Convertible Debentures (CCDs) of M/s MKY Constructions Pvt. Ltd. The loss had been set off against a Long-Term Capital Gain (LTCG) of Rs. 10,38,72,609 from the sale of a residential property. The Assessing Officer (AO) contended the entire sequence of transactions was a pre-planned, colourable arrangement to evade tax.

Key Facts

The assessee, Shri Subhash Chander Agarwal, and his wife, Smt. Shanti Devi, were promoters and guarantors of M/s Action Bridgegap Constructions Pvt. Ltd. (later renamed M/s MKY Constructions Pvt. Ltd.), a road construction company.
The company secured a contract worth Rs. 135.20 crores from Haryana State Roads and Bridges Development Corporation Ltd. in 2015.
The company availed credit facilities from Axis Bank and State Bank of India to execute the project.
Due to litigation over non-payment by the client, the company faced mounting interest liabilities and defaulted on loan repayments.
Banks initiated SARFAESI proceedings and recalled credit facilities by 2018.
To prevent coercive recovery and protect personal assets, the assessee mortgaged their jointly owned residential property at 48/78, West Punjabi Bagh, New Delhi, to Indiabulls Commercial Credit Ltd. and raised a loan.
On 06.09.2018, the assessee subscribed to 2,50,000 CCDs of face value Rs. 1,000 each (total Rs. 25 crores) in the company, using the loan proceeds.
The CCDs were unsecured and carried no interest.
The company’s financial position remained distressed; its auditor’s report for FY 2018-19 and 2019-20 noted negative net worth and going concern issues.
On 08.05.2019, the assessee sold the residential property, realizing Rs. 34 crores (50% share: Rs. 17 crores), resulting in LTCG of Rs. 10,38,72,609 after indexed cost.
On 21.03.2020, the assessee sold 1,25,000 CCDs (50% of holding) at Re. 1 per CCD, realizing Rs. 1,25,000.
An independent SEBI-registered Category-I Merchant Banker valued the CCDs as of 15.03.2020 at a negative fair market value.
The sale price of Re. 1 per CCD was above the negative valuation.
The assessee claimed STCL of Rs. 12,48,75,000 and set it off against the LTCG, carrying forward the balance loss of Rs. 2,10,02,391.
The AO disallowed the set-off, alleging lack of commercial substance and tax avoidance.
The CIT(A) upheld the assessee’s claim, finding the transactions genuine and documented.

Procedural History

06.09.2018: Subscription of 2,50,000 CCDs at Rs. 1,000 each.
08.05.2019: Sale of residential property; LTCG declared.
15.03.2020: Independent valuation of CCDs by SEBI-registered merchant banker.
21.03.2020: Sale of 1,25,000 CCDs at Re. 1 each.
27.09.2022: Assessment order u/s 143(3) r.w.s 144B passed by AO disallowing STCL set-off.
20.05.2025: CIT(A) order deleting disallowance.
26.02.2026: Hearing before ITAT Delhi.
30.03.2026: ITAT judgment pronounced.

The Parties' Positions

For the Revenue (Appellant):

Argued the transaction lacked commercial substance.
Contended the CCD subscription was a sham to generate artificial loss to offset LTCG.
Highlighted the company’s negative net worth, resignation of the assessee as MD before subscription, and transfer of 50% CCDs to wife.
Relied on McDowell & Co. Ltd. and Sumati Dayal to assert the need for substance-over-form analysis.
Claimed the valuation report did not justify subscription at par value.

For the Assessee (Respondent):

Maintained the transactions arose from genuine financial distress.
Emphasized the guarantor liability, coercive bank actions, and necessity to settle dues.
Provided loan sanction letters, bank statements, subscription agreement, and valuation report.
Argued that commercial prudence cannot be judged with hindsight.
Cited CIT(A)’s findings on documentary evidence and absence of collusion.

Relief Sought

The Revenue sought to restore the AO’s order disallowing the STCL set-off of Rs. 12,48,75,000 and denying carry forward of Rs. 2,10,02,391. The assessee sought confirmation of the CIT(A)’s order allowing the set-off and carry forward.

The Legal Issue

The central question was whether a Short-Term Capital Loss arising from the sale of Compulsorily Convertible Debentures, subscribed during genuine financial distress and supported by documentary evidence, can be disallowed as a colourable device merely because it offsets Long-Term Capital Gain in the same assessment year.

Arguments Presented

For the Appellant

The Revenue contended that the transaction was a pre-planned, artificial arrangement designed to neutralize taxable capital gains. It relied on the company’s negative net worth, the timing of the CCD subscription (after loan defaults), the resignation of the assessee as MD, and the subsequent transfer of 50% CCDs to his wife. The Revenue argued that no prudent investor would subscribe to unsecured debentures of a distressed company without an ulterior motive. It invoked McDowell & Co. Ltd. and Sumati Dayal to assert that tax authorities may look beyond form to substance and reject arrangements lacking commercial rationale.

For the Respondent

The assessee argued that the CCD investment was a necessary act of financial compulsion to prevent personal liability under guarantee and avoid SARFAESI proceedings. The loan was raised against personal property, funds were used to repay bank dues, and the sale of CCDs occurred only after the company’s condition did not improve. The valuation report by a SEBI-registered merchant banker confirmed negative fair market value, and the sale price of Re. 1 was above that value. The assessee emphasized that the sequence of events was not premeditated for tax avoidance but was a consequence of business failure.

The Court's Analysis

The Tribunal examined whether the transaction was a genuine commercial response to distress or a manufactured tax avoidance scheme. It noted that the Revenue did not dispute the authenticity of any document - the loan agreement, bank statements, subscription deed, or valuation report were all verified and unchallenged.

"The investment in CCDs was not a case of parking surplus funds for earning return but was a case of financial compulsion arising out of guarantee obligations."

The Tribunal rejected the Revenue’s reliance on McDowell & Co. Ltd. and Sumati Dayal, observing that those cases involved deliberate structuring to avoid tax through artificial transactions with no underlying economic activity. Here, the company had executed a real project, incurred real liabilities, and faced real coercive recovery actions.

The Tribunal emphasized that commercial prudence cannot be judged with hindsight. The fact that the assessee was a seasoned businessman with multiple entities did not negate the reality of personal liability as a guarantor. The resignation as MD before subscription was explained as a step to distance himself from the failing entity - not as a prelude to tax evasion.

"Lack of commercial prudence, in such like transaction cannot be made basis to allege a malice. Every pursuit of business decision making must be examined objectively from perspective of business man not only if it was always a profitable."

The Tribunal held that the timing of the LTCG and STCL in the same year was coincidental, not orchestrated. The law permits set-off of capital losses against capital gains, and the mere fact that the loss neutralized a gain does not render the loss artificial. The absence of any money trail back to the assessee, the negative valuation, and the documented financial distress collectively negated the allegation of colourable device.

The Tribunal also dismissed the argument that the valuation report failed to justify the subscription price. It noted that the subscription was at par, and the subsequent decline in value was due to unforeseen business failure - not manipulation.

The Verdict

The appeals filed by the Revenue were dismissed. The ITAT Delhi upheld the CIT(A)’s order, allowing the set-off of Short-Term Capital Loss of Rs. 12,48,75,000 against Long-Term Capital Gain of Rs. 10,38,72,609 and permitting the carry forward of the unutilized balance loss of Rs. 2,10,02,391. The Tribunal directed that the assessment order be modified accordingly.

What This Means For Similar Cases

Genuine Financial Distress Overrides Suspicion of Tax Avoidance

Practitioners may now argue that transactions arising from real business distress - including guarantee obligations, bank recovery threats, and asset liquidation - are protected from being labeled as colourable devices.
Tax authorities must produce concrete evidence of collusion or sham, not merely rely on the timing of gains and losses.

Valuation Reports and Documentary Trail Are Critical

Independent, SEBI-registered valuation reports carry significant weight in validating the fair market value of non-traded instruments.
Maintaining complete documentation of loan disbursements, bank communications, and corporate resolutions is essential to substantiate commercial intent.

Substance Over Form Requires Contextual Application

The doctrine of substance-over-form applies only where there is no underlying economic reality. Where real liabilities, real assets, and real distress exist, the form of the transaction (e.g., CCDs) cannot be disregarded.
Courts will not penalize business owners for taking desperate but lawful steps to protect personal assets from coercive recovery.
Do not assume that high-value transactions involving family entities are inherently suspect.
Always document the chain of financial compulsion - from loan default to guarantee liability to asset liquidation.
Avoid speculative arguments about "what a prudent investor would do"; focus instead on what the taxpayer actually faced and how they responded.

Section 45 IT Act | Genuine Financial Distress Validates Capital Loss Set-off from CCDs : ITAT Delhi