Exemption from capital gains on sale of equity shares – Misuse and Amendment

Earlier to Finance Act 2017, section 10(38) of Income Tax Act provided opportunity to tax-evaders. It provided the exemption of tax on the capital gains arising on sale of equity shares after one year of its acquisition, if transaction was chargeable to securities transaction tax (STT).

STT was originally introduced in 2004 to stop tax avoidance of capital gains tax. However, recently the government realized that the exemption itself was being misused by certain persons for declaring their unaccounted income as exempt long-term capital gains by entering into sham transactions.

Misuse – Modus Operandi

The operator has clients who wish to convert their black money into white (Mr. X) and also the clients who want their white money to be converted into black money (Mr. Y). In return, the operator gets the agreed commission.

The modus operandi followed by operator was as follows:

• The equity shares of the shell company were listed on a stock exchange. That is, the operator would follow the listing agreement of stock exchange, SEBI regulations and MCA requirements only for establishing a company that has no assets or business in existence.
• The company then makes a preferential allotment of certain number of equity shares at a low price to Mr. X. In some cases, Mr. X would buy the shares from the market on the instruction of the operator.
• As per SEBI regulations, the equity shares allotted on preferential basis are locked-in for a period of one year. This period coincides with the period required to get the capital gain on sale of shares exempted. Thus, Mr. X would hold the shares for the period of one year.
• The prices of the shares were rigged. Rigging of prices involves trading among the group of individuals who have formed the cartel amongst themselves, thereby increasing the demand for shares and consequently its price.
• After completion of one year, Mr. Y who wants black money would buy the shares at high price from Mr. X, thus legally transferring the white money to the bank account of Mr. X. In return, Mr. X will give black money to Mr. Y through operator. Therefore, there is no tax implication on either Mr. X or Mr. Y since capital gain arising on sale of listed equity shares after one year was exempt.
• In cases where there was no Mr. Y, common man was tricked into buying the shares of such shell companies at high prices by sending SMS and other promotional means. The black money of Mr. X will then be stocked by the operator for future needs.
• Also, in cases where Mr. X required instant conversion of its black money without waiting for one year, the back-dated instruments were used for making preferential allotments of equity shares of shell companies at very low price at previous date. This would lead to ‘instantly exempt capital gains’.

This simple technique was used to evade huge taxes and as per the investigation report of income tax department, the income tax department has identified about 64,000 entities who had evaded taxes to the tune of Rs. 38,000 crores.

The role of SEBI is restricted to regulation of stock market and can only act only on those cases where it is able to establish price rigging.

Amendment

The Finance Act, 2017 therefore provided the much-needed amendment in section 10(38) to prevent its abuse. The Central Government also issued notification for the clarification of application of amendment to ensure that the genuine transactions are not denied the exemption.

The amendment states that for claiming exemption of capital gains on sale long term equity shares STT should have been paid at the acquisition of equity shares in specified cases. It is pertinent to note that the earlier provision had the condition of payment of STT only on the sale of equity shares. Thus, now the specified cases will have to fulfill both the conditions that are payment of STT on sale and acquisition of equity shares.

Specified cases

• where acquisition of existing listed equity share in a company whose equity shares are not frequently traded in a recognized stock exchange of India is made through a preferential issue
• where transaction for acquisition of existing listed equity share in a company is not entered through a recognized stock exchange of India
• acquisition of equity share of a company during the interim period from the date on which the company is delisted till the date on which it is re-listed on a recognised stock exchange

This amendment is intended to cover cases where the exemption is already wrongly claimed by entering into sham transactions. Therefore, now the tax officer has a legal backing to disallow the exemption which is wrongly claimed.

First case covers the preferential issue of only that equity shares which are not frequently traded. Therefore the companies controlled by the operator will be covered under this case, since such companies are made only to route the black money and are not actively traded.

Furthermore, second case covers the acquisition of those equity shares which are not preferentially issued but which are bought at the instruction of operator in off-market transaction.

The government went one step further by specifying the third case which covers acquisition of equity shares during the interim period of delisting and re-listing. It may have come to the knowledge of government that earlier the operator would identify those companies which are delisted from stock exchange, enter into an agreement with the promoters of those companies to issue shares to the clients of operator at low price and then re-list the companies on stock exchange again to carry out sham transaction.

In all the above cases, STT would not have been paid at the time of acquisition of shares, since STT is only paid in an on-market transaction and therefore the exemption will be disallowed.

Carve-outs from above cases

However, to protect the interests of genuine investors who would not have paid STT at the time of acquisition of equity shares, the government has carved out certain situations from the above cases. For example, acquisition through IPO, FPO, bonus or rights issue by a listed company; acquisition under ESOPs; acquisition by non-residents in accordance with FDI guidelines; acquisitions which have been approved by the Court/NCLT/SEBI/RBI in the scheme of amalgamation / merger; etc.

Therefore, investors now need to be extra careful while claiming the exemption in section 10(38) and should know whether they fall into any of the cases specified by the amendment or the carve-outs specified in the amendment.

For any deeper discussion on how this issue might affect your business, you can reach us at ersteadvisory@gmail.com