The Indian domestic tax law has, since October 2004, exempted long-term capital gains realised by investors on transfer of equity shares provided the transaction of sale of such shares is chargeable to securities transaction tax (STT). Investigations undertaken by the market regulator and the income-tax department have revealed that certain market participants were misusing the said exemption for declaring their unaccounted income by entering into sham transactions. Therefore, in continuation of the government’s efforts to prevent abuse of the tax law, the Budget announcement in February 2017 included an amendment to the domestic tax law to curtail the long-term capital gains exemption to only those share acquisitions (after October 1, 2004) that were chargeable to STT. Power to notify exceptions to this rule was given to the government.
On April 3, 2017, the government issued a draft notification inviting public comments, proposing a negative list of transactions where the exemption would no longer be available. This negative list included preferential issue of shares by a company that is infrequently traded, acquisition of listed equity shares otherwise than through a stock exchange and acquisition of unlisted equity shares of a company during the period between its delisting and re-listing on a stock exchange. In response to the draft notification, concerns were expressed that the proposed negative list was very broad and covered within its ambit a significant number of genuine acquisitions which could be seen by the wider investor community as a back-door approach to reverse the tax policy of exempting long-term capital gains on STT paid share transfers.
On June 5, 2017, after extensive stakeholder consultation, the government issued the notification largely maintaining the negative list proposed in the draft while including a number of carve-outs to protect genuine acquisitions for which the exemption would continue to be available.
Carve-out for preferential issue of shares by a company that is infrequently traded includes acquisition of shares by non-residents in accordance with the Foreign Direct Investment policy, share acquisitions by institutional investors such as Sebi-registered Alternative Investment Funds, Venture Capital Funds and other Qualified Institutional Buyers (QIBs). QIBs as defined in the Sebi regulations notably excludes Category III Foreign Portfolio Investors who would need to analyse the impact of preferential issues in which they may have participated. Preferential issue of shares approved by the Supreme Court, High Court, National Company Law Tribunal, Sebi and RBI have also been protected. It is expected that share issuances that are excluded from the definition of preferential issue under the relevant Sebi regulations (viz public issue, rights issue, bonus issue, employee stock option/ stock purchase scheme, qualified institutions placement, sweat equity shares, etc) should continue to be exempt.
As regards acquisition of shares not entered through a stock exchange, in addition to carve-outs provided in the context of preferential issues, exclusions have been provided for share acquisitions by scheduled banks, reconstruction companies, securitisation companies and public financial institutions during the ordinary course of their business. Further, acquisition of shares from the government or acquisitions in a scheme framed under the Sebi ESOP guidelines, under the Sebi takeover code and acquisitions by a mode of transfer which are not considered taxable under the domestic tax law (viz mergers, demergers, etc) or by way of purchase in a slump sale, provided the transferor was eligible for the capital gains exemption under the notification had such shares been sold by the transferor.
As such, no carve-outs have been provided where a person acquires shares of a company pursuant to its delisting where the company is subsequently listed. Such investors would be taxable on their gains even if the transfer is undertaken on a stock exchange and STT is paid on such transfer. Present and potential investors in such companies would need to factor the taxation of their gains on divestment going forward.
It is evident from the notification that the government has made a very honest endeavour to enlist exceptions to protect genuine share transactions based on feedback received and the effort deserves due credit. By its very nature, it would have been very challenging to bring in the amendment to the law in its present form without impacting some genuine acquisitions. One expects that as the experience in implementation of the amended law and the notification matures, the list of exceptions will be expanded to ensure that only sham or fraudulent transactions are caught within the scope of the amended provisions.
All things said, time will tell whether the government’s design will deter those that abuse the law to secure a tax gain or would it result in hardship to those genuine investors who find themselves caught between the cross fire.
By Subramaniam Krishnan
(With contributions from Amit Gouri, senior tax professional, EY)