As part of Swachh Bharat mission, the finance minister decided that it was time to clean up a few dirty practices in the Indian stock markets too. The problem in a nutshell—there is no long term capital gains tax (LTCG) if you sell shares of a listed company on the market after a 12 months holding period, but this exemption was being abused to convert unaccounted money via sham transactions. To deal with this malaise, a new provision was introduced in section 10(38) whereby the LTCG exemption for listed shares would be denied in certain situations. While introducing this proposal, the FM was quick to provide assurance that genuine cases will not be adversely impacted.
Availability of LTCG exemption for listed shares is an investment catalyst for all constituents of the market, whether you consider sophisticated overseas investors, organised domestic players or small individual investors. Accordingly, the market was keenly awaiting the draft notification to see which transactions would be exempt and which ones wouldn’t. On April 3, the ministry of finance issued a draft notification where LTCG exemption will not be available if the shares were acquired after October 1, 2004 and securities transaction tax (STT) was not paid at the time of acquisition. To be clear, this entire discussion is not relevant to acquisitions of listed shares prior to October 1, 2004, since they continue to enjoy the LTCG exemption in the same way as earlier.
It would be interesting to see whether the notification lives up to the FM’s stated intention of targeting mischievous elements without causing hardship in genuine cases. Note that the notification is a draft to seek public comments, and a final version is awaited. So, what does the draft notification say? True to the FM’s original promise, several categories of acquisitions continue to enjoy the LTCG exemption fully (pre or via IPO, rights issues, bonus issues, FPOs). The notification says that if you acquired shares of a listed company after October 1, 2004 without paying STT, you can still claim LTCG exemption at the time of sale on the market (by paying STT) in all cases except the following three scenarios, ie, a negative list:
Scenario 1 for issue of shares: Shares of an infrequently traded listed company acquired via preferential issue route (provided that Chapter VII of SEBI ICDR, 2008 on Preferential Issues applies to such issue)
This was expected because it’s a category of transactions (ie, stocks that are not frequently traded on a recognised stock exchange) that features regularly in shams, and hence merits close scrutiny by market regulators. The take away from Scenario 1 is (a) if the company is frequently traded on a recognised stock exchange, all preferential issues are eligible for LTCG exemption (b) all shares issued pursuant to a scheme of arrangement (merger, demerger, etc) or as part of a BIFR approved scheme are eligible for LTCG exemption and (c) all shares issued pursuant to conversion of loan/debt instruments are eligible for LTCG exemption.
Scenario 2 for transfer of shares: Transaction for purchase of shares is not entered via recognised stock exchange
Again, one can understand why off-market trades and transactions outside the recognised stock exchanges would be denied LTCG exemption, but this one could have unintended collateral damage. For example, a foreign private equity investor will now lose the LTCG exemption at the time of sale if it had originally purchased the shares in a secondary trade, because FDI laws force it to buy listed shares only in an off-market trade (foreign investors cannot buy shares of a listed company on the floor of the exchange except in limited instances, eg: it is a registered FPI/FII or already holds a position of control in the listed company). So, the foreign investor is barred by FDI laws to purchase shares on the floor of the exchange, but tax laws will deny LTCG exemption for buying shares in an off-market trade.
Needless to say, if the foreign investor has protection under a tax treaty, that would continue to be available. In view of the above, Scenario 2 could cause hardship and merits a rethink; one option could be to limit application of Scenario 2 only to infrequently traded stocks. A related point of interest would be see if ‘gift’ of listed shares would be outside the ambit of Scenario 2 since it speaks about a ‘purchase’ of shares. Similarly, if shares of a listed company are transferred from one holding company to another as part of a merger/demerger, LTCG exemption should continue to be available since no ‘purchase’ is involved.
Scenario 3 for relisted companies: Shares acquired during the period when a company was delisted
This provision deals squarely with companies that delist for a certain period of time and then list again after a cooling off period. This provision ensures that the shares acquired during the time when the company is delisted are not eligible for LTCG exemption, when sold post re-listing. The language seems to deal with delisted companies and not those whose trading is merely suspended. One area which merits close attention is the impact of this notification on employee stock option plans (ESOP), since it’s a powerful device for employees to participate in the growth of a listed company and build personal wealth.
ESOP schemes would typically involve a fresh issue of stock to employees or a secondary transfer from an ESOP Trust—we hope that the final version of the notification provides a complete exemption for ESOPs since there is some risk of applicability of Scenario 2. Overall, the notification is rightly conceived and achieves much of the agenda that was originally envisioned in Budget 2017. One hopes that the final version (after incorporating public comments) will iron out the wrinkles so that this amendment strikes at the root of malpractices and simultaneously provides the requisite impetus to markets.
(With inputs from Ankit Mohan, senior vice president, M&A, BMR Advisors)