Introduction

The Finance Act, 2017 amended the provisions of section 10(38) of the Income-tax Act, 1961 (IT Act). Prior to this amendment, section 10(38) of the IT Act provided that long term capital gains arising from the transfer of listed equity shares of a company would be exempt from capital gains tax, if such transfer was chargeable to Securities Transaction Tax (STT) (i.e. such transfer was executed on a stock exchange).

It was felt that this benefit was being misused. Penny stocks bought using unaccounted income without going through the stock exchanges would then result in exempt long term capital gains. In order to prevent such misuse, the Finance Act 2017 has amended this section to provide that, on the transfer of shares which were acquired on or after 1 October 2004, i.e. since STT was introduced, the capital gains tax exemption benefit would only be available if such shares were acquired after paying STT. However, conscious of many genuine cases where it was not possible to have paid STT for acquisition of listed shares, the Government in the memorandum to the Finance Bill, 2017 also stated that they would notify those acquisitions to which the condition of payment of STT at acquisition shall not apply.  These genuine acquisitions included pre‑IPO or at IPO, a FPO, bonus or a rights issue by a listed company or an acquisition by a non-resident in accordance with FDI Policy, shares acquired under ESOP etc.

Draft Notification

The Central Board of Direct Taxes (CBDT)) has now issued a draft notification, specifying that except for certain transactions of acquisition of equity shares, entered into on or after 1 October 2004, acquisition under all other transactions which did not result in payment of STT at the time of acquisition would be eligible for the benefit under section 10(38). The acquisition of listed shares without payment of STT which do not qualify for the exemption under section 10(38) are as follows:

  1. Acquisition by way of preferential issue of listed equity shares of a company whose equity shares are not frequently traded on a recognized stock exchange.

However, preferential issues not covered under Chapter VII of the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2009, (ICDR Regulations) shall not be covered under this exception and thus, long term capital gains arising from transfer of such shares would continue to be exempt from capital gains tax provided that STT is paid at the time of transfer.  These are as follows:

  1. Pursuant to conversion of loan or option attached to convertible debt instruments in terms of sub-sections (3) and (4) of Section 81 of the Companies Act 1956 or sub-section (3) and (4) of Section 62 of the Companies Act 2013, as applicable.
  2. Pursuant to a scheme approved by High Court under Sections 391 to 394 of the Companies Act, 1956 or a Tribunal under sections 230 to 234 of the Companies Act, 2013, as applicable.
  3. In terms of a rehabilitation scheme approved by the Board of Industrial and Financial Reconstruction under the Sick Industrial Companies (Special Provisions) Act, 1985 or the Tribunal under the Insolvency and Bankruptcy Code, 2016, as applicable

For the purpose of this clause, the term ‘frequently traded shares’ shall mean shares of a company, in which the traded turnover on a recognised stock exchange during the twelve calendar months preceding the calendar month in which the transfer is made, is at least 10% of the total number of shares of such class of the company.

  1. Where a transaction for purchase of listed equity shares of a company is not entered through a recognised stock exchange
  2. Acquisition of equity shares during the period between the delisting of a company from a recognised stock exchange and its re-listing on a recognised stock exchange in accordance with the Securities Contracts (Regulation) Act, 1956 and the SEBI regulations.

The CBDT has invited all stakeholders to provide their comments and suggestions on the draft notification by 11 April 2017.

Khaitan Comment

The notification sets out a negative list and provides that all acquisitions of equity shares other than those set out in such list would not be required to fulfil the condition of STT being paid at the time of acquisition and shall accordingly be eligible for the exemption under section 10(38) of the IT Act. It seems that shares tendered in an IPO as well as acquired under gift, on inheritance, conversion of preference shares/ debentures/ loans into equity shares, shares acquired from company under ESOP etc. would continue to be exempt due to the generic exemption.

As per the notification, preferential allotment of thinly traded shares, covered under Chapter VII of the ICDR Regulations, shall be required to fulfil the condition of payment of STT at the time of acquisition.  Perhaps this is the one that was targeted the most by the introduction of this new restriction on availability of exemption from capital gains tax. 

Further, as per point (b) of the said notification, it appears that only a “purchase” of shares i.e., a secondary transfer, that is not carried out on the stock exchange, attracts the rigours of this amendment. In this regard, considering that point (a) of the list deals with direct allotment of shares in the form of preferential issue and point (b) of the list deals with a “purchase” of shares, it appears that a direct subscription or allotment of shares through an FPO, qualified institutional placement, rights issue, merger or demerger does not fall within the purview of this condition. However, clarity from the CBDT in this regard is highly desirable to avoid doubt and litigation. In addition, while the memorandum to the Finance Bill, 2017 as well as the press release issued in relation to the instant draft notification, indicate that the intention of notifying the transactions is to protect all genuine investments including an acquisition by non-resident in accordance with the extant FDI policy, it seems from the notification, that instances of genuine secondary off-market acquisitions such as private equity investments by residents or non-residents, acquisition of shares by employees from an ESOP Trust and the like would come under the purview of the amendment. We are hopeful that the CBDT shall amend the notification to specifically include such genuine investments in the exempt category.

Having said that, as per the provisions of point (c) of the list, if a primary or secondary acquisition is carried out between the period of delisting and re-listing of the shares of the company on a recognised stock exchange, the condition of STT being paid at the time of acquisition would have to be fulfilled. Accordingly, by implication, it would appear that the transfer of such shares may not be exempt under section 10(38) of the IT Act.