PEs, VCs want clarity on long-term capital gains

With the Budget proposing doing away with long-term capital gains tax exemption if shares have been purchased without paying STT, venture capital and private equity investors want clarification to keep their investment in unlisted companies and ESOPs exempted.
While the new provision is mainly aimed at checking misuse of this exemption for tax evasion through 'sham transactions' in the stock market, it also provides for continued exemption for "genuine cases" where STT could not have been paid like in acquisition of shares in IPOs, FPOs, bonus or rights issue of shares by listed companies by non-resident investors.
However, there is no mention of ESOPs or purchase of shares in unlisted companies by PE or VC investors who typically seek to sell their shares post listing and therefore STT (Securities Transaction Tax) may not have been charged at the time of purchase of shares or grant of ESOPs.

The investors and the start-ups, where a trend is prevalent for grant of ESOPs and investment by PEs and VCs much before listing, fear that the proposed amendment to rules governing tax exemptions for long-term capital gains could potentially place an onerous tax burden on such transactions.
Therefore, they want clarity of application of new rules.
Currently, the income arising from transfer of long-term capital asset, being equity share of a company or a unit of an equity-oriented fund, is exempt from tax.

There is apprehension that any sale of employee stock ownership plans (ESOPs) might also attract long-term capital gains tax as STT was not paid when the ESOPs were issued. ESOPs granted before 2004 might also be taxed if not notified.

The long-term capital gains from sale of unlisted shares in the hands of non-residents attract a tax of 10 per cent.
"With a view to preventing this abuse, it is proposed to amend section 10(38) to provide that exemption under this section for income arising on transfer of equity shares acquired or on after October 1, 2004, shall be available only if the acquisition of shares is chargeable to STT," said the memorandum to the Finance Bill 2017.
However, to protect the exemption for genuine cases where STT could not have been paid like acquisition of share in IPO, FPO, bonus or right issue by a listed company acquisition by a non-resident, it has been proposed "to notify transfers for which the condition of chargeability to STT on acquisition would not be applicable".

This amendment will take effect from the assessment year 2018-19.
IVCA Chairman Rajat Tandon said "it is not clear if VC/PE investments in unlisted shares will suffer higher rates of long-term capital gains taxation when sold after the IPO event".
"An unintended consequence of this rule is to potentially place an onerous tax burden on ESOPs -- which represent the most powerful wealth creation instrument that cash-strapped start-ups use to motivate employees -- when their shares are sold post-listing," he added.