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The Union Budget proposal to levy 10 per cent long-term capital gains (LTCG) tax on equity shares acquired by not paying the securities transaction tax (STT) has raised uncertainty in the capital markets.
Experts and tax consultants feel there is now uncertainty on wide ranging off-market transactions such as mergers and acquisitions (M&A), private placements, employee stock options (ESOPs) and private equity (PE) investments in unlisted companies.
Introduced in 2004, STT has to be paid on all securities transactions on the stock exchange platform, in lieu of zero tax on LTCG. In a surprise move, the government now wants investors who haven’t paid STT at the time of acquisition of equity shares or units to pay LTCG. It has said transactions such as a rights or bonus issue or initial public offers of equity (IPOs), where there is no incidence of STT, will be exempt. Market participants believe the measure will impact a lot of other transactions which haven’t found mention in the official proposal.
“The intention is to restrict sham transactions. But, as there are a host of genuine business transactions, it might be worthwhile to evaluate the feasibility of limiting the applicability of this amendment to specified transactions,” said Naveen Aggarwal, tax partner at consultancy KPMG.
A worry is that the move could also apply on fund-level action of foreign portfolio investors (FPIs). For instance, X acquires Y. Then, all the securities owned by X would be transferred to Y. Although X has paid STT while buying these securities, Y will not pay any tax during change of hands from X. Hence, LTCG could be levied on Y if he tries to sell these.
“In the case of FPIs, there are overseas mergers which happen often, due to which the shares in India are transferred off-market, after necessary Sebi (sector regulator) approval, free of price, to another entity. No STT is paid on such transfers. In such cases the acquirer will be subject to tax, as per the Budget proposals. If situations like these are not covered, it will cause hardship to genuine investors. The government should also demonstrate the agility to notify additional situations as and when these are brought to its attention,” said Suresh Swamy, partner at consultancy PwC.
A senior finance ministry official said the government will be issuing final guidelines on the matter, aimed at addressing concerns raised by market players.
The market would like more clarity on private equity (PE) investments in unlisted companies, pre-IPO placements, private placement by a listed company and conversion of ESOPs. Under the current law, these transactions don’t attract any STT, as they don’t take place on an exchange platform. However, if an investor sells shares acquired through these methods, they might not get the zero LTCG benefit. “From the provisions, it is not clear if venture capital or PE investments in unlisted shares will suffer higher rates of LTCG when sold after the IPO event. Another 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 after listing,” said Rajat Tandon, President, Indian Private Equity and Venture Capital Association.
Venture capitalists said the provision could have been introduced as an anti-abuse framework to prevent the use of sham transactions in penny stocks to convert black money into white. However, it could end up hurting genuine investors.
‘‘Global investors have been wary of the tough exit paths for Indian alternative assets (PE, VC infra funds). This only adds to the cost of exit and a dent in revenue for investors,” said Ashish Fafadia, chief financial officer, Blume Venture. Fafadia said the move could be unintentional as after Budget the authorities have tried to pacify the industry by acknowledging they do not wish to tax genuine transactions. It is a common for PE and VC funds to invest in equity shares of unlisted companies and exit such investments through an initial public offering. Experts said while computing gains of PEs and VCs in unlisted shares, the tax authorities should factor their internal rate of return.
