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In these times of IPO boom, a question that lurks on the horizon is the tax treatment of existing shares offered for sale (OFS). For sellers (usually the promoters), the trigger of capital gains tax at the OFS event is a known devil. However, the malignancy of the spirit is discovered when one goes to the drawing board to ascertain their capital gains tax liability.
One area of squabble is the determination of the period of holding of shares alienated in an OFS and the consequent applicable income tax rate. The rate of tax prescribed under IT Act for long-term capital gains arising from sale of shares is lower than that prescribed for short-term capital gains on share sale.
Characterisation of shares as long-term or short-term is a factor of its period of holding by the seller. It differs between a share listed on a recognised stock exchange in India, which is required to be held for more than 12 months for it to be a long-term capital asset. Comparatively, for an unlisted share, the minimum holding period is 24 months.
Differential tax treatment
This differential tax treatment between listed and unlisted shares has landed taxpayers in a quandary on typifying shares being sold in OFS. SEBI ICDR Regulations mandate that shares offered in an OFS shall be held by the selling shareholders for at least one year prior to the date of filing the DRHP.
The question is, what happens in cases where the shares were held for over a year, but for under 24 months? After all, the OFS happens through the bidding platforms of the stock exchanges, which then makes them more in the nature of listed shares.
However, OFS is a means to get listed and a stage anterior to listing. Hence, OFS shares could be construed as unlisted shares subjecting them to a longer (24 months) period of holding to be eligible for a beneficial capital gains tax rate. This difference of opinion and the consequences it may have on tax outflows warrants a specific clarification from tax legislators on treatment of share offloads in OFS.
As per Memorandum to Finance (No 2) Bill, 2014, a shorter period of holding of not more than 12 months for consideration as short-term capital asset was introduced for encouraging investment on stock market where prices of securities are market determined. Pricing mechanism for sale of shares through an OFS is also market based and OFS shares do get subsequently listed.
Therefore, a clarification providing for a shorter period of holding for OFS shares would be consistent with the intention of the legislature. For OFS shares which do not get subsequently listed, the longer period of holding currently prescribed could continue to be applicable.
The case for testing OFS shares against a shorter holding period may gain credence when one considers that, similar to listed shares, sale of OFS shares is subject to Securities Transaction Tax (STT).
Given the line-up of upcoming IPOs in the current financial year, it is only reasonable to assume that the share of STT collected from OFS shares will not be insignificant when compared with STT collected from listed shares in the overall STT pie. Therefore, it appears that it is only justified that this extra outflow from sellers in the form of STT while selling OFS shares is compensated by way of a shorter period of holding.
Pre-OFS events and the added enigma
It is common for corporates to split their shares prior to listing to make the shares seem more affordable to small investors. The IT Act is silent about whether the period of holding of original shares should be after the split or would include the pre-split period too. A clarification on this is needed.
Corporates are also required to dematerialise their shares prior to listing if they are not already dematerialised. Shares which are held in a dematerialised form are fungible in nature i.e., all dematerialized equity shares are identical and interchangeable. It is for this reason that it is not possible to link the purchase of a share with its sale.
The IT Act provides that the period of holding of shares held in dematerialised form shall be determined on the basis of FIFO method. When applied to a demat account holding, it implies that out of existing holdings, the item that first entered into the account is deemed to be first to be sold.
In many cases of a company which is undertaking an IPO, all shares are dematerialised at one go. Difficulty arises in applying FIFO method in such cases because it becomes impossible to determine which share is sold out of the fungible lot. This brings into focus the issue of whether the start date for computing period of holding of dematerialised shares should be the actual date of purchase of shares or date of dematerialisation of such shares.
A booming capital market is an indicator of positive investor sentiments in India. It would be unfortunate if tax uncertainties play a spoilsport and create bottlenecks in the IPO party. Clarifications on these uncertainties are much needed to assuage frayed nerves of capital market players and maintain the IPO momentum.
The authors are Partner and Associate Director, respectively, with Nangia Andersen, a law firm
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