Presently, any income arising from the transfer of a long term capital asset, being an equity share in a company or a unit of an equity oriented fund is exempt under the provisions section 10 (38) of Income Tax Act, 1961 (ITA) subject to following conditions:

• The transaction i.e; sale of such equity shares or unit is entered into on or after 1^stOctober, 2004; and
• Such transaction is chargeable to securities transaction tax (STT).

Under current norms, any capital gains from shares held for more than a year are fully tax- exempt if STT of 0.1% is paid at the time of selling them. However, the said STT is not paid when shares are acquired in off- market transactions such as gifts, ESOP’s, etc.

The Finance Bill, 2017 proposes to amend section 10(38) of ITA to provide that “any income arising from the transfer of a long-term capital asset, being an equity share in a company shall not be exempted, if the transaction of acquisition, other than the acquisition notified by the Central Government in this behalf, of such equity share is entered into on or after the 1st day of October, 2004 and such transaction is not chargeable to securities transaction tax under Chapter VII of the Finance (No. 2) Act, 2004”.

However, to protect the exemption for genuine cases where the STT could not have been paid like acquisition of share in IPO, FPO, bonus or right issue by a listed company acquisition by non-resident in accordance with FDI policy of the Government etc., the Finance Minister during his Budget speech has clarified to notify transfers for which the condition of chargeability to Securities Transactions Tax on acquisition shall not be applicable.

This could be relevant, for instance, in cases of misuse of inactive listed companies though price manipulation or mergers, preferential allotment etc. The language of the proposed proviso allows for certain carve outs through the mechanism of notifications for genuine cases where the STT was not paid such as IPOs and FPOs.

The Memorandum explaining the Finance Bill,2017 provides that the intent for the amendment to this section is to prevent its abuse as a modus operandi for declaration of uncounted income as exempt long-term capital gains by entering in to sham transactions.

As per reports of tax department, there exist a trail of INR 38,000 Crores involving manipulation in 84 BSE-listed penny stocks and through 5000 listed and unlisted firms, many of them being shell companies. It says at least 64,811 entities evaded taxes through such fraudulent methods.

Further, as per reports available on public domain, the Securities Exchange Board of India (SEBI) had taken effective action in the recent past in the matter and more than 200 shell companies were suspended and more than 1,300 entities banned from the market for taking the benefit of bogus long-term capital gain. The prima facie amounts involved in tax evasion were quoted as being over INR 15,000 crores.

In many such reported instances, modus operandi followed has been typically on following lines:

• A person, say X, seeking to launder unaccounted money, approaches an entry operator- an agent who controls a large number of paper/shell companies
• The entry operator asks X to buy shares of an illiquid listed penny stock. Alternatively, the agent may arrange for a private placement/preferential allotment of shares in the same company. Typically, these shares are allotted or bought at a very low price-say X buys 1000 shares in company A at Re. 10, spending Rs. 10,000
• The operator starts rigging the price of the listed company through circular trading over a year. The prices of shares are increased to some pre-determined level with the help of the same set of buyers and sellers. Let’s say the price of these shares touches Rs. 500; therefore, the total value of A shares with X equals Rs. 5,00,000
• Once a year is over (holding period to claim capital gains tax exemption), the operator asks X for the unaccounted cash. This cash is routed to the books of various paper companies, Say B, C and D.
• Then, the operator asks X to place a sell order of his shares at a particular lot size and time. Simultaneously, he asks B,C and D to place buy orders for company A shares, matching X’s sell orders;
• Once the trade is executed, X is able to show Rs. 4,00,000 (less initial outlay of Rs. 10,000) as a long term capital gain. This, exempt income from tax, is black money converted into accounted-for money.

This menace of black money conversion using long term capital gains tax exemption and penny stocks was widely used by the companies thereby evading voluminous taxes, thereby creating burden for the honest tax payers.

Speaking at a  CNBC TV18 event, revenue secretary Hasmukh Adhia said the provision was mainly formulated as an anti-abuse provision. “Many penny stock companies were coming up where investors were investing money and inflating the value of stock and then exiting. This is a provision targeted at this kind of transactions. Genuine transactions will not be covered under this provision. The law provides for exemptions and we will notify these to protect genuine transactions,” he said.

The proposed amendment is an anti-abuse measure and part of the larger program of the Government for cracking down on black money, a program which has been reflected in various Budget proposals. While the intention of the Government to crack down on black money is appreciated, the approach of providing a proviso in the legislation but leaving carve-outs for such proviso to be introduced through notifications can create uncertainty for taxpayers. Considering that the carve-outs are meant to be created for genuine transactions, the fallout of the approach is that genuine taxpayers will be put to hardship arising from the uncertainty that their relief would be left to the mercy of notifications. The hope is that the notifications in this regard are drafted with extreme clarity and issued at the earliest.